APPENDIX I
SPECIFIC COMMENTS AND RESPONSE TO QUESTIONS
The answers to specific questions posed in the Revised ED are embedded within our updated comments
and cross-referenced accordingly. Our comments related to Disclosures, Presentation and Transition are
included herein while our Recognition and Measurement comments are included in Part II of our letter on
the Revised ED. Our Disclosures, Presentation and Transition comments are organized as follows:
-
-
Disclosures (Question #5)
a. Why Revenue Disclosures Are Important and Require Improvement
b. Overarching Observations Regarding Disclosures
c. General Recommendations for Improving Revenue Disclosures
d. Investors Require Complete Interim and Annual Revenue Disclosures
e. Evaluation of Proposed Disclosure Requirements and Recommendations
- Disaggregation
- Rollforward (Reconciliation) of Contract Balances
- Performance Obligations
- Revenue Recognition Steps and Judgments
- Step #1 (Contract Definition)
- Step #2 (Identifying Separate Performance Obligations)
- Step #3 (Determine Transaction Price)
- Step #4 (Allocate Transaction Price)
- Step #5 (Satisfaction of Performance Obligations)
- Cost Disclosures
Presentation (Question #3)
Transition and Effective Date
1
APPENDIX I
DISCLOSURES (QUESTION #5)
WHY REVENUE DISCLOSURES ARE IMPORTANT AND REQUIRE IMPROVEMENT
The importance and need for improvement of disclosures is supported by CFA Institute member feedback
and an evaluation of revenue disclosures of the 30 companies comprising the Dow Jones Index.
CFA Institute Survey Results Shows Investors Believe Revenue Disclosures
Are Important and Require Improvement
The importance of revenue disclosures to investors and the need for their enhancement is reflected in the
quote below and the results from our 2007 CFA Institute member survey:
Revenue recognition disclosures are often too vague. They include statements of broad principles
(boilerplate) rather than a description of policy alternatives and the choices made. They cover
principal services only and not all revenue sources – Portfolio Manager
Importance
Score
(Mean)
Disclosure
Revenue recognition criteria
4.2
Key qualitative and quantitative assumptions used to determine value
4.2
Description of the underlying method and policy for each measurement basis used
4.1
Description of changes in measurement bases from prior reported periods,
including the reasons for the changes and the effect of making the changes
3.9
Timing of cash flows for contract-based assets or liabilities
3.9
Importance Score = Scale of 1 to 5 (1 = Not important to analysis to 5 = Very important to
analysis) 1
1
The survey conducted in 2007 had 671 respondents.
2
APPENDIX I
Review of Revenue Disclosures of Dow Jones Companies Shows Disclosures Require Improvement
In connection with CFA Institute’s recent webcast on revenue recognition, we reviewed the revenue
disclosures of the 30 companies comprising the Dow Jones Industrial Average 2. The review of the
disclosures highlighted the following matters:
– Boilerplate Disclosures – In most instances, financial statement disclosures were highly generic (nonentity specific) in description and included recitation of accounting guidance rather than a discussion
regarding application of the guidance to entity.
– Difficult to Discern Nature, Significance and Presentation of Revenue Related Balances – In our
review of the revenue recognition policy notes, specifically, and the footnotes, more generally, it was
difficult to ascertain the nature, presentation (e.g. classification as reductions of revenue or expense)
and significance of revenue related matters such as refunds, rebates, incentives, or warranties.
– Poor Quantitative Disclosures – Only 7 of 30 companies provided any quantitative information
regarding revenue recognition.
– MD&A Revealed Revenue Recognition A Critical Estimate in 50% of Companies But No Disclosure of
Quantitative Information Existed – Fifty percent of the Dow 30 companies listed revenue recognition
as a critical accounting policy in the MD&A. However, none of the 15 where it was critical provided
quantitative information to facilitate better understanding of the impact of these critical estimates on
the amounts or timing of revenue recognized. It is great to know something is critical, but not
meaningful if there is nothing to contextualize the significance of the judgements.
– Contract Assets and Contract Liabilities Which Would Necessitate “Rollforward” Aren’t As Prevalent
As One Would Believe Based Upon Preparer Complaints – Surprisingly only 8 of 30 companies
mentioned the existence of deferred revenue (i.e. contract liability) in the accounting policy footnote
with only five mentioning in another note – usually to provide only a balance of the amount. It was
difficult to ascertain what might be considered to be contract assets.
– Multiple Element Arrangements Identified in 40% of Companies But No Significant Discussion of
Estimates – Multiple element arrangements were mentioned by 7 of 30 companies, but there we no
significant discussion of key estimates.
Highly Generic Revenue Recognition Disclosures and
Importance of Revenue to Investors Necessitates Substantial Disclosure Improvements
The aforementioned disclosure review and member feedback demonstrate the poor current state of
revenue disclosures and the importance of revenue to investors and other users of the financial statements.
Both suggest that substantial disclosure improvements are necessary. As we articulate below, investor
needs and the facts versus the myths of the existing disclosures as well as the quality and the time
intensity and cost of the proposed new disclosures needs to be more empirically evaluated.
2
This review was conducted for CFA Institute based on the 2010 Annual Reports of the 30 companies comprising the Dow
Jones Industrial Average (“DJIA”).
3
APPENDIX I
OVERARCHING OBSERVATIONS REGARDING DISCLOSURES
One of the stated objectives of the Revenue Recognition Project is to improve transparency about the
revenue amounts recognized by enhancing disclosures for the benefit of users of financial statements. We
recognize and support the Boards efforts towards improving revenue disclosures including the
requirements for roll-forwards, performance obligation maturity analysis, and requiring disclosures of
significant judgments or changes in judgments made.
However, we can only consider the proposed disclosures as being a starting platform upon which to seek
to further address investor information needs. We believe the Boards need to evaluate the disclosures in
light of investor needs. Disclosures require further enhancement not reduction or prioritization for
potential elimination.
Significant Increase in Disclosures Across All Companies is A False Premise:
Disclosures Expand With Increase in Use of Estimates and Judgments and
Disparity in Timing of Revenue Recognition Relative to Cash Collection
There is a fundamentally flawed yet widely held premise that the proposed disclosure requirements in the
Original ED and the Revised ED will be universally burdensome for all companies. This premise is
flawed because the disclosures will only have an impact where there are multiple-element contract
arrangements or long-term contracts with significant estimates.
For most companies, new disclosure requirements do not differ significantly from current requirements
because:
a) the cash conversion cycle tends to be well synchronized with the satisfaction of the performance
obligation;
b) contracts are basic contracts that are verbal or simply implied by customary business practice; and
c) it is unlikely that preparers will provide other than their standard boilerplate revenue recognition
language in the critical accounting policies section of the financial statements.
For a significant portion of the preparer population, a majority of the disclosures will not be required (e.g.
performance obligations are only required when contracts are greater than one year and roll-forwards are
only required when a contract asset or liability exists, etc.) For those companies where the disclosures will
be required, the increase in disclosures is warranted because these businesses are contract intensive; there
are significant disparities between the date revenue is recognized and cash is collected; and there are
significant judgments involved in estimating the amount and timing of the revenue recognized. All of
these are important to investors.
4
APPENDIX I
Disclosures Are Not Excessive Given Importance of Revenue To Investment Decision-making
Revenue disclosures are necessary given that revenue is pervasive for all industries. Further, the long
history of earnings management and need for restatement in this area demonstrates that companies should
be held to a high standard in making these disclosures. We believe it is disingenuous for preparers to be
highly vocal in seeking to minimize the required disclosures to provide given the importance of revenue
and the low quality of the disclosures. As noted above, this concern is misplaced for most companies with
simple contracts.
Furthermore, CFA Institute has recently conducted a survey aiming to inform the development of a
disclosure framework and the results show that from a user perspective, the frequently cited concerns
about volume of disclosures are not commonplace among investors. Instead, the survey results show that
investors are primarily interested in enhancing the information content and comprehensibility of
disclosures.
Revenue Disclosure Requirements Should Be Considered In the Context of Other Disclosure
Requirements
It seems ironic and counterintuitive that preparers are requesting the Boards seek to rationalize disclosures
for this highly relevant financial statement element. There are presently and more detailed disclosure
requirements with respect to pensions, financial instruments, taxes, and many other financial statement
elements than are required for revenue which drives the entirety of the business. The Boards should
consider why they believe fewer disclosures are required for revenue than for these financial statements
elements when reaching their decision with respect to rationalizing or enhancing disclosures.
Investors Are Skeptical When Companies Say They Can’t Produce the Revenue Disclosures
Overall, we find it troublesome that preparers suggest gathering such information will be burdensome or
impossible. Investors would question management’s ability to manage the business, and provide cash
flow projections or earnings guidance if they cannot provide such information. The disclosures simply
call for communication of the judgments and estimates management has made in the recognition and
measurement of revenue, the determination of the nature of the performance obligations management has
committed to perform and an explanation of the cash versus revenue recognition pattern associated with
those commitments.
Disaggregation and Rollforwards:
If They Aren’t Important to Revenue Disclosures When Will They Ever Be?
Many of the complaints with respect to the revenue disclosures focus on the requirement to disaggregate
revenue disclosures in the notes and to prepare rollforwards/reconciliations of contract assets and
liabilities. Disaggregation and rollforwards were key elements of the Financial Statement Presentation
Project which the Boards deferred. We have expressed the importance of these two items in our
Comprehensive Business Reporting Model (2007). We believe if the Boards back away from these key
elements of disclosure and presentation at this time in such a key project they will be making a broader
statement to investors that they do not believe these financial reporting elements – critical , despite their
importance to investors. This would be a substantial step backwards for the investor community.
5
APPENDIX I
The IASB and FASB Need to Evaluate:
Disclosure Requirements Against Investor Needs
The Boards and IASB and FASB staff need to make a paradigm shift in their consideration of the revenue
recognition disclosures. The Board’s stated mission is providing decision-useful information to investors.
If disclosures provide decision-useful information and investors are willing to pay for them, then the
burden should be on preparers, to justify their inability to provide the information. Given the significant
enhancement in revenue recognition disclosures required, believe the Board is asking the wrong question
in the Revised ED. Asking investors which of the currently specified disclosure proposals should be
either eliminated or prioritized – so as to assuage preparer desire for a minimal compliance burden – are
not consistent with serving the needs of investors. Rather, the Boards should be evaluating whether the
disclosures are necessary to explain to investors the estimates and assumptions employed in the revenue
recognition process and to communicate the disconnect between the timing of revenue recognition and
cash collection (i.e. the cash conversion cycle). If reporting is to be useful it should be anchored to
investor needs.
The Boards should make it clear to all stakeholders that there will be no significant increase in disclosure
requirements for most companies. This clarification will minimize any exaggerated concern about
additional burden on disclosures. The Boards should also:
a) Require preparers to specifically articulate which disclosures are “overburdensome” and
“unnecessary”;
b) Require preparers to justify why investors do not require such information; and
c) Evaluate more precisely where disclosures will be expanded and why these changes are necessary.
6
APPENDIX I
Disclosures Require Greater Specificity and Enhancement, Not Rationalization
Though we support the principle of requiring enhanced disclosures, the current requirements – especially
post their “adjustment” from the Original ED to the Revised ED – are either too broad or they are not
sufficiently comprehensive to provide a full reflection of all revenue related flows. We fear that the broad
specification of requirements may lead to boilerplate and uninformative disclosures.
This is particularly true with respect to the disclosure requirements for significant judgments or changes
in judgments made, as an example. There are no disclosure requirements with respect to identifying the
contract with the customer (Step #1) or identifying the distinct performance obligation (Step #2). As it
relates to significant judgments or estimates in determining transaction price (Step #3), allocating
transaction price (Step #4) or transferring control (Step #5) the requirements are specified at such a highlevel that they are likely to be boilerplate.
Further exemplifying this point are the disclosure enhancements necessary for performance obligations.
As we have set forth below, without enhancement of these requirements there is likely to be confusion
with respect to what the disclosures actually communicate.
Our concern about these high-level specifications of disclosure requirements are exacerbated due to the
significant number of exceptions within the model, the ambiguous definition of key principles of the
model and the significant level of discretion accorded to preparers within the model.
We have evaluated each of the proposed disclosures and have provided our views on the necessary
enhancements in more detailed below. We believe the Boards need to provide a more comprehensive
specification of disclosure requirements so as to sufficiently enhance transparency around reported
revenue amounts. Given the importance of revenue as an input towards enabling investors to monitor
earnings quality on an on-going basis, the package of enhanced disclosures should apply for both interim
and annual reports.
Investors Need to See the Connection Between Revenue and Cash
Revenue reported under the Revised ED would contain both inherent economic and accounting
uncertainty and only a robust disclosure regime that complements recognition and measurement, can help
investors to assess the association between reported revenues and related cash flows from these revenues.
That association is critical to enterprise valuation. We believe that reporting cash flows by type of
revenue in a direct method statement of cash flows would allow investors to understand the linkage
between revenue recognition patterns and cash flow collections. Enterprise valuation requires
confirmation that revenue recognized is ultimately converted to cash, and knowledge regarding the timing
of the conversion. Our historical advocacy for the direct cash flow method stems from the importance to
investors of this need to connect revenue and cash measurements. Under the indirect cash flow method,
users cannot directly see the connection between revenue and the related cash collection of such revenues.
Attempts to estimate direct method cash flows generally prove fruitless given the level of aggregation as
well as the impact of foreign currency and business combinations.
7
APPENDIX I
Investors Likely to Be Disappointed By Actual Disclosures Provided: An Expectations Gap Exists
We have participated in numerous presentations where users have been queried regarding their views on
the sufficiency and appropriateness of the Revised ED’s disclosure requirements. Unfortunately, such
inquiries have not been preceded by a thorough review of the disclosures including a discussion of the
nature of contract assets, contract liabilities and performance obligations which is presented and
articulated in a manner that is accessible to investors. We believe that many investors and other
stakeholders may not understand the accounting parlance being used to explain these terms, and because
of this, there is not a complete understanding of the nature of the balances created by the standard. As a
result, investors do not understand that contract assets are not accounts receivable, deferred revenue is one
type of contract liabilities and performance obligations are not “backlogs.” Further, investors are not clear
that:
a) the reconciliation to be provided is not a rollforward of accounts receivable;
b) the rollforward of contract assets and contract liabilities will not be provided unless such balances
are present in the statement of financial position and that not every company has such balances; and
c) when a reconciliation is provided, it will include income statement elements (e.g. cash sales and
sales on account which flow through accounts receivable) which do not necessarily flow through
the contract asset and liability accounts.
We could provide innumerable examples of similar expectations gaps with respect to the disclosures. A
complete analysis of the disclosures is provided below.
8
APPENDIX I
GENERAL RECOMMENDATIONS FOR IMPROVING REVENUE DISCLOSURES
Nature of Balances Created by Standard Are Unclear To Stakeholders and
Decrease Accessibility and Understanding of Proposed Standard
As we allude to above, our discussions with investors, preparers and auditors has yielded a conclusion
that stakeholders are not sufficiently clear on:
a) the distinction between accounts receivable and contract assets;
b) the nature of contract liabilities (e.g. deferred revenue is a contract liability);
c) how contract liabilities differ from performance obligations; and
d) how performance obligations differ from backlogs.
The stakeholder confusion and queries relating to aspects of these foundational concepts were
acknowledged during the IASB and FASB webcast held on February 29, 2012. After a discussion paper
and two exposure drafts, the fact that this foundational concept is not clear should cause the Boards pause
and require that they provide clearer guidance not simply on the definition of the these financial statement
elements but also how they differ. This distinction should also address how these are different from the
elements of revenue in the financial statements that are prevalent today (e.g. deferred revenues). The
confusion regarding the differences between these terms leads to a partial understanding of the revenue
recognition model and contributes to the limited ability of stakeholders to meaningfully evaluate what is
included or excluded within some of the disclosure components such as the roll-forwards as we describe
more fully elsewhere herein. We recommend that the final standard should clarify the distinction and
interrelationships between these financial statement elements.
Disclosures Should Require Consistent and User-Friendly Presentation (i.e. Tabular Format)
The final standard should include a requirement (not an option) that all reconciliations/roll-forwards and
other disclosures which can be presented in a tabular format be required to be presented in such a manner.
Tabular presentation will greatly increase the clarity and usefulness of the information to investors.
Disclosures Should Be a Complement to – Not a Substitute for –
Appropriate Presentation in the Key Financial Statements
Strong preference is accorded by investors to the presentation of appropriate revenue related items on
balance sheet, income statement and cash flow presentation rather than in footnotes. Presentation in the
main financial statements where appropriate – rather than in the footnotes – will facilitate easier investor
access to this information for analytical purposes.
Disclosures Should be Based on Consistent Unit of Account
The performance obligation is the unit of account for revenue determination under the Revised ED and
revenue disclosures should, at a minimum, aim to inform on judgments related to performance
obligations. Preparers can provide additional disclosures such as onerous contracts but these should be
complementary to disclosures related to unit of account. See more comprehensive discussion under
disaggregation disclosures.
9
APPENDIX I
INVESTORS REQUIRE COMPLETE INTERIM AND ANNUAL REVENUE DISCLOSURES
All one needs to do is listen to business news channels during earnings season and it is readily apparent
that interim disclosures about revenues can drive share prices. It is therefore obvious that the disclosures
regarding disaggregation of revenue, as an example, are important at interim reporting dates and it is
puzzling that the Boards are posing the question regarding the need to make interim revenue disclosures
equivalent to annual revenue disclosures.
Disaggregation by product and geography (e.g. China, S. America, Europe) is a major issue because of
the regions differing growth rates and recessionary pressures which are especially important to the
markets assessment of a global company’s performance. There is unequivocal evidence that securities are
being traded based upon revenue disclosures in earnings releases. To not include the information on the
face of the financial statements at the time of the press release runs counter to the Boards mission of
providing decision-useful information to investors. We think the Boards should have to justify why it is
not necessary – rather than investors having to defend the obviously relevant nature of the disclosures – as
the market does not wait until year-end to incorporate revenue information.
The need for interim disclosures was supported by the results of a survey question during the joint CFA
Institute, IASB and FASB webcast on revenue recognition where 59% of 208 survey respondents
indicated that they wanted the same quantitative disclosure information for both interim and annual
reports.
Further, in our comment letter to the Original ED we articulated why revenue – in addition to the
observation above – is one of the most important metrics for investors. We cited the following reasons:
- Starting Point for Analysis – It is the starting point of financial analysis of a firm and is used to
generate earnings forecast, make future cash flow estimates and perform valuations for the purpose of
making investment decisions.
- Used in Valuation Models – It is used in valuation models (i.e. relative value methods applying
price/sales ratio comparisons) for certain industries, usually for companies that are growing rapidly but
are not yet profitable.
- Primary Source of Restatements and Earnings Management – It has been a primary source of
restatements and earnings management. These restatements have had an adverse impact on investor
confidence.
Investors routinely pay attention to year-on-year and seasonal performance trends. This is because for
many business models, there can be significant information content regarding the effectiveness of a
company’s strategy and long -term prospects based on the half year or quarterly performance or trends of
half yearly performance. Because earnings quality is influenced by, and earnings management can occur
due to, intra-period revenue recognition practices, it is important that comprehensive disclosures be
provided through both interim and annual revenue reports. It is only on this basis that a rigorous valuation
of companies by investors can occur across the full annual reporting cycle.
10
APPENDIX I
EVALUATION OF PROPOSED DISCLOSURE REQUIREMENTS AND RECOMMENDATIONS
The illustration below pictorially depicts the key elements of the Revised ED’s disclosure requirements:
Summary of Proposed Disclosures
1
Paragraphs 109 to 130 of the Revised ED describe the disclosure requirements in detail. Key elements of
the disclosures are summarized below and evaluated in the sections which follow:
1) Disaggregation of Revenue – Disaggregation of revenue by category (e.g. by good or service, geography,
customer and type of contract) in the notes to the financial statements, not on the face of the income statement, is
required (Paragraph 114-115).
2) Roll-forwards – A reconciliation of the opening to the closing aggregate balance of contract assets or contract
liabilities is required (Paragraphs 117). Paragraph IE 17 provides an example of the elements of the rollforward.
This example is analysed in greater detail at Appendix II.
3) Performance Obligations –
a) Nature of Performance Obligations – Details of performance obligations including goods and services;
significant payment terms; when the performance obligation is typically satisfied; obligations for returns,
refunds and similar obligations; types of warranties and related obligations (Paragraph 118). A maturity
analysis of performance obligations for contracts with an original expected duration greater than one year is
required but may be done qualitatively (Paragraph 119-120). If revenue is recognized in accordance with
amounts billed they are exempt from the disclosure even if the contract is greater than one year (Paragraph
121).
b) Onerous Performance Obligations – The existence of onerous performance obligations requires including a
roll-forward/reconciliation disclosure; details of why performance obligations have become onerous and
when the liability will be satisfied (Paragraphs 122-123).
4) Significant Judgements – Significant judgements used in determining the:
a) Timing of Satisfaction of Performance Obligations (Step #5) – Timing of the satisfaction of performance
obligations which are satisfied over time and at a point in time shall be disclosed (Paragraph 125-126); and
b) Transaction Prices and Amounts Allocated to Performance Obligations (Steps #3 and #4) – Transaction price
and allocations of transaction price to performance obligations shall be disclosed. This includes the basis of
estimating selling prices of separate performance obligations; the measurement of obligations for returns,
refunds and similar obligations; and the measurement of liabilities for onerous contracts (Paragraph 127).
5) Assets Recognized Related to Costs – A reconciliation of the opening and closing balances of assets recognized
from the costs deferred shall be provided. A description of the methods used to amortize the balances shall be
provided (Paragraph 128-129).
11
APPENDIX I
In our comment letter to the Original ED, we identified several omissions and shortcomings with the
proposed disclosures. Other than the inclusion of disclosures related to deferred costs, the Revised ED
does not address most of the issues that we highlighted. Further, several key disclosures have been
removed from Revised ED. In the sections which follow we review the contents of the disclosures
provided and provide our feedback on the disclosure. We remain concerned that key disclosures will be
omitted and we anticipate that the high-level specification of many of the disclosure requirements will
lead to boilerplate and uninformative disclosures.
12
APPENDIX I
Disaggregation
Disaggregation of Revenue on Income Statement Is Preferable to Footnote Disclosures
Due to Enhanced Timing and Increased Prominence of Income Statement Presentation
We support the disaggregation of revenues. During the CFA Institute’s joint webcast on revenue
recognition with the FASB and IASB 85% of 224 respondents indicated that they require greater
disaggregation of revenue. There is a strong preference that this disaggregation is done on the face of the
income statement because it will ensure that the information is accorded its appropriate prominence and
the information will be delivered at the time of the earnings release – rather than weeks later in the notes
to the financials. This is especially true under IFRS rather than U.S. GAAP as SEC revenue disclosures
require a disaggregation of at least goods and services on the face of the income statement.
SEC Regulation S-X Requirement to Disaggregate Revenue: Goods vs. Services
We would note that SEC Regulation S-X Rule 5-03 requires disaggregation of revenue by net sales of
tangible products (gross less discounts, returns, and allowances) and revenue from services. However, we
would observe that the Revised ED does not include a definition of “goods” or “services.” In fact Step #5
of the revenue recognition model takes great care not to make the distinction on how to recognize revenue
for goods vs. services separately. Rather, revenue recognition is based upon the notion of transfer of
control and no alternative use. Throughout the Revised ED “goods and services” is used as a collective
term without each being defined separately. We would observe the Master Glossary in the Codification
also does not include definitions for the term “goods” or the term “services”
We believe it is important to define “goods” vs. “services” under U.S. GAAP and IFRS so that there is a
consistent application of that distinction. Without such definitions we believe there will be a lack of
comparability around the world.
Disaggregation Criteria Lack Linkage to Revenue Recognition Model, SEC Guidance and Segments
We are concerned that there is a disconnect between how decisions are made under the steps of the
revenue recognition model and how revenue will be communicated in the financial statements.
Paragraphs 114 and 115 require that revenue be disaggregated into the primary categories that depict how
the nature, amount, timing and uncertainty of the revenue and cash flows are affected by economic
factors.
This disaggregation of revenue disclosure requirement is not, however, necessarily consistent with the
decisions made under the revenue recognition model in the Revised ED. Specifically, Step #2 requires
distinct performance obligations be identified and Step #5 requires that there be a determination made
regarding whether there is pattern of transfer over time or at a point in time. The Revised ED does not,
however, require any disclosure regarding these decisions and their impact on the disaggregation
decisions yet they have significant bearing on the nature and timing of revenue recognition.
Further, there is no requirement to disaggregate revenues by goods and services as noted above nor is
there any requirement to link the disaggregation decisions to the segment reporting disclosures. We are
concerned that there will be a disconnect in the communication of the disaggregation of revenue, the
decisions made in the model and the other financial reporting requirements as it relates to revenue.
Before finalizing the Revised ED, we believe the Boards should consider a requirement which facilitates
the linkage of these different decisions.
13
APPENDIX I
Disaggregation is Fundamental to Financial Statement Presentation
We are concerned that the Boards are being pressured to eliminate the greater disaggregation
requirements of the Revised ED. We would note that the concept of disaggregation is central to effective
financial analysis and investors have been requesting better disaggregation for decades. If the Boards
abandon greater disaggregation for revenue – arguably the most important number on the income
statement – they are making a broader statement with respect to the importance they place on the concept
of disaggregation. As we note elsewhere herein (i.e. Investors Require Complete Interim and Annual
Revenue Disclosures) all one needs to do is listen to business news channels during earnings season and it
is readily apparent how important the elements of disaggregation of revenue are to investors.
Absent the disaggregation objectives set forth in the Financial Statement Presentation Project, we believe
greater disaggregation requirements should be set forth as it relates to this key financial statement element
in the Revised ED. We believe investors will take such a decision to as a broader decision by the Boards
to abandon the central tenets of the Financial Statement Presentation Project, which is premised on the
need for more disaggregation.
14
APPENDIX I
Rollforwards/Reconciliations
Rollforward of Contract Balances Requires Enhancements:
Nature and Contents of Rollforward Are Not Clear to Many Stakeholders
We are fully supportive of the inclusion of a rollforward of contract assets and liabilities. Rollforwards
communicate significant information with respect the nature of the balances and their activity which can
be highly informative in understanding the valuation of balance sheet accounts and their impact on the
income statement. More important, they separate cash from non-cash and operating from non-operating
elements. As we articulate above, rollforwards are a central tenet of the Financial Statement Presentation
Project and the Boards should resist pressure to eliminate these rollforwards – and greater disaggregation
– as doing so sends a message to the investor community regarding the Boards views on the importance
of these essential financial statement presentation tenets.
We believe there are misunderstandings and miscommunications amongst all key stakeholders (investors,
preparers, and auditors) regarding the scope and content of these rollforwards. Greater discussion and
clarity is required to appropriately communicate to investors what will be provided and to temper the
assertions of preparers. Below we articulate our concerns with respect to the rollforwards and our
recommended enhancements.
Concerns Regarding Rollforwards
Our principal concerns with respect to the rollforwards are as follows:
– Lack of Clarity on Balances Within Scope of Rollforward Requirement – The lack of clarity regarding
the difference between a contract asset and an accounts receivable has left many investors with the
mistaken perception that this disclosure requirement will result in a rollforward of accounts receivable.
It will not. Paragraph 117 of the Revised ED only requires rollforwards when a contract asset or
contract liability exists in the statement of financial position. Further, the requirement calls for an
aggregated and net rollforward of contract asset and liability balances. In our review of the 30 DJIA
companies it appears the most common contract liability will be deferred revenue with 8 of 30
companies having a deferred revenue account (i.e. contract liabilities). We would observe that the
aggregation of balances on the statement of financial position makes it difficult to discern the existence
of other contract asset or liability accounts. It is our view that the rollforward will not appear in many
financial statements as only a limited number will have significant contract asset or contract liability
balances. If it does appear, it will be an aggregate of all contract assets and liabilities which are then
netted – the result being information with little meaning or decision-useful value.
- Aggregation and Net Presentation of Rollforwards Limits Decision-Usefulness – The Proposed Update
allows the preparation of the reconciliation on an aggregate (all contract assets and all contract
liabilities) and net (contract assets netted against contract liabilities) basis. We understand that this net
presentation would be allowed because preparers have expressed concerns regarding situations where a
contract may move from a contract liability to a contract asset position (or vice versa). Our issue is
that netting the contract asset and contract liability balance is meaningless to users as contracts are
either in a contract asset or contract liability position and contract assets and liabilities have no
relationship to each other. A contract asset arises when a performance obligation has been completed
and recognized as revenue yet another performance obligation needs to be completed before a contract
asset may be billed. A contract liability arises when cash has been collected and the performance
obligation is yet to be completed. The cash collected which gives rise to the contract liability has
nothing economically to do with the contract asset which cannot be billed until some performance
obligation unrelated to the contract liability – as it is unlikely that a customer would pay for the second
performance obligation in advance of paying for the performance obligation where the revenue has
15
APPENDIX I
been recognized but is dependent on the completion of another performance – is satisfied. The notion
that the contract asset and contract liability should be netted is based upon a mechanical convenience
which has the effect of improperly convening there is a relationship between the two balances.
Similarly, presenting a rollforward of all contract assets and all contract liabilities does not result in
decision-useful information as the nature of the balances may be very different. The insight provided
by the rollforward is substantially mitigated when many different balances are aggregated and netted.
Accordingly, we believe rollforwards should be presented individually and not netted. There is no
additional work required by preparers to present this information in this manner as all the information
will have to be accumulated by account. In fact, not aggregating or netting will reduce the work
required by preparers to accumulate and net the balances.
– Requirement to Reconcile Income Statement Elements of Rollforward to Income Statement is Not
Apparent to Most Stakeholders and May Reduce Decision-Usefulness of Rollforwards To Investors –
Paragraph 117 which establishes the contract balances reconciliation requirement references Paragraph
IE 17 which provides an illustrative example of the reconciliation. We have reconstructed the
reconciliation at Paragraph IE 17 and presented it in Appendix II.
Review of Paragraph IE 17 communicates through the example that once a reconciliation is required,
there must be reconciliation of satisfied performance obligations in the rollforward to the income
statement. However, not all satisfied performance obligations are associated with the contract assets
or liabilities being reconciled. For example, the Paragraph IE 17 illustration shows that cash sales of
$1,000 which would not be associated with contract assets and liabilities as well as sales made on
account (i.e. amounts recognized as accounts receivable) of $14,000 are included in the reconciliation.
Cash sales (i.e. debit cash and credit revenue) and sales on account (i.e. debit accounts receivable and
credit revenue) which have nothing to do with contract assets and contract liabilities will be included
in the reconciliation so as to facilitate the reconciliation’s connection to the income statement. We
illustrate these points through our breakdown of the illustration at Paragraph IE 17 in Appendix II.
Inclusion of items which do not flow through the contract asset and contract liability accounts –
besides being incorrect – distorts the usefulness of the reconciliation.
Further, the construction of this reconciliation – while it may be useful in the construction industry –
does not seem to acknowledge the accrual nature of many contract asset and liability accounts. Many
such balances are not directly impacted by cash transactions. For example deferred revenue is
generally an accrual which is made at the end of the accounting period. Cash collected during the
period is recorded in the income statement (i.e. debit cash and credit revenue) with a period end
subsidiary ledger computation and accrual of deferred revenue (e.g. debit revenue and credit deferred
revenue). In such circumstances, the reconciliation is not providing the most meaningful information
related to deferred revenue. We describe the more meaningful information below and in the discussion
of contract liabilities.
16
APPENDIX I
Recommended Enhancements
Our review of the reconciliation/rollforward requirement resulted in a series of refinements to the
reconciliation and other disclosures which are necessary to provide investors with decision-useful
information regarding contract asset and liability balances and accounts receivable. Those are set forth
below:
– Accounts Receivable Rollforward Should Be Separately Presented and Cash Sales Separately
Disclosed – Paragraph IE 17 requires the inclusion of sales on account and cash sales in the
rollforward of contract assets/liabilities. The inclusion of these items decreases the usefulness of the
reconciliation to investors as we describe above. As we illustrate at Appendix II, the contract
balances reconciliation should be separated into its component parts to be decision-useful to investors.
This would result in the separate presentation of an accounts receivable rollforward and the separate
presentation of cash sales. This requires no additional effort for preparers. The decision-usefulness of
the rollforward is increased exponentially by the separate reconciliation of these account receivable
balances.
– Rollforward of Contract Assets and Contract Liabilities Should Be Done Separately – Because
contracts are either in an asset or liability position, and, as described above, it is misleading to
communicate that such balances are related, we believe the reconciliation of contract asset and contract
liabilities should be done separately. The fact that a contract moves from a contract asset or contract
liability should not result in the communication of misleading net information to investors. The
contract balances will have to be rolled forward separately so the requirement to present separately is
no additional work for preparers.
– Rollforward Requirement Missing Key Elements – We find the rollfoward example omits key elements
of the rollforward such as the impacts of foreign currency changes, acquisitions and divestitures, and
the time value of money. These should be presented as separate and distinct elements of the
rollforward as they are economically different from operating changes. We also think it is important to
discuss the meaningfulness of the revenue allocated to prior periods as a result of the performance
obligations satisfied in prior periods. We are not sure investors appreciate the nature of this element of
the rollforward and what it has the capacity to communicate.
– Contract Assets: Disclosure of Contingent Performance Necessary – Contract assets are satisfied
performance obligations (i.e. revenue has been recognized) for which cash is not yet due because
another performance obligation must be satisfied prior to billing the customer. As such, there is need
for disclosure regarding the nature of the contingent performance and when is it expected to occur.
Said differently, investors want to know the period during which the contract asset will convert to a
receivable and then to cash. Further, investors need to know when a contract asset is reduced and
revenue reversed because the secondary performance obligation was not satisfied. These are the most
essential disclosures associated with contract assets but are not a part of the disclosure package in the
Revised ED.
– Contract Liabilities: Disclosure of Revenue Recognition Pattern Necessary – As contract liabilities
are simply cash received in advance of satisfaction of a performance obligation, the principal issue for
investors is when are the performance obligations expected to be satisfied and when are contract
liabilities expected to become revenue. As we describe more fully below, any performance obligations
included within contract liabilities that relate to a contract with an original duration of greater than one
year, will be included in the performance obligation disclosures. However, as discussed more fully
below, the extent of the overlap will not be disclosed and therefore eliminates the decision-usefulness
of the information. We believe disclosures associated with the pattern of revenue recognition are the
17
APPENDIX I
most valuable information associated with such balances and have proposed additional disclosures
below.
Overall
The final standard must include the aforementioned enhancements for the disclosures to be of any
meaningful use to investors. As noted earlier, the limited understanding by stakeholders of differences
between contract assets versus accounts receivables and contract liabilities versus performance
obligations and backlog contributes to partial understanding of these rollforward disclosures by all
stakeholders to the project – not simply investors. Before finalizing the decision and discussion regarding
rollforwards, the Boards must more carefully study the information content of the disclosures, their actual
prevalence and the perceived versus actual costs and benefit.
18
APPENDIX I
Performance Obligations
Performance Obligation Disclosures Are Essential:
Current Proposals Are Incomplete and Confusing and Do Not Provide Decision-Useful Information
The Problem with the Proposed Performance Obligation Disclosures
We believe the disclosure requirements with respect to performance obligations in Paragraphs 118
through 121 will not result in the most decision-useful information to investors and could potentially
result in confusing, at a minimum, and potentially misleading information for investors. Our view stems
from several key factors:
1) The lack of disclosures of all performance obligations – rather than simply performance obligations
with an initial duration of greater than one year.
2) The inability of investors to discern the overlap – or lack of overlap – between contractual liabilities
and performance obligations.
3) The lack of disclosures regarding the relationship between performance obligations to be satisfied
and contract assets for which revenue has already been recognized but is dependent upon the
satisfaction of future performance obligations to become collectible.
4) The lack of distinction between performance obligations as defined under the standard and
“backlogs” – specifically the inability investors will have to discern the difference between these
disclosures and backlog disclosures required by SEC Regulation S-K Item 101 (c) (viii).
5) The lack of a requirement to make of all the aforementioned disclosures (performance obligations,
contractual liabilities, backlogs) in a cohesive quantitative manner.
6) The lack of quantitative disclosure of the expected realization (i.e. maturity analysis) of revenue
from such performance obligations, contractual liabilities, and backlogs.
The figure below diagrammatically illustrates the omission, overlap and confusion which will be created
by the proposed disclosures.
Backlogs:
Backlogs are a subset of performance
obligations. Performance obligations
are not backlogs per se. SEC Reg S-K
Item 101(c) (viii) requires backlog
disclosures but the interrelationship of
these requirements is unclear.
All
Performance
Obligations
Contract
Liabilities
Disclose Only =
Performance
Obligations Greater
Than One Year
Satisfied in One
Year or More
Disclosures Need Further
Enhancement:
Disclosures will not include quantitative
information regarding all performance
obligations and will not identify which
performance obligations are already
contract liabilities.
Further, the “run-off” or “maturity” of
both will not be provided which will
eliminate the information’s analytical
usefulness. It may also confuse and
potentially mislead investors.
19
APPENDIX I
We would make the following observations with respect to the specific disclosure requirements in the
Revised ED:
1) The requirements with respect to Paragraph 118 (a) to (e) are highly generic.
2) Paragraph 119 which only requires disclosure of performance obligations with an original duration
of more than one year, is not helpful to investors as we touch upon above and expand upon below.
3) Paragraph 120 allows a qualitative rather than quantitative disclosure of information with respect to
performance obligations greater than one year.
4) Paragraph 121’s practical expedient which allows a company to omit the performance obligation
disclosure if it has the right to bill for performance completed as per Paragraph 42 is not clear.
Investors are interested in disclosure of all performance obligations including those which will be
satisfied within one year as evidenced by the discussion of backlogs in press releases. Such disclosures
provide useful information in assessing a company’s revenue trends and earnings prospects. From our
discussions with investors it is evident that there is not a clear understanding of the definition of
performance obligations nor the distinction between performance obligations and backlogs.
We also find that many investors do not understand the definition of contract liabilities and their
relationship to performance obligations. Adding to the confusing is the notion that all contract liabilities
represent performance obligations, but that such contract liabilities represent performance obligations that
may, or may not, be included in the performance obligation disclosure proposed – depending on whether
they relate to a contract with a maturity of greater than one year. Said differently, analysts will not know
if they should count both the contract liability, the performance obligation, some of each or both in
expectations of future revenue. Investors will also not understand how the backlog information relates to
performance obligations.
Further, disclosure of the performance obligations related to contract assets is not required by the Revised
ED. The lack of disclosures regarding the relationship between performance obligations to be satisfied
and contract assets for which revenue has already been recognized is necessary for investors to
understand the cash flow prospects of the firm.
Without clearer distinction between contract liabilities, performance obligations and backlogs as well as
the relationship between future performance obligations and existing contract assets it is impossible to
utilize the information in a decision-useful manner. Without insight into the completeness of the
balances/obligations and their relationship to each other, the information provided is not useful to
investors in projecting future revenue trends or understand future cash flow prospects.
While the Boards may not want to define backlogs, without clarity on this distinction, and better
disclosure regarding performance obligations and contractual liabilities there is likely to be a confusion
regarding what all of the disclosures represent and they may have the impact of confusing and possibly
misleading, rather than informing, investors.
Proposed Enhancements to Performance Obligation, Contractual Liability and Backlog Disclosures
Definitional Enhancements – As we note above, clearer definitions and demarcations of performance
obligations, contractual liabilities and backlogs are necessary as each are meaningful predictors of future
revenue. We believe the relationship, or lack thereof, of the backlog disclosures as defined under SEC
Reg S-K Item 101 should be clarified and defined in the context of the definition performance obligations
included in the Revised ED. If this is not done, the meaningfulness of SEC Reg S-K Item 101 and the
performance obligation disclosures are both made substantially less meaningful.
20
APPENDIX I
Complete and Cohesive Disclosures of Performance Obligations, Contract Liabilities and Backlogs –
Hand-in-hand with clearer definitions should come complete, cohesive and quantitative disclosures of all
performance obligations, contractual liabilities and backlogs. As we believe it provides an incomplete
picture, we do not agree with the disclosures related to the presentation of a maturity analysis of
performance obligations with durations of more than one year. Without clearer distinctions and
quantification of the amounts, the information is not decision-useful.
Maturity Analysis of Performance Obligations, Contract Liabilities and Backlogs – In addition to a
quantitative and cohesive disclosure of performance obligations, contractual liabilities and backlogs, we
also need disclosure of the expected “run-off” or “maturity” of each of these items in order for the
information to be predictive and decision-useful.
Additionally, the extent to which current period revenue represents amounts included in prior period
backlogs would also be useful to investors.
Performance Obligations Related to Contract Assets – As analysts are interested in when contract assets
will convert to cash, it is important for performance obligations that are related to contract assets to be
separately identified and their timing to be separately disclosed. Delay in performance of such
obligations will result in an extension of the cash conversion cycle and failure to perform the obligation
will result in a reversal of revenue. Analysts are also interested in disclosures of revenue which is
reversed due to failure to complete the subsequent performance obligation.
Unsigned Contracts – Additionally, if an entity has substantial contracts that are deferred for signature –
or performance – until the inception of the next accounting period, we believe disclosures of such
information would be useful to investors. This is simply another form of backlog.
Enhancement to Onerous Performance Obligations Also Required
Further to the disclosures already required for onerous contracts in Paragraphs 122 and 123, it would be
useful if there were disclosures of:
a) contracts near to becoming onerous (i.e. a “watch list”); and
b) the nature and amounts of contracts that are onerous but exempt from loss recognition requirements.
We also believe it is important for preparers to analyze the root causes for performance obligations
becoming onerous and evaluate whether the onerous nature of the obligations results from a misallocation
of revenues at that inception of the contract.
21
APPENDIX I
Revenue Recognition Steps and Judgments
Disclosures Related to Revenue Recognition Steps and Judgments Needs to be Enhanced:
Quantitative and Qualitative Information is Necessary
As we noted in our comment letter on the Original ED, the Revised ED fails to include a requirement to
disclose certain key judgments and estimates which we believe are essential to understanding the revenue
recognition and measurement decisions made by management. In addition, we believe it is important that
the disclosures regarding such judgments and estimates be made in sufficient detail and with sufficient
specificity (i.e. not boilerplate disclosures) that investors can determine how such decisions correlate with
the revenue recognition measurements included in the financial statements. This would include more than
just a qualitative description of the decisions and judgments. Such qualitative decisions should be
connected with quantitative measurements or revenue included within the financial statements. The
disclosure omissions, shortcomings and enhancement opportunities are described in more detail below
and are mapped to the key steps of the proposed revenue recognition model.
Step #1 (Identify Contracts with Customers) –
Contract Definition Disclosures Remain Unaddressed in the Revised ED
In order to meaningfully analyze disclosures regarding significant judgments and make inferences
regarding the comparability of reporting companies, investors will require greater clarity regarding the
contract definition including contract combination and modification decisions. Investors also need to
know how contract terms could influence the recognition of revenue. Robust disclosures are necessary to
adequately communicate regarding these different aspects of contracts with customers. The Revised ED
does not, however, have explicit disclosure requirements related to Step #1 of the revenue recognition
model.
We recommend that the final standard explicitly require disclosures related to contract definitions and
entity-specific judgments made for contract definitions including modification and combination decisions.
As an example, disclosures should be made for revenue adjustments related to contract modifications. In
such cases, it is of interest to users to know how current or prior period revenues could have been
impacted if the original revenue determination had been based on the updated contract terms (i.e. price
and scope).
Step #2 (Identifying Separate Performance Obligations) –
Lack of Disclosures Regarding Methods for Identifying Separate Performance Obligations
Remain Unaddressed in the Revised ED
The Revised ED provides no disclosures related to Step #2 of the revenue recognition model. The
judgements regarding whether performance obligations are distinct are an entity-specific judgment. The
application of entity-specific criteria should necessitate disclosures regarding the basis of judgment so as
to enable investors to determine the timing and behaviour of revenue within a reporting entity as well as
to compare whether economically similar companies have reported revenues in a consistent and
comparable fashion. Presently, there are no disclosures required in connection with the judgements
associated with identifying separate performance obligations. These judgements are the foundation
regarding how transaction price will be allocated in Step #4 and when revenue will be recognized in Step
#5, yet the Revised ED requires no disclosures of these judgements.
22
APPENDIX I
Step #3 (Determine Transaction Price) –
We recommend the explicit and specific enhancement of disclosures regarding measurement of revenues
in the following areas:
Variable Consideration and Reasonably Assured Threshold: Significant Enhancements Required
Paragraph 127 with respect to disclosures about judgments made in determining the transaction price is
highly generic. The disclosure guidance in this paragraph or elsewhere in the Revised ED makes no
mention of the need to make disclosures associated with variable or uncertain consideration. Still further,
the “reasonably assured” recognition criteria have been added to the Revised ED without the addition of
any disclosure requirements. These highly variable and subjective measurement and recognition criteria
cannot be added without disclosure to investors.
Greater specificity as it relates to “uncertain” vs. “variable” consideration is necessary for investors.
These terms can be applied to a broad spectrum of measurement issues where revenue may be highly
subjective for very different reasons. The notion that the same level of disclosures is necessary for
revenue measurement which is contingent based upon market indicators (e.g. market based investment
management performance fees) and revenue measurement based upon refunds or rebates in a business
with highly stable/predictable refund patterns does not seem sensible. Further, some “variable
consideration” results in revenue not being reasonable assured, or collected, and not reflected in the
financial statements (e.g. market based investment management performance fees) and variable
consideration results in revenue collected but not recognized (e.g. refunds/returns). There should be
separate disclosure requirements when this threshold is invoked.
It is important to understand the specifics of variable or uncertain consideration and the application of the
reasonably assured threshold in the context of revenue measurement and recognition as these are the areas
where the line between measurement and recognition become blurred and especially challenging. They
are highly subjective and they result in some of the most significant abuses, estimation problems and
causes of restatement (e.g. Groupon).
The generic language in Paragraph 127 is not sufficient. Investors need to understand several key factors
related to variable consideration including:
1) The nature of the items resulting in variable or uncertain consideration and the degree of estimation
and subjectivity involved.
2) Disclosure of whether the items are considered separate performance obligations and the nature of the
obligations.
3) The basis of selecting either the probability weighted or most likely method for determining the
amount. If material, we believe variable consideration disclosures should be required to include
disclosures of the number of outcomes considered, the estimated variable consideration initially
included in the transaction price and a range around the expected outcome.
4) A quantitative measure of the subjectivity involved in the estimation (e.g. range of possible
outcomes).
5) Significant changes in estimates or estimation techniques.
6) The amount of revenue recognized related to this uncertain/variable amount.
7) The amount of uncertain/variable consideration excluded from recognition. (i.e. includes amounts
which were not reasonably assured).
8) The nature of the uncertainties and the period in which management believes the uncertainties will be
resolved.
23
APPENDIX I
9) The uncertain consideration from prior periods where the certainty was resolved in the current period.
10) Changes in estimates related to uncertain amounts estimated in prior periods.
11) The related financial statement balances created (e.g. return liabilities, assets related to returns, etc.)
12) Classification of the variable consideration on the income statement (e.g. reduction of revenue or
expense).
Credit Risk: Several Additional Disclosure Elements Necessary
Disaggregation of Credit Risk – In the Presentation section we set forth our support for the adjacent
presentation of the credit risk adjustment. However, we recognize that this adjacent amount will
commingle a number of items that investors would like separated. For example investors would like to
make a distinction between the following:
a) current versus prior period uncollectible amounts;
b) expected versus realized losses; and
c) adjustments 3 for differences between initial recognition amounts for accounts receivable and
revenue.
There should be a disclosure in the notes related to this adjacent income statement line which
disaggregates these amounts. This disclosure is required to help users to appropriately interpret the
revenue amount and accurately derive the current period gross margin ratio.
Expected vs. Ultimate Losses – We believe the final standard should include separate disclosures of initial
expectations of credit losses as well as subsequent changes in expectations. This should include
cumulative expected versus actual uncollectible amounts. These disclosures are necessary to enable users
to evaluate credit losses relative to revenue. Some preparers suggest linking these subsequent adjustments
to the revenue amounts is not possible. We question this statement as this would imply that the company
does not “age” their accounts receivable. To the extent a company understands the age of the accounts
receivable, they can identify the period in which the revenue originated.
Rollforward – Further, we believe a roll-forward of credit losses (allowances) should be provided within
the notes to the financial statements. Such roll-forward should include beginning and ending allowances
for credit losses on previously recognized revenue amounts, estimates of expected credit losses on new
revenue, revisions to expectations of credit losses, and adjustments related to foreign currency, business
combinations.
Time Value of Money – Discount Rate Disclosures Required
The Revised ED does not require disclosure of the discount rate. In addition, there should be clarification
regarding whose discount rate (i.e. seller vs. customer) should be, and has been, applied. The basis of
discount rate determination (e.g. seller vs. customer) – along with the discount rate – should be included
in the disclosure requirements. The Revised ED proposals would adequately reflect the effects on the
income statement by separately reporting interest expense or interest income. In similar fashion, we
would propose the disaggregation of the contract asset (liability) portions to reflect the interest payable
(receivable) and to have the interest reflected on the financing section of the cash flow statement.
3
The ED does not fully reflect the different components of information within the credit risk adjustment. For example, that
there will be further adjustments within the credit risk adjustment for differences that may arise due to an accounts receivable
being recognized on a fair value basis on day 1 while the revenue being based on contractual consideration. The
aforementioned adjustment was only communicated by the IASB/FASB staff during the outreach webcast on February 29,
2012 and is not explicitly highlighted through Paragraphs 68 and 69.
24
APPENDIX I
Changes in Transaction Price
The ED does not include provisions for disclosures regarding changes in transaction price. While revenue
from allocating changes in transaction price to performance obligations satisfied in previous reporting
periods is included in the contract asset or liability roll-forward, there are no disclosures required
regarding total changes in transaction price. We believe total changes in transaction price should be
disclosed.
Step # 4 (Allocate Transaction Price) –
Need Specific and Robust Disclosure Requirements for Estimated Selling Prices and Allocation
Methods
As we described in our comment letter to the Original ED, the disclosure requirements provide generic
guidance regarding the disclosure of methods, inputs and assumptions used to estimate stand-alone selling
prices. Despite our calls for improved disclosures in our comment letter on the Original ED nothing was
done to improve the disclosures in this regard.
Despite the enormous importance of these judgments, there is but one line in the Revised ED with respect
to disclosures of the methods used to determine estimated selling prices. This is Paragraph 127(d). There
is nothing which requires disclosure of the use of market vs. estimated selling prices in Paragraph 72 or
73, the allocation method chosen in Paragraph 73, the discount method chosen in Paragraph 74 or
Paragraph 75 or the existence of contingent amounts in Paragraph 76.
We recommend more robust disclosures regarding the basis of determining the estimated selling price. As
we highlighted through previous commentary, our experience in the United States has been that
disclosures related to the use of estimated selling price per EITF 08-1, Revenue Arrangements with
Multiple Deliverables, and EITF 09-3, Applicability of AICPA Statement of Position 97-2 to Certain
Arrangements That Include Software Elements – two standards that mirror the proposals in this ED – are
usually uninformative. Our reservations are compounded by the expectation that preparers will be
reluctant to disclose the confidential information used to model estimated selling prices. These concerns
were confirmed by our recent review of disclosures – including the earlier noted review of the 30
companies in the DJIA – which showed that there is very poor disclosure of estimated selling prices
although such disclosures are necessary for investors to assess revenue timing and quality, where
estimated selling prices are based on management estimates rather than on observable market prices. The
review of DJIA 30 companies showed that only two companies had qualitative disclosures (none had
quantitative disclosures) on vendor specific objective evidence (VSOE) determination practices and only
seven companies had qualitative disclosures of multiple-element arrangements. None of the companies
had quantitative disclosures of these mentioned components. For this reason, we fear that the high-level
specification of the Revised ED disclosure requirements will create minimal change from current working
practices and that most disclosures will be boilerplate in nature.
We believe more robust disclosures are required regarding the basis of determination of estimated selling
price. There should also be disclosure of the magnitude of distinct performance obligations based on the
proposed hierarchy of estimated selling prices as we outline in our separate letter on Recognition and
Measurement issues. We suggested that the final standard require reporting entities to apply the
following hierarchy of entity-specific entry prices, from most reliable to least reliable:
-
Level 1 – Current sales price charged by the entity in an active market.
Level 2 – Current sales price of competitors in an active market.
Level 3 – Current sales price charged by the entity in an inactive market.
Level 4 – Current sales price charged by competitors in an inactive market.
25
APPENDIX I
-
Level 5 – Estimates of sales prices using entity-specific inputs that reflect the entity’s own internal assumptions.
This hierarchy should prioritize the application of available market evidence and it should also necessitate
greater levels of disclosure, including the basis of estimate of these selling prices for any management
estimates that are not based on objective evidence.
Step #5 (Satisfaction of Performance Obligations) –
Measurement of Performance Obligations Satisfied Over Time or At A Point In Time:
Disclosure Enhancements Required
The satisfaction of performance obligations at a point in time or over time is premised on transfer of
control. However, there are no explicit requirements for disclosures regarding the criteria used to
determine whether a performance obligation has occurred at a point in time or over time. The disclosures
required by Paragraphs 125 and 126 are provided without requiring disclosure regarding how it was
determined which (i.e. overtime or point in time) would apply. For example, was a judgment made that a
good or service transfers over time because it had no alternative use or because the customer maintains
control of the asset? Was the revenue recognized because there was a right to payment? Further, the
requirements of Paragraphs 125 and 126 are highly generic given the importance – and newly added
complexity – of this step in the Revised ED. It is essential that users have disclosures regarding the
judgments associated with the determination of when and how transfer of control to customers occurs.
There should be explicit disclosure requirements for:
-
-
The basis of determination of transfer of control. Specifically which of the criteria under
Paragraphs 31–33, 35, 36 and 37 form the basis of determining that control has been transferred to
customers;
The criteria for determining whether assets created have no alternative use or are under the control of
the customer; and
Measurement methods of performance obligations satisfied over time (i.e. the output or input methods
applied).
The Revised ED requires separation of distinct performance obligations yet no disclosure of revenue by
these types of distinct performance obligations. It requires recognition of revenue by whether the
performance obligation is satisfied over time or at a point in time, but provides not requirement that
revenue recognized by either method be disaggregated and disclosed by this method. Additionally, we
expect that disclosures will be made by goods versus services (as required in the U.S. by SEC rules), yet
there will be no connection of the goods and services disclosures to the performance obligation or
whether it will be is satisfied over time or at a point in time. Overall, there is substantial effort being put
forth in executing the keys steps to the model proposed in the Revised ED but no transparency to
investors with respect to how those judgments and estimates result in the revenue recognized and
displayed in the financial statements.
26
APPENDIX I
Cost Disclosures
Additional Cost Disclosures Required To Prevent Earnings Management
We are pleased to see the addition of some disclosures (Paragraph 128 and 129) related to the deferral of
costs in the Revised ED as the Original ED did not include any cost related disclosures. However, these
cost deferrals and amortization methods are highly subjective and laden with earnings management
potential. We believe key disclosures related to cost deferral, amortization and impairment are missing
from the Revised ED. Cost deferral and amortization have the effect of separating the cash and expense
recognition patterns in the financial statements. Accordingly, sufficient disclosures are necessary for
investors and users to understand the disparity of the cash vs. expense recognition trends. Disclosures
should be robust enough to deter any earnings management behaviour and make any unusual trends
readily apparent to investors.
The disclosures proposed below are essential to preventing abuses of the cost deferral and recognition
guidance in Paragraphs 91 to 103 of the Revised ED:
1) Costs Deferred – Preparers should disclose the nature of costs deferred during the period and the
basis for capitalizing such costs. Currently no such requirement exists. Only separation by main
functional category of assets deferred is required when preparing the reconciliation. The nature and
basis for deferral of costs should be disclosed. Changes in the nature of costs deferred should also be
disclosed.
2) Roll-forwards/Reconciliations – In addition to the requirements outlined in Paragraph 128, rollforwards should disaggregate the impacts of foreign currency fluctuations and business combinations.
Further, impairment reversals should be presented separately from impairments.
3) Allocation to Performance Obligations and Amortization – The method by which costs have been
allocated to various performance obligations and, accordingly, the amortization pattern of recognizing
such costs as expense should be disclosed.
4) Allocation to Renewal Contracts or Contracts Not Yet In-Force – The Revised ED allows
amortization to occur over future renewal periods or over periods for which contracts are not yet inforce. The extent to which this is occurring in the amortization pattern should be disclosed to
investors.
5) Significant Changes in Expected Transfer of Goods or Services – Paragraph 99 requires updating of
the amortization method should there be a significant change in the transfer of goods and services;
however, there are no disclosures required to communicate this change in amortization pattern to
users of the financial statements. A disclosure of this nature must be added.
6) Impairments and Reversals – Other than including impairments in the roll-forward, there is no
requirement to disclose the reason for the impairments or the nature of the write-off of other
associated assets as required by Paragraph 102. Further, there is no requirement to disclose
impairment reversals separate from impairments or the basis for determining the amount and timing
of such reversals.
7) Expected Run-off of Deferred Costs – For certain intangibles under U.S. GAAP there is a requirement
to disclose their amortization pattern. Given the importance and nature of these deferred costs, we
recommend a similar “run-off” schedule to allow investors and analysts to ascertain the recognition
pattern of these expenses and how it may trend over time. Investors are interested in comparing the
expected run-off of costs to the performance obligations and contractual liabilities disclosed in the
financial statements.
8) Time Value – The extent to which costs have been incurred and are being assessed for recoverability
over time, there should be consideration given to the impact the time value of money has on these
deferred costs.
27
APPENDIX I
PRESENTATION
Revised ED Needs to Address Income Statement and Cash Flow Presentation Issues
Our review of Paragraphs 104 through 108 of the Revised ED would suggest that all the presentation
issues addressed by the Revised ED are balance sheet related. These paragraphs of the Revised ED
address none of the income statement or cash flow presentation issues arising from the proposed standard.
Some issues are addressed elsewhere in the Revised ED (e.g. collectability and time value) but others
such as the classification of “revenue adjustments” on the income statement as we describe more fully
below or the classification of time value elements (e.g. financing or operating) on the statement of cash
flows. Before finalizing the Revised ED, we urge the Boards to cohesively review their presentation
decisions.
Disaggregation of Revenue on Income Statement Is Preferable
We support greater disaggregation of revenues. That said, we believe the disaggregation should appear on
the face of the income statement rather than in the notes to the financial statements to provide greater
prominence and timeliness to the disclosures. See a more complete discussion above under disclosures.
Income Statement Presentation of Gross Revenue and Credit Risk Adjustment is Appropriate
Why We Support Gross Revenue and Adjacent Presentation
Effectively, credit risk is addressed as a presentation issue under the Revised ED and no longer as a factor
that influences the recognition or measurement of gross revenue. We are strongly supportive of the
proposed adjacent presentation of credit risk as it increases the information content related to underlying
gross revenue and credit impairments related to revenue. The joint CFA Institute webcast with the IASB
and FASB on revenue recognition showed that 63% of 195 respondents found information about
uncollectibility of revenue to be useful.
We support this “gross revenue” presentation as we do not believe investors are aware of the current
practice of reducing revenue for amounts where collectability is not reasonably assured nor are they
provided with the amount of these reductions. Gross presentation of revenue with adjacent presentation of
credit risk has the effect of increasing transparency. We also support the presentation of subsequent
updates to credit risk measurement through the same line. We do, however, have suggested improvements
in disclosures that we believe are necessary to support this presentation and provide an understanding of
the initial versus ultimate expectations of credit losses – such an understanding is important to the
assessment of earnings quality. Our proposed disclosure enhancements are presented in the appropriately
labeled section elsewhere herein.
Greater Transparency Will Make Earnings Management More Challenging: A Positive Result
We think it is important for the Boards to understand that adjacent presentation has the effect of making
earnings management of net income (i.e. increasing credit risk reserves in good times and releasing them
in bad times) a bit more challenging because of the increased transparency. Assuming that earnings
management has been done through bad debt expense under existing guidance, under the new proposed
guidance increasing reserves has the effect of not only decreasing net income but reducing a revenue line
item. This simultaneous reduction of revenue may serve as a deterrent. That said, a reduction in previous
established reserves will have the beneficial impact of increasing a revenue line item whereas it would not
have had that impact before. The adjacent presentation will, however, have the impact of providing
greater transparency to the earnings management done through “bad debt expense.” Similarly, if earnings
28
APPENDIX I
were managed through the “collectability is not reasonably assured criteria” investors will now have some
insight into such amounts where it was not transparent before.
Boards Changes From Original ED and Current Practice May Not Be Obvious To Users At This Stage
As noted above, and in our discussion of Step# 3 in our letter on Recognition and Measurement issues
associated with the Revised ED, we don’t believe there is a comprehensive understanding of existing
practice with respect to the reduction of revenue for amounts for which collectability is not reasonably
assured. Further, we don’t believe there is an appreciation of the theoretical difference in approach
proposed in the Original ED and how it differs from the current guidance or how it has evolved into the
proposals in the Revised ED. We do not believe the change in approach from the Original ED to the
Revised ED has been clearly communicated to investors and, as such, there may not be a full appreciation
of the Boards decisions and the theoretical change in perspective which has been made. Still further,
many view the Revised ED as simply a reclassification of the bad debt expense from expenses to a contra
revenue line without consideration of the change in the gross revenue presentation. Greater clarity on the
changes by the Boards may facilitate better investor feedback on this issue.
Boards Should Clarify Linkage of Revenue and Credit Risk and Retain Their Position on This Topic
Our view is that commentators who object to the proposed presentation fail to sufficiently realize that at a
minimum, gross revenue and credit risk have to be inextricably linked. It is also surprising that some
preparers are objecting to a change that does not impose additional cost or compliance complexity and
that many arguments against the change seem to be influenced by a preference towards sticking to
familiar presentation requirements even at the expense of greater transparency.
We believe that the Boards and final standard should make it clear that at a minimum, gross revenue and
credit risk will have to be inextricably linked. The final standard should make it crystal clear that the
“when or how much” no longer matters for gross revenue determination and that is the reason underlying
the proposed adjacent presentation.
Presentation of Time Value Needs Several Refinements to Be Cohesive
The Revised ED proposals would adequately reflect the effects on the income statement by separately
reporting interest expense or interest income. In similar fashion, we would propose the disaggregation of
the contract asset (liability) portions to reflect the interest payable (receivable) and to have the interest
reflected separately in the financing section of the cash flow statement.
29
APPENDIX I
Presentation of “Revenue Adjustments” Is Not Sufficiently Transparent to Investors
We noted in our review of the 30 DJIA companies, that their policy footnotes and disclosures were vague
as to the precise presentation, and even more so as to the amounts, of what we would refer to as “revenue
adjustments” – despite their significant prevalence. We define “revenue adjustments” to include items
such as warranties, incentives, rebates, refunds (in cash and in-kind), options, etc. We do not believe the
Revised ED, or the Original ED, makes it readily apparent to investors which of these items are
considered separate performance obligations (e.g. warranties which can be purchased separately), which
are simply reductions of revenue (e.g. refunds) and which may flow through expense captions on the
income statement (e.g. warranties accounted for under IAS 37 or refunds in-kind). Accordingly, their
presentation within the income statement is not readily apparent and the related disclosures also lack
clarity.
These items have been the source of significant debate, restatements and commentary and interpretation
by regulators such as the SEC. Further, their location in the income statement can alter ratios or trends
that the company and investors believe are important. Comparability between companies can also be
impaired. Consequently, the proper classification of these items should not be overlooked by the Boards.
We find, however, very little guidance on the presentation of such items within the Revised ED. Only
through discussion of related topics is the presentation issues associated with these “revenue adjustments”
touched-upon.
Our view is that the Boards need to undertake a comprehensive consideration of the presentation of these
“revenue adjustments” to ensure that the guidance is complete and consistent. If not, interpretative
guidance will undoubtedly be required as the treatment of these items is likely to vary in practice.
Balance Sheet Presentation: Nature of Balances Created by Standard Are Unclear To Stakeholders
and Decrease Accessibility and Understanding of Proposed Standard
(Contract Assets vs. Accounts Receivable, Contract Liabilities vs. Performance Obligations,
Performance Obligations vs. Backlogs)
See discussion above under General Recommendation for Improving Revenue Disclosures.
30
APPENDIX I
TRANSITION AND EFFECTIVE DATE
Investors Need Full Retrospective Application: Optionality Is Unacceptable
As we articulated in our previous commentary, investors require full retrospective application of the new
revenue standard.
Where the impacts of the conversion to a new revenue recognition standard are likely to be most
significant are areas where there a multiple elements arrangements, unobservable selling prices and an
extended cash conversion cycle. The areas of greatest change are simultaneously the areas of most
significant subjectivity and judgment and where analysts and investors will want to gauge the impact of
the change on earnings trends – necessitating historical information.
An entirely prospective method mixes old recognition and measurement guidance with new guidance and
creates information which is not decision useful is unacceptable. Further, a modified prospective
approach provides no historical trends that investors can use to assess performance and use as a
benchmark for future analysis. While investors may see a cumulative effect to retained earnings they have
no insight or transparency into the trends or the impacts over time. Some suggest an approach similar to
that followed under the adoption of EITF 08-01 be followed. Our view is those disclosures were not
useful. We believe it would be acceptable willing to defer the effective date of the standard so as to
ensure that comparable information is available for analysis and investment decision-making. It should
go without saying that the Boards should prohibit any optionality in transition approach. This will
destroy comparability between organizations –for many years and possibly permanently– and should not
even be considered by the Boards.
Some want to short-cut the transition approach to reduce costs, but they fail to consider that the transition
information is highly relevant to investors as it is the mechanism by which the change in recognition and
measurement is communicated to investors. The lack of information creates greater uncertainty which is
ultimately priced by investors. Preparers and their auditors fail to consider this cost in their efforts to
advocate for less useful transition information.
As a part of our joint webcast with the FASB and IASB on the Revised ED, we queried participants
regarding their desire for retrospective information. Survey results showed that 62% of 210 respondents
required prior period information when new standard is enacted.
We reiterate our comments made on the Original ED:
Users need comparable information for all prior periods on a consistent basis. Given the
importance of revenue and cost information to the valuation of the enterprise, it is imperative
that trends be provided through communication of at least three periods of information (two
prior periods and the current period). Optionality related to the retrospective versus
prospective adoption is entirely unacceptable to users.
We do not object to an effective date which allows companies to plan for adoption and
improve the quality of retrospective application, but even such a delay should not prevent the
need for those enterprises with long term contracts (e.g. greater than two to three years in
duration) to engage in some element of retrospective application.
We are surprised by the lack of transition guidance provided in the ED. We expect that upon
transition, questions will arise related to the availability of historical information and the use
of hindsight in the determination of transaction prices, estimated selling prices, etc. For
31
APPENDIX I
example, would a long term contract which is onerous at the date of transition- but which
was not expected to be onerous at inception- be considered onerous upon inception under a
retrospective transition application? Similarly, would estimated selling prices which, upon
inception of the contract, and the initial allocation, had not been observable, but which
become observable by the date of transition, utilize currently existing information to perform
allocations or use then existing information?
Cost of Converting to a New Revenue Standard Should Not Be Confused
With Cost of Retrospective Adoption
During a recent roundtable on the Revised ED in Norwalk, it became clear that many are
confusing/intermingling the cost of transitioning to a new revenue recognition standard with the cost of
preparing retrospective information. Many cite the cost of building new IT systems, reviewing contracts
with customers, and determining the follow-on impacts as reasons not to provide retrospective
information.
We think it is important for the Board to bifurcate the “cost of change” with the “cost of retrospective
application”. For example:
1) Cost of New IT Systems – The cost of building a new IT system is a cost of change, not a cost of
retrospective adoption. Whether retrospective adoption is applied or not, a new system will need to be
built. Accordingly, the cost of new IT systems in the discussion of retrospective vs. prospective
application is not meaningful to that decision.
2) Cost of Running Parallel Systems – With a deferred effective date and retrospective adoption, the most
significant cost would be the cost of running the two systems in parallel. And, it would be the cost of
running the old, not the new system, which is the incremental cost of transition. We would note,
however, with a deferred effective date of 2-3 years there is at least one year of parallel processing that
is necessary under even a prospective approach to ensure the integrity of the new data. As such, the
entire cost of running parallel cannot be attributed to retrospective adoption.
3) Cost of Reviewing Contracts with Customers – The cost of reviewing contracts with customers is a
cost of change. An entirely prospective adoption – one which intermingles old revenue and new
revenue recognition methods – requires that only new contracts be evaluated under the new guidance.
This method is not acceptable to investors/users in a situation where there are long-duration contracts.
A modified prospective method would require review of all prospective contracts and existing
contracts. A retrospective method would require review of all prospective contracts, existing contracts
and all contracts which existed in the restatement periods but which are not in existence today. The
difference between a modified prospective and a retrospective approach are, therefore, only the
contracts which existed in the restatement period but do not exist as of the transition date. A deferred
effective date of say three years would have the effect – in businesses where the contracts are less than
three years – of being equivalent in cost of a modified prospective method or an entirely prospective
approach. Only in companies with contracts having a period of greater than three years would there be
a difference in the cost of a prospective versus a modified prospective or retrospective approach – and
it would be those businesses where the prospective method would be least appropriate given the
intermingling of old and new revenue recognition methods. As such, the Boards need to be disciplined
in their consideration of the cost of reviewing contracts with customers as a cost of retrospective
change. In most cases, it is just a cost of change and a deferred effective date substantially mitigates
the cost of transition.
4) Cost of Computing Other Impacts – Some suggest the cost of computing balance sheet and income
statement impacts (e.g. deferred tax effects) in a retrospective approach is prohibitively expensive.
These changes would have to be computed under a modified prospective approach as well. As such,
only a prospective approach would mitigate cost of implemented such changes. However, those
32
APPENDIX I
entities with significant costs emanating from computing these other impacts (i.e. deferred taxes) are
those with the longest duration contracts where the impact of a prospective adoption would most
obfuscate the earnings trend of the company.
We address the issues above because we believe the conversation regarding transition approach
(prospective vs. modified prospective vs. retrospective) conflates the “cost of change” and the “cost of
retrospective adoption.” Further, as we describe above, we believe a deferred effective date has the effect
of mitigating the cost by converting what many perceive as wasted efforts/costs in looking backward to a
prospective consideration of changes. Moreover, a deferred effective date approach would permit
preparers to implement the new standard over time. It also has the benefit of providing them with the
ability to analyze the impact of the change and better communicate that impact to investors. We
understand there is a cost of change, but the decision to create a new standard has already been made. We
do not believe the costs of retrospective change are being computed properly and we encourage the
Boards to be disciplined in their analysis. Finally, investors want retrospective presentation and, as
owners of the company, they pay for that information, and it should be provided.
33