Revenue Recognition: It's Not Sexy but You Need To

Revenue Recognition: It’s Not Sexy but You Need to Know

Andrew Reading, Dopkins & Company LLP Eric Lucas, KPMG LLP David Antoni, KPMG LLP

National Society of Accountants for Cooperatives 2019 Tax, Finance & Accounting Conference for Cooperatives Denver, CO August 5, 2019

1 The information in this document is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials provided to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in the materials. The information in this document is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

2 Agenda • ASC 606 Overview • Cooperative Implementation Considerations and Best Practices • Tax Revenue Overview • Tax Considerations

3 Key Concepts • Replaces substantially all prior guidance • Effective January 1, 2019 for calendar issuers • Scope – all contracts with customers except where other guidance is provided in ASC (ex. Leases etc.) • Principles based – need to document judgments • Revenue is recognized based on a 5 step model – Applied on a contract by contract basis – Portfolio approach as practical expedient

4 The Five-step Model

An entity recognizes revenue to depict the transfer of promised goods or services to Core customers in an amount that reflects the consideration to which the entity expects Principle to be entitled in exchange for those goods or services

1 Identify the contract(s) with a customer

2 Identify the performance obligations in the contract

3 Determine the transaction price

4 Allocate the transaction price to the performance obligations in the contract

5 Recognize revenue when (or as) the entity satisfies a performance obligation

5 The Five-step Model

1 Identify the contract(s) with a customer

2 Identify the performance obligations in the contract

3 Determine the transaction price

4 Allocate the transaction price to the performance obligations in the contract

5 Recognize revenue when (or as) the entity satisfies a performance obligation

6 Step 1 - Identify the Contract • “An agreement between two or more parties that creates enforceable rights and obligations”. – The accounting reflects the legal rights and obligations • Considerations: – Written contracts/e-mails – Purchase orders – Standard terms/conditions – Verbal agreements – Past business practices – Combining contracts

7 Step 1 - Identify the Contract • Cannot apply 5 step model until a contract is deemed to exist as part of Step 1 • Existence criteria: – Approvals and commitment to perform by both parties – Rights of both parties and payment terms are identified – Commercial substance exists – Collection is probable (likely to occur) • Consider contract termination provisions • Contract modifications

8 The Five-step Model

1 Identify the contract(s) with a customer

2 Identify the performance obligations in the contract

3 Determine the transaction price

4 Allocate the transaction price to the performance obligations in the contract

5 Recognize revenue when (or as) the entity satisfies a performance obligation

9 Step 2 – Identify Performance Obligations • A performance obligation (PO) is a promise to deliver a good or service that is: – Capable of being distinct (customer can benefit from on own or combining it with other resources readily available to customer) – Distinct within the context of the contract (separately identifiable)

10 Step 2 – Identify Performance Obligations • Identify all promised goods and services in the contract (explicit vs. implicit) • Determine if they meet PO definition • Practical expedient – immaterial in context of the contract

11 Step 2 – Identify Performance Obligations • Key Considerations – Warranties (assurance type vs. service) – Customer options for additional goods/services including loyalty programs – Shipping and Handling

12 The Five-step Model

1 Identify the contract(s) with a customer

2 Identify the performance obligations in the contract

3 Determine the transaction price

4 Allocate the transaction price to the performance obligations in the contract

5 Recognize revenue when (or as) the entity satisfies a performance obligation

13 Step 3 – Determine the Transaction Price • Amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (i.e. certain sales taxes). • Based on contract terms and customary business practices – Does not consider cancellation, renewal or modification terms

14 Step 3 – Determine the Transaction Price • Determined at contract inception – Fixed cash and any noncash consideration – Expected variable consideration • Refunds • Returns • Discounts • Performance bonuses • Rebates • Penalties • Royalties

15 Step 3 – Determine the Transaction Price • Other transaction price considerations – Significant financing component – Consideration payable to the customer (i.e. Slotting / Coupons ) – Sales and similar taxes – Nonrefundable upfront fees

16 The Five-step Model

1 Identify the contract(s) with a customer

2 Identify the performance obligations in the contract

3 Determine the transaction price

4 Allocate the transaction price to the performance obligations in the contract

5 Recognize revenue when (or as) the entity satisfies a performance obligation

17 Step 4 – Allocate Transaction Price to Performance Obligations • Key concept – allocate an amount to each PO representing the consideration to which the entity expects to be entitled as a result of transferring control of the underlying goods or services to the customer. • Generally allocated using stand-alone selling prices

18 The Five-step Model

1 Identify the contract(s) with a customer

2 Identify the performance obligations in the contract

3 Determine the transaction price

4 Allocate the transaction price to the performance obligations in the contract

5 Recognize revenue when (or as) the entity satisfies a performance obligation

19 Step 5 – Recognize Revenue • Recognize revenue when control is transferred in connection with the satisfaction of a performance obligation a)over time or b)at a point in time

• Transfer of control - customer has the ability to direct the use of the asset and receive substantially all of the related remaining benefits

20 Step 5 – Recognize Revenue • Indicators that control has transferred – Customer is obligated to pay Cooperative for the transferred asset – Customer has: • Legal title • Physical custody • Significant risks and rewards of owning asset • Accepted asset • Indicators are not solely determinative – often require significant judgment

21 Step 5 – Recognize Revenue • Over time vs. point in time - assessed at contract inception • Over time if any one are met, otherwise recognized at a point in time: – Customer simultaneously receives and consumes benefits as entity performs – Customer controls the asset as the entity creates or enhances the asset – No alternative use and an enforceable right to payment

22 Step 5 – Recognize Revenue • Over time – use output or input methods that reasonably measure progress toward completion of POs • Must be consistently applied to all similar transactions • Point in time – when customer obtains control of the asset underlying the performance obligation

23 Step 5 – Recognize Revenue • Key considerations: – Customer’s unexercised rights (i.e. breakage) – Repurchase agreements – Consignment arrangements – Sales to distributors – Bill-and-Hold arrangements – Customer acceptance – International sales (when has control transferred)

24 Other Overall Considerations • Licensing and rights to use (IP) • Principal vs. Agent (gross vs. net reporting) • Onerous (loss) contracts • Contract costs – to fulfill and obtain

25 Transition • Full Retrospective application to all periods presented. Certain practical expedients with disclosure • Modified Retrospective – Applied to either (a) all contracts at the date of initial application or (b) only contracts that have not been completed at the date of initial application

26 Transition • Modified Retrospective - continued – Prior periods are not adjusted – Cumulative effect adjustment is reflected in the opening balance of retained earnings as of initial application date (i.e. January 1, 2019) – Additional disclosures: • Determine the amount of revenue and related costs it would have recognized under legacy GAAP • Financial statement changes and reason

27 ASC 606 Disclosures • Private company disclosures to include information about: – The entity’s contracts – Judgments (and changes in those judgments) made in applying ASC 606 – Fulfillment costs and incremental costs to obtain contracts that have been capitalized in accordance with ASC 340-40

28 Revenue recognition – section 451(b) and ASC 606

29 Prior law • Under an accrual method, gross income is recognized in the tax year in which all events have occurred to fix the right to receive income and the amount can be determined with reasonable accuracy – Earlier of earned, due, or received – Special deferral rules under Rev. Proc. 2004-34 and Treas. Reg. §1.451-5 • Special statutory methods of accounting available – IRC §453 installment sales – IRC §460 long-term contracts • Financial accounting methods were not determinative for tax purposes

30 Tax Cuts and Jobs Act (TCJA) changes • Two new provisions • IRC §451(b) – book / tax conformity requirement – Timing rule now becomes earlier of earned, due, received, or included in book revenue • IRC §451(c) – codifies Rev. Proc. 2004-34 and implicitly repeals all other non-statutory deferral rules • What did not change • Realization – footnote 872 • Availability of special accounting methods in IRC • Income recognition rules for taxpayers – Using cash method, or – Not having an applicable financial statement (AFS)

31 Exception: realization • IRC taxes income only when it has been both realized and recognized – The realization concept applies to all accessions to wealth – No income can be recognized until it is first realized – Previously, realization typically mattered only for transactional events, such as sales, exchanges, casualty events, etc. • New 451(b) does not affect the realization concept – Has the item been realized? • Accession to wealth through a closed and completed transaction – If so, the item is recognized based upon • The taxpayer’s potential method of accounting (all events test) plus • Potential application of a deferral provision (e.g., IRC §§1031, 1033) • Potential application of special accounting methods (e.g., IRC §475)

32 Exception: realization • Footnote text: – “…The provision does not revise the rules associated with when an item is realized for Federal income tax purposes and, accordingly, does not require the recognition of income in situations where the Federal income tax realization event has not yet occurred. …For example, the provision does not require the recharacterization of a transaction from sale to lease, or vice versa, to conform to how the transaction is reported in the taxpayer’s applicable financial statement. Similarly, the provision does not require the recognition of gain or loss from securities that are marked to market for financial reporting purposes if the gain or loss from such investments is not realized for Federal income tax purposes until such time that the taxpayer sells or otherwise disposes of the investment…” • Distinction between realization and first-prong of all events test – When is service income not yet “realized” versus the taxpayer not yet having a fixed right to receive a determinable amount? – How is rent “realized” – How are IP royalties “realized”

33 Example: variable consideration • Variable consideration – New standard requires an estimate of variable consideration (e.g., performance bonuses, incentives) to be included in transaction price if it is probable that amount will not result in significant revenue reversal when uncertainty is resolved – For tax, variable consideration generally does not trigger income until contingency is resolved (similar to current GAAP treatment) – Example – revenue from inventory sales – seller receives bonus for on-time delivery over three year period:

Revenue 2018 2019 2020 2021 Current Book $200 $200 $200 $400 Future Book $250 $250 $250 $250 Pre-TCJA 451 $200 $200 $200 $400 New 451(b) $250 $250 $250 $250

34 IRC §451(c) • Codifies Revenue Procedure 2004-34 – One-year deferral for most income derived from provision of goods and services – Specifically excludes rent, insurance premiums, financial instruments, others • IRC §451(c) not identical with Rev. Proc. 2004-34 – IRS has stated taxpayers may continue to rely on revenue procedure until it issues new guidance • Invalidates longer deferral period of Treas. Reg. §1.451-5 – Proposed regulations would remove the regulations

35 Potential Changes • Returns – ASC 606 requires returns, subject to an overall constraint, to be estimated using the expected value or most likely amount method. The consideration of the overall constraint /change in estimation method could result is a change from legacy GAAP. – Right of return assets and liabilities are now required to be separately presented on the balance sheet.

36 Potential Changes • Determining the transaction price using a new estimation method – Example • Scenario – Dairy Co-op markets and sells milk for its members. When selling the milk, Dairy Co-op gives its largest customers a one-time incentive rebate if the customer makes purchases above a threshold in a given time period. • Considerations – Dairy Co-op must estimate the amount of consideration to be included in the transaction price using either the expected value (probability-weighted amount) or the most likely amount method. – When a co-op employs volume discounts or rebates, or any other pricing method that results in an inconsistent price per unit, estimation of variable consideration must be considered.

37 Potential Changes • Contract Manufacturing/Bill-and-Hold etc. – Legacy GAAP required entities to defer revenue recognition until all of the significant risks and rewards of ownership are transferred to the customer. – ASC 606 views the transfer of significant risks and rewards of ownership as an indicator of when control is transferred. – Need to closely evaluate additional factors to conclude when control transfers to the customer. It is likely some companies will accelerate recognizing revenue.

38 Potential Changes • Sales to resellers/distributors • Some entities defer revenue recognition until the product is sold to the end customer (sell through method) • ASC 606 requires revenue to be recognized when control is transferred to the reseller based on an estimate of the variable consideration. This could result in the acceleration of revenue recognition. • Conversely, consignment arrangements are deferred until sold to the end customer.

39 Potential Changes • Consideration paid/payable to a customer • Generally reported as a reduction of sales price • Reported as cost if the good/service provided by customer is distinct – Determination of distinct may result in different conclusion than legacy GAAP focused on the receipt of an identifiable benefit… • Consideration payable recorded at later of transferring goods/services or when the entity promises to pay – Variable consideration guidance is broad – could require this consideration to be estimated based on past history / intent. – Therefore, expecting less entities following the “later of” provision

40 Potential Changes • Principal vs. Agent (Gross vs. Net) • Carefully evaluate presentation of revenue at gross vs. net when Third Parties are involved in the sale of goods • Principal – controls promised good/service before transferring to customer. • Agent – records revenue for its agency services • Change from legacy GAAP is ASC 606 focus on the “Transfer of Control”

41 Potential Changes • Principal vs. Agent (Gross vs. Net) - Example Scenario Local Co-op operates a receiving station to which members deliver watermelons. Local Co-op is a member of Fed Co-op, which purchases the watermelons and delivers them to restaurants and grocery stores. Watermelons are perishable items, and Local Co-op typically has possession for several days or less. Considerations Local Co-op will need to evaluate the indicators to determine whether it is acting as principal. ASC 606-10-55-37 states that “an entity does not necessarily control a specified good if the entity obtains legal title to that good only momentarily before legal title is transferred to a customer.”

42 Key potential impacts to farmer cooperatives

Step 2: Identify the performance • Does the sale of certain products by supply co-ops contain more than one performance obligation? obligations in the contract

Step 3: • Do sales of products by marketing co-ops contain volume discounts or rebates that may be Determining the transaction considered variable consideration? price • Gross v. Net Revenue Recognition on Direct Shipments

• If the sale of certain products by supply co-ops contains multiple performance obligations, would the pattern of revenue recognition change? Step 5: Recognizing revenue • If a local co-op takes only momentary possession of products, would it still be considered a principal and report gross? What about repurchases of patron product from contract manufacturers?

• Do co-ops pay certain types of commissions or incur other types of costs that may be considered Contract Costs costs to obtain contracts or costs to fulfill performance obligations?

• New disclosures are required by ASC 606, but private companies are not required to apply all new Disclosures disclosures.

43 Example - Step 2: Identify the performance obligations in the contract • Scenario – Supply Co-op provides pesticides to its members. The pesticide is purchased in bulk and contained in large drums. Rather than provide smaller containers of pesticide to the members, Supply Co-op applies the purchased amount of pesticide to fields using its own equipment. – Supply Co-op always applies the pesticide for the members, and does not sell the pesticide any other way; however, other providers may sell the pesticide without application, and farmers may use their own equipment for application. • Considerations – Supply Co-op must consider whether the sale and application of the pesticide are separate performance obligations. – Goods and/or services that are sold separately and do not form part of an integrated bundle may be considered separate.

44 Example Step 3: Determine the transaction price • Scenario – Dairy Co-op markets and sells milk for its members. When selling the milk, Dairy Co-op gives its largest customers a one-time incentive rebate if the customer makes purchases above a threshold in a given time period. • Considerations – Dairy Co-op must estimate the amount of consideration to be included in the transaction price using either the expected value (probability-weighted amount) or the most likely amount method. – When a co-op employs volume discounts or rebates, or any other pricing method that results in an inconsistent price per unit, estimation of variable consideration must be considered.

45 Automatic consent procedures • Rev. Proc. 2018-29: Changes in timing of • Rev. Proc. 2018-60: Changes in timing of income recognition due to ASC 606 income recognition under new § 451(b) – Temporary automatic consent procedures for – Applies to accrual method taxpayers with AFS taxpayers changing accounting methods to changing accounting methods to comply with conform with ASC 606 in the TY of adoption §451(b)(1)(A) or §451(b)(4) – Timing: – Timing: • Only for taxpayer’s first, second, or third taxable • For tax years beginning after 12/31/17 (or after year ending on or after 5/10/18 12/31/18 for OID) – Manner of making the change: DCN 231 – Manner of making the change: DCN 239 • May be implemented with either a §481(a) • Must describe where §481(a) adj. is reflected on adjustment or on a cutoff basis the return (6 year spread for OID changes) • 5 year scope limitation waived • Short form permitted; duplicate copy filing waived – Applies to early adopters (Rev. Proc. 2018-49) • 5 year scope limitation waived in first, second, or – Possible book conformity for: third year • Audit protection • Allocation of contract price • May make concurrent change on same 3115 to • Acceleration of variable consideration conform with ASC 606 • Timing of recognizing unbilled revenue for partially performed services – Streamlined procedures: • No 3115 for first TY beg. after 12/31/17 for small business taxpayers or if zero §481(a) adjustment • No audit protection or concurrent changes on same 3115; 5 year scope limit waived in first year

46 Implementation Lessons Learned and discussion points • Significantly more time and effort than expected • I don’t expect a change… why do I need to do anything ? – Contracts need to be determined, located and reviewed. – Judgments regarding the 5 step model need to be documented under a principles based model – Others may need to be interviewed to consider past business practices

47 Implementation Lessons Learned and discussion points • Getting used to Principles vs. Rules • You need a team, timeline and periodic status reports to keep on task • Utilize your outside CPA – many practical expedients / policy elections – small details that could trip you up • Establish ongoing systems to maintain ASC 606 documentation for new contracts / modifications

48 Other Observations • IT systems may require updating • Contract risk management – Which customers should have written contracts – Authorization levels to approve – Centralized document storage – Compliance with contract terms (financial or otherwise)

49 Questions ?

50 Contact Information Andrew Reading Dopkins & Company, LLP Director T: (716) 634-8800 | [email protected]

Eric Lucas KPMG LLP Principal, Washington National Tax T: (202) 533-3023 F: (202) 609-8959 | ejlucas@kpmg.com

David Antoni KPMG LLP Managing Director, Tax T: (267) 256-1627 F: (267) 604-0310 | [email protected]