3.1.01 Aerospace and defense entities often do business with the U.S. federal government, as well as with foreign government entities. These contracts are unique for various reasons, including (1) restrictions the U.S. federal government attaches to foreign sales of certain goods or services and (2) the U.S. federal government’s annual budget process, which results in incrementally-funded contracts. This section evaluates how these two circumstances affect an entity’s conclusion about when a contract exists for purposes of applying the revenue recognition requirements of FASB ASC 606.

Foreign Contracts With Regulatory Contingencies

3.1.02 U.S. aerospace and defense companies can sell in the international market through two main channels — foreign military sales (FMS) and foreign direct commercial sales (DCS).

3.1.03 For FMS sales, the aerospace and defense entity contracts with the U.S. federal government, and the U.S. federal government contracts with a foreign government in a government-to-government sales agreement. Therefore, for FMS sales, the U.S. federal government obtains the required regulatory approvals (without involvement from the aerospace and defense entity), and the contract is not executed between the U.S. federal government and the aerospace and defense entity until all regulatory approvals have been obtained. Because regulatory approvals are obtained prior to execution of the contract, FMS sales are not the focus of this section.

3.1.04 For DCS sales, the aerospace and defense entity contracts directly with the foreign government customer, and the U.S. federal government is not a party to the contract. Therefore, for DCS sales, after a contract is executed between the aerospace and defense entity and the foreign government customer, the aerospace and defense entity is required to obtain necessary regulatory approvals from the U.S. State Department or Commerce Department (for example, export license). Additionally, for certain contracts, the Arms and Export Control Act requires that a certification be provided to Congress, whereby Congress is required to be notified of the potential sale to the foreign entity, herein referred to as congressional notification (or CN). After being notified, Congress has a specified number of days to block the sale; no further action is required by the entity. For these contracts, the CN period must lapse prior to physical delivery of any defense articles that are restricted by the U.S. State Department or Commerce Department.

3.1.05 Although the CN period must lapse prior to delivery of any defense articles restricted by the U.S. State Department or Commerce Department, aerospace and defense entities may begin work on the executed contract prior to the lapse of the CN period. Additionally, even after export licenses are obtained and CN has passed, it should be noted that Congress could potentially block the sale any time during the contractual period, as long as the goods or services have not been delivered to the recipient country.

3.1.06 FASB ASC 606-10-25-1 contains five criteria that must be met in order for an entity to account for a contract with a customer: (a) the contract has approval and commitment from both parties; (b) rights of the parties are identified; (c) payment terms are identified; (d) the contract has commercial substance; and (e) collectibility of consideration is probable. When an entity enters into a DCS contract, it will need to assess whether these criteria are met and the contract is legally enforceable.

3.1.07 Generally, the contract between the aerospace and defense entity and DCS customer is legally binding upon the effective date of the contract, which may be the contract execution date (that is, the date of signature by both parties). Therefore, on the contract effective date, AICPA’s Financial Reporting Executive Committee (FinREC) believes the criteria for contract existence would be met because the aerospace and defense entity has an approved legally enforceable contract with the DCS customer that clearly states the contractual terms, including the parties’ rights and the payment terms related to the goods and services to be transferred, and the DCS customer has the intention and ability to pay the aerospace and defense entity for the goods and services.

3.1.08 As part of fulfilling the contractual obligations, the aerospace and defense entity is required to obtain regulatory approvals. Obtaining regulatory approvals is an obligation within an enforceable contract. Therefore, FinREC believes the requirement to obtain regulatory approvals does not preclude an entity from concluding that the contract existence criteria in FASB ASC 606-10-25-1 are met. However, FinREC acknowledges there are varying levels of uncertainty related to the likelihood of obtaining regulatory approvals that the entity must consider when applying the recognition, measurement, and disclosure requirements in FASB ASC 606.

3.1.09 The likelihood of obtaining the necessary regulatory approval will include a high level of judgment and depend on the facts and circumstances of each situation, but the following factors may be considered:

a.     An entity’s history of receiving regulatory approval (that is, whether the entity has a history of receiving regulatory approval and has worked closely with the U.S. State Department prior to signing the international contract).

b.     The level of participation and communication an entity has with the U.S. State Department during its review. (For example, were any issues raised resolved prior to the U.S. State Department notifying Congress? Generally, the U.S. State Department will review the case with congressional staffers prior to the official notification and once the U.S. State Department is relatively sure the case will not be blocked by Congress, it is sent to the notification process.)

c.     The existence of U.S. advocacy in which senior U.S. government officials have advocated for foreign governments to award the contract to a U.S. defense contractor.

d.     Recent prior regulatory approvals of sales to the same country that cover the same goods subject to the current regulatory approval. For example, there may be a regulatory approval for part of an aerospace and defense system, and then a short period later, there is another regulatory approval needed for the entire system because different contractors are providing different pieces of the system.

Unfunded Portions of U.S. Federal Government Contracts

3.1.10 Doing business with the U.S. federal government is unique because of the U.S. federal government’s annual budget process. Each year, the U.S. federal government releases a budget with funds appropriated to buying commands that, in turn, award contracts to industry. In the aerospace and defense industry, it is common for a company to be awarded a long-term contract that is only partially funded at inception. Using judgment and the considerations described in this chapter, an entity needs to determine whether and how to apply the requirements of FASB ASC 606 to the unfunded portion of a contract.

3.1.11 FinREC believes that the criteria for contract existence in FASB ASC 606-10-25-1 would be met for both the funded and unfunded portions of a contract if the aerospace and defense entity has an approved enforceable contract with the U.S. federal government that clearly states the contractual terms, including the parties’ rights and the payment terms related to the goods and services to be transferred; and the U.S. federal government has the ability and intention to pay the aerospace and defense entity for the promised goods and services.¹

3.1.12 After determining that the contract meets the criteria for contract existence, the entity would apply the other requirements of FASB ASC 606. In determining the transaction price, FASB ASC 606-10-32-4 states that "an entity shall assume that goods or services will be transferred to the customer as promised, in accordance with the existing contract and that the contract will not be cancelled, renewed, or modified." FinREC believes the unfunded portion of a contract should be considered variable consideration, similar to award fees and incentive fees included in the transaction price of aerospace and defense contracts prior to their funding being certain.

3.1.13 FASB ASC 606-10-32-11 explains that an entity should include in the transaction price some or all of an amount of estimated variable consideration only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Therefore, an entity may conclude that both the funded and unfunded portions of the contract could be included in the transaction price, subject to the constraint guidance.

3.1.14 In accordance with the guidance on constraining estimates of variable consideration in paragraphs 11–13 of FASB ASC 606-10-32, prior to recognizing revenue in excess of funding, an entity should perform an assessment to analyze the likelihood that the unfunded portion of the contract will not result in a significant revenue reversal. FinREC believes the following factors should be considered when an entity performs such an assessment:

a.     Whether there is a short period of time before contract funding is expected

b.     Whether the work is sole source, a follow-on effort, or there is high competition

c.     Whether customer funding and budget exist and the task of processing the funding is administrative only

d.     Whether it is a major program or the customer is in critical need of the program

e.     Whether there has been communication from the customer that funding will be obtained

f.     Whether the entity has a history of receiving funding in similar situations

3.1.15 FinREC believes that if an entity concludes that it is probable that the unfunded portion of the contract will become funded (that is, it is probable that including the unfunded portion of the contract in the revenue calculations will not result in a significant revenue reversal solely due to the fact that it is initially unfunded), then in accordance with FASB ASC 606-10-32-11, the entity should include the unfunded portion of the contract in the transaction price prior to the funding being appropriated and continue to recognize revenue in excess of funding as long as the conditions surrounding the constraint on variable consideration have been met.

3.1.16 The following examples are meant to be illustrative; they focus on what an entity may do after it determines the contract meets the existence criteria. The following examples are not all-inclusive, and any other relevant indicators that could result in a significant reversal in the amount of cumulative revenue recognized on the contract should be considered.

Example 3-1-1

On September 1, 20X1, an aerospace and defense contractor signed a contract with the U.S. federal government for a fixed price of $600 million over a three-year period of performance. The program will receive annual funding of $200 million, starting on September 30, 20X1. The entity concludes that the entire $600 million contract is within the scope of the revenue standard because the entity has an approved contract in writing signed by both parties, it clearly identifies each party’s rights regarding goods and services to be delivered, the payment terms are clearly identified, and collectibility is probable because the customer has both ability and intent to pay.

On August 1, 20X2, the entity has recognized revenue of $200 million based on costs to date (plus a reasonable profit margin). In deciding whether to continue performing and recognizing revenue on the contract beyond funding, the entity analyzes the probability that it will receive funding and, therefore, not incur a significant reversal of cumulative revenue recognized. The entity considers the following factors:

•     Time period before contract funding is expected is short (two months).

•     Program is a follow-on contract.

•     U.S. federal government has both the ability and intention to pay.

•     U.S. federal government has a need for the program.

•     Entity has received communication from the customer that funding will be obtained.

•     Historically, the entity was able to receive funding and recover its costs on contracts that led up to this follow-on work.

Based on these considerations, the entity concludes that the risk of a significant reversal of cumulative revenue is remote and, therefore, the unfunded amounts are included in the transaction price and recognized as revenue.

Example 3-1-2

Consider the same facts as example 3-1-1, except for the following factors:

•     U.S. federal government has expressed uncertainty with regard to the need for the program.

•     Entity has not received communication from the customer that funding will be obtained.

In deciding whether to continue performing work and recognizing revenue on the contract beyond funding, the entity analyzes the probability that it will receive funding and, therefore, not incur a significant reversal of cumulative revenue recognized. Although there is only a short period of time before contract funding would occur, the entity determines it is not probable that a significant reversal of revenue will not occur if both the funded and unfunded portions of the contract are included in the transaction price. Therefore, the entity determines that the unfunded portion of the contract is constrained, and revenue is not recorded. This evaluation is updated each period until either funding is provided on the contract or the contract is terminated.

3.1.17 At the November 2015 meeting of the TRG, an implementation issue was discussed regarding how to determine the term of the contract when the customer has the unilateral right to terminate a contract and whether termination penalties affect that analysis.

3.1.18 As discussed in paragraphs 50–51 of agenda paper 48: Customer Options for Additional Goods and Services, Issue 2: Customer Termination Rights and Penalties, the FASB and IASB staff recommended that contracts with customer termination provisions should be accounted for the same as contracts with unexercised options when the contract does not include a substantive termination penalty. That is, if the termination penalty is not substantive, this may indicate that the contract term, in accordance with FASB ASC 606, is less than the stated contractual period. As explained in TRG Agenda Ref. No. 49, November 2015 Meeting — Summary of Issues Discussed and Next Steps, paragraph 10 states:

3.1.19 Aerospace and defense contracts with the U.S. federal government are governed by the Federal Acquisition Regulations (FAR), which governs the process by which the U.S. federal government purchases goods and services. Contracts with the U.S. federal government typically contain a Termination for Convenience (T for C) clause that allows the U.S. federal government to terminate a contract whenever “…it is in the Government’s interest.” (FAR 52.249-1). Hence, the U.S. federal government has the right to unilaterally terminate the contract for events such as the need to discontinue a contract because of technological developments that make continued work on the contract out of date, lack of funding due to budgetary restrictions, or in some instances, because the work is simply no longer needed.

3.1.20 Per FAR 49.201(a), the U.S. federal government in a T for C clause should “compensate the contractor fairly for the work done and the preparations made for the terminated portions of the contract, including a reasonable allowance for profit.” When the U.S. federal government terminates a contract for its convenience, a contractor is entitled to recover the following costs associated with the termination:

a.     Costs incurred for work completed and accepted at the time of the termination

b.     Costs for incomplete work that are considered allowable, allocable, and reasonable

c.     Close-out, demobilization, and settlement proposal costs associated with preparing a final cost proposal for submission to the government

d.     Profit on the above costs incurred

3.1.21 If a contract is terminated for convenience, the costs that are incurred related to preparations for termination generally are significant (and would be recovered from the customer). Additionally, the timing of payments is different in a termination event as compared to payments for normal execution of the contract because previously unbilled amounts become billable as part of the termination claim. These costs would not have been incurred had the contract not been terminated, therefore, these costs are considered akin to an early termination penalty. Examples of recoverable costs that constitute a penalty include the following:

a.     All costs associated with “shutting-down” a production line due to T for C clause.

b.     Stranded costs related to equipment or facilities used solely for the contract. For example, if the entity has leased a building specifically related to the contract for five years and the customer terminates the contract in year one, the customer would have to pay for the entire five-year lease (or the penalty to cancel the lease early).

c.     Disposition of customer-owned work in process and equipment.

3.1.22 Commercial aerospace and defense contracts may also include a clause with similar economic characteristics for recovery of costs incurred as the T for C clause included with contracts with the U.S. federal government. Judgment will be required to evaluate whether the economic characteristics for commercial aerospace and defense contracts are similar to the T for C clause included in contracts with the U.S. federal government.

3.1.23 When an aerospace and defense contract includes a T for C clause or a clause with similar economic characteristics, FinREC believes the termination payment generally would be considered substantive and, therefore, the entity would not assume cancelation in determining the scope and term of the contract. In accordance with FASB ASC 606-10-32-4, in determining the transaction price (and the disclosed amount allocated to remaining performance obligations), it is assumed that the contract will not be cancelled and would reflect all of the scope on the contract (including for exercised options).

3.1.24 For aerospace and defense contracts that do not contain a T for C clause or a clause with similar economic characteristics, judgment will need to be applied to the facts and circumstances of each termination provision, consistent with the TRG discussion as explained in paragraph 10 of TRG Agenda Ref. No. 49.

3.1.25 The following examples are meant to be illustrative, and the actual determination of whether the contract contains a substantive termination penalty should be based on the facts and circumstances of an entity’s specific situation.

Example 3-1-3

A contractor enters into a fixed price production contract for $100 million for development, fabrication, integration, test, and delivery of a specialized aerospace and defense system with the U.S. federal government. The contract meets all criteria for existence in accordance with FASB ASC 606-10-25-1 and includes a T for C clause. The term of the contract is not relevant in this example because the customer has contracted for the delivery of a specialized aerospace and defense system and not a recurring service. In accordance with FASB ASC 606-10-32-4, for the purpose of determining the transaction price and disclosure of remaining performance obligations under FASB ASC 606-10-50-13, an entity should assume that the goods or services will be transferred to the customer, as promised, in accordance with the existing contract and the contract will not be cancelled, renewed, or modified. Therefore, the entity determines that the transaction price is $100 million for this contract.

Example 3-1-4

A contractor enters into a four-year service contract with the U.S. federal government for $100 million ($25 million fee for each year of service). The contractor also enters into a significant lease for four years for performance of the services under the contract. The contract meets all criteria for existence in accordance with FASB ASC 606-10-25-1 and includes a T for C clause. Because the T for C clause is a substantive penalty (the U.S. federal government would have to pay for the all costs associated with this contract, including the entire four-year lease costs in the event of an early termination in addition to costs for incomplete work, severance costs for employees assigned to this contract, costs to prepare the termination claim and so on, including reasonable profit), the contract term is four years. In accordance with FASB ASC 606-10-32-4, for the purpose of determining the transaction price and disclosure of remaining performance obligations under FASB ASC 606-10-50-13, an entity should assume that the goods or services will be transferred to the customer as promised in accordance with the existing contract and the contract will not be cancelled, renewed, or modified. Therefore, the entity determines that the transaction price is $100 million for this contract.

Example 3-1-5

A contractor enters into a four-year service contract with a commercial customer for $100 million ($25 million fee per year of service). The contract meets all criteria for existence in accordance with FASB ASC 606-10-25-1, and the customer can cancel the contract without a penalty at the end of any year. Because there is no penalty for cancelation of the contract, each year of service is akin to an option that gives the customer the right to acquire additional years of service of the same type as those supplied under an existing contract. Therefore, in this example, the contract term is limited to the year that is currently under contract. In accordance with FASB ASC 606-10-32-4, for the purpose of determining the transaction price and disclosure of remaining performance obligations under FASB ASC 606-10-50-13, an entity should assume that the goods or services will be transferred to the customer, as promised, in accordance with the existing contract and the contract will not be cancelled, renewed, or modified. Therefore, the entity determines that the transaction price is $25 million for this contract (at inception for year one). The contractor still needs to determine if the option to renew each year at a fixed price conveys a material right.

Example 3-1-6

A contractor enters into an indefinite quantity production contract for a fixed price of $2 million per unit of a specialized aerospace and defense system. The contract includes a guaranteed minimum order quantity (GMOQ), committing the customer to purchase 50 units within four years, or pay a $1 million per unit termination liability (TL) for each unit not purchased. In addition, the contract allows the customer to purchase additional units of hardware, beyond the GMOQ, at a price of $2 million per unit. In this example, it is assumed that the option does not represent a material right. The contract meets all of the criteria for existence in accordance with FASB ASC 606-10-25-1 and includes a substantive penalty (the company concluded that a substantive penalty exists to enforce the GMOQ based on the requirement to pay a $1 million TL for each unit of the GMOQ not ordered within four years). The term of the contract is not relevant in this example because the customer has contracted for the delivery of a specialized aerospace and defense system and not a recurring service. Therefore, the entity determines that the transaction price is $100 million ($2 million time 50 GMOQ units) for this contract.

3.1.26 It is common in the aerospace and defense industry for customers to change contract specifications and requirements, particularly in development contracts. This is because development contracts typically span over multiple years and include the integration of multiple goods and services. These contracts typically authorize the contractor to proceed with the modifications to the scope of the contract even though the price has not been agreed upon between the parties. Judgment will often be needed to determine whether changes to existing rights and obligations should have been accounted for as part of the original arrangement (that is, should have been anticipated due to the entity's business practices) or accounted for as a contract modification.

3.1.27 A contract modification could change the scope of the contract, the price of the contract, or both the scope and price of the contract. As noted in FASB ASC 606-10-25-10, a contract modification exists when the parties to a contract approve a modification that either creates new or changes the existing enforceable rights and obligations. A contract modification could be approved in writing, oral, or implied by customary business practices.

3.1.28 Aerospace and defense industry service and maintenance contracts may contemplate and allow for future changes to technical plans to comply with FAA service bulletins or to implement an improved repair process or procedure. The risk or reward, or both, of changes to the technical plan are key characteristics of the performance obligation underlying the nature of these contracts when the entity is standing ready to provide an integrated maintenance service. Although changes to the technical plan may require customer approval (required by FAA as the operator or customer must "own" the technical plan) and take the form of a contract amendment or modification, judgment will be necessary to determine whether the changes create new or change the existing enforceable rights and obligations of the contract. Revenue related to a modification is not recognized until new enforceable rights and obligations exist or existing enforceable rights and obligations are changed.

3.1.29 In some cases, the entity may make a claim (described in paragraph BC81 of FASB Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), as "specific modifications in which the changes in scope and price are unapproved or in dispute") against a customer for additional amounts that the entity seeks to collect in excess of the agreed contract price. Claims are normally made as a result of customer-caused delays, errors in specifications and designs, contract terminations, change orders in dispute or unapproved concerning both scope and price, or other causes of unanticipated additional costs. Claims can also give rise to a contract modification. However, as stated in FASB ASC 606-10-25-11, "in determining whether the rights and obligations that are created or changed by a modification are enforceable, an entity shall consider all relevant facts and circumstances including the terms of the contract and other evidence."

3.1.30 Enforceability of the rights and obligations in a contract is a matter of law. The practices and processes for establishing contracts with customers vary across legal jurisdictions, industries, and entities. In addition, they may vary within an entity. An entity should include consideration of those practices and processes in determining whether and when an agreement with a customer creates enforceable rights and obligations.

3.1.31 Determination of whether a contract claim is an enforceable right will require judgment. Management should consider whether the contract or other evidence provides a legal basis for the claim.

3.1.32 Paragraph BC39 of FASB ASU No. 2014-09 states that "the Boards clarified that their intention is not to preclude revenue recognition for unpriced change orders if the scope of the work has been approved and the entity expects that the price will be approved. The Boards noted that, in those cases, the entity would consider the guidance on contract modifications." BC81 of FASB ASU No. 2014-09 also addresses unpriced change orders and claims and notes that the boards concluded it was unnecessary to provide specific guidance on the accounting for these types of modifications because FASB ASC Topic 606 includes relevant guidance in paragraphs 10–13 of FASB ASC 606-10-25.

3.1.33 Contract modifications are accounted for as either a separate contract or as part of the existing contract depending on the nature of the modification.

3.1.34 FASB ASC 606-10-25-12 requires that a contract modification be accounted for as a separate contract if both of the following conditions are present:

a.     The scope of the contract increases because of the addition of promised goods or services that are distinct; and

b.     The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling price of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For example, an entity may adjust the standalone selling price of an additional good or service for a discount that the customer receives, because it is not necessary for the entity to incur the selling-related costs that it would incur when selling a similar good or service to a new customer.

3.1.35 FASB ASC 606-10-25-13 explains that if a contract modification does not meet both of the criteria in ASC 606-10-25-12 to be accounted for as a separate contract, the remaining promised goods or services should be accounted for as an adjustment to the existing contract, either prospectively or through a cumulative catch-up adjustment depending on the specifics of the contract modification.

3.1.36 As explained in FASB ASC 606-10-25-13a, an entity should account for a contract modification as if it were termination of the existing contract, and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. The amount of consideration to be allocated to the remaining performance obligation (or to the remaining distinct goods or services in a single performance obligation identified in accordance with FASB ASC 606-10-25-14b is the sum of

a.     The consideration promised by the customer (including amounts already received from the customer) that was included in the estimate of the transaction price and that had not been recognized as revenue and

b.     The consideration promised as part of the contract modification.

3.1.37 As explained in FASB ASC 606-10-25-13b, an entity should account for a contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied when the contract is modified. The effect of the contract modification on the transaction price would be recognized as an adjustment to revenue at the date of the contract modification (that adjustment to revenue is made on a cumulative catch-up basis).

3.1.38 When a change order is combined with the original contract and the remaining goods or services are part of a single performance obligation that is partially satisfied, the contractor should consider the guidance in paragraphs 12–13 of FASB ASC 606-10-25 and update the transaction price and measure of progress towards completion of the contract accordingly. As noted in FASB ASC 606-10-25-13b in this situation the contractor will recognize the effect of the contract modification as revenue (or as a reduction of revenue) at the date of the contract modification on a cumulative catch-up basis.

3.1.39 When measuring the change in transaction price as a result of an approved contract modification when the price of the modification has not been agreed upon between the parties and the modification will be combined with the original performance obligation, an entity should follow the guidance in paragraphs 5–9 of FASB ASC 606-10-32 on estimating variable consideration and paragraphs 11–13 of FASB ASC 606-10-32 on constraining estimates of variable consideration. The entity should incorporate all relevant information and evidence in evaluating its best estimate of variable consideration and whether it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the amount is ultimately finalized. Some of the factors to consider in evaluating this amount include documentation for change order costs that are identifiable and reasonable, and the entity's favorable experience in negotiating change orders, especially as it relates to the specific type of contract and change order being evaluated. FinREC believes that this constrained estimate of the change in transaction price as a result of the contract modification should be used in accounting for any adjustment to revenue arising from the application of this guidance (for example, a cumulative adjustment to revenue as described in FASB ASC 606-10-25-13b).

3.1.40 If the final change in transaction price ultimately agreed with the customer for the unpriced change order or claim differs from the estimate determined previously, that change should be accounted for in accordance with paragraphs 42–45 of FASB ASC 606-10-32. FinREC believes that an entity should not subsequently revisit or adjust the original conclusion as to the type of modification the change order represented (for example, whether the change in transaction price reflected the standalone selling price of additional distinct goods or services), unless there are indications that the original assessment reflected a misapplication of the facts as they existed at the time.

Options Including Unexercised Options in a Loss Position

3.1.41 Determining if an option conveys a material right. Aerospace and defense contracts often contain options that give customers the right to purchase additional goods or services. Contracts with the United States Government (USG) may contain options for additional units or renewals. FASB ASC 606-10-55-42 states the following:

3.1.42 As noted in FASB ASC 606-10-55-43, options to acquire additional goods or services at a price that reflects the standalone selling price do not provide the customer with a material right. Options included in contracts with the USG are typically negotiated at standalone selling prices because pricing is established based on costs to complete the contract scope plus a reasonable margin.

3.1.43 If an entity determines that an option provides a customer with a material right that is then accounted for as a performance obligation, in accordance with FASB ASC 606-10-32-29 an entity is required to allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis. This would include allocating a portion of the transaction price to the option.

3.1.44 As explained in FASB ASC 606-10-55-44, the estimate of the standalone selling price of a customer option should reflect the discount that the customer would obtain when exercising the option, adjusted for both any discount that the customer could receive without exercising the option and the likelihood that the option will be exercised.

3.1.45 FASB ASC 606-10-55-45 provides a practical alternative to allocating transaction price to an option. If a customer has a material right to acquire future goods or services that are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, the transaction price can be allocated to the optional goods or services by reference to the goods or services expected to be provided. Typically, those types of options are for contract renewals.

3.1.46 The assessment as to whether or not an option grants a customer a material right is completed at contract inception. No re-assessment of material rights is required, even in cases where performance issues or cost increases may result in a reduction in expected contract margins. Reduced margin due to actual performance on a contract (that has options) in relation to other contracts for similar products or services does not result in a material right being granted to that customer because the customer did not pay in advance for the future goods or services.

3.1.47 Accounting for customer’s exercise of a material right. In accordance with FASB ASC 606-10-25-23, an entity recognizes revenue as the amount allocated to the material right when the future goods or services are transferred or when the option expires.

3.1.48 At the March 30, 2015 TRG meeting, the accounting for an option representing a material right upon exercise was discussed (TRG Agenda Ref. No. 32). As explained in paragraphs 11 and 12 of the Agenda Ref. No. 34, March 2015 Meeting — Summary of Issues Discussed and Next Steps, on Issue 1: How should an entity account for a customer’s exercise of a material right?

3.1.49 Differentiating between an option and variable consideration. Determining whether a contract contains an option to purchase additional goods and services or includes variable consideration based on variable quantities (such as indefinite delivery or indefinite quantity (IDIQ) contracts within the aerospace and defense industry) will require entities to exercise judgment.

3.1.50 Although the accounting for a contract that contains an option to purchase additional goods and services and a contract that includes variable consideration may result in only minimal differences in the timing and measurement of revenue recognized in a reporting period, there could be differences in required disclosures. Further, the determination can result in significant differences in the amount and timing of revenue recognized in a reporting period when contracts contain multiple performance obligations.

3.1.51 Although judgment will sometimes be needed to distinguish between contracts with an option to purchase additional goods or services and contracts that have variable consideration, at the November 9, 2015 TRG meeting, the TRG discussed the accounting for customer options for additional goods and services (TRG Agenda Ref. No. 48). Paragraph 9 of TRG Agenda Ref. No. 49 noted the following:

3.1.52 Unexercised options in a loss position. Existing industry guidance provides for the inclusion of contract options that are probable of exercise in the determination of a loss and related provision. FASB ASC 605-35-25-46 (as amended for FASB ASC 606) states "When the current estimates of the amount of consideration that an entity expects to receive in exchange for transferring promised goods or services to the customer, determined in accordance with ASC 606, and the contract indicates a loss, a provision for the entire loss on the contract shall be made." This guidance only applies to contracts within the scope of FASB ASC 605-35.

3.1.53 FASB ASC 605-35-25-46A (as amended for FAB ASC 606) also states, "For the purpose of determining the amount that an entity expects to receive in accordance with paragraph 605-35-25-46, the entity shall use the principles for determining the transaction price in paragraphs 606-10-32-2 through 32-27 (except for the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration) and allocating the transaction price in paragraphs 606-10-32-28 through 32-41."

3.1.54 Therefore, stakeholders may interpret that FASB ASC 606 would not require entities to record a provision for losses relating to contractual options that are probable of exercise. However, FinREC believes the boards’ intent in amending and retaining the guidance in FASB ASC 605 on accounting for contract losses was that the accounting would not change compared to current industry guidance. In general, entities should continue to include losses on options that are probable of exercise in determining the provision for losses on contracts, consistent with current industry guidance. Additionally, consistent with current guidance, entities would not include profitable options that are probable of exercise when determining the amount of the provision for loss on an existing contract.

3.1.55 The following examples are meant to be illustrative, and the actual determination of the appropriate method for accounting for the contract modification as stated in FASB ASC 606-10-25-10 should be based on the facts and circumstances of an entity’s specific situation.

Example 3-1-7 — Modification — Sale of Additional Products Upon Exercise of Option

Part 1 — Option is distinct

A contractor enters into an arrangement with the government to sell 1,000 rocket launchers for $10M ($10,000 per rocket launcher), with an option to purchase an additional 500 rocket launchers for $10,000 each. The option does not include a material right because the price of the additional rocket launchers represents the standalone selling price. The rocket launchers are transferred to the customer over a six-month period. The contractor has concluded that all 1,000 rocket launchers represent a single performance obligation as the rocket launchers are highly customized and specialized for the customer and the entity is responsible for the overall management of the contract, which requires a significant service of integration of various activities, including procurement of materials, identifying and managing subcontractors, and performing manufacturing, assembly, and testing for all rockets. The parties modify the contract in month six upon exercise of the government’s option to purchase the additional 500 rocket launchers for $10,000 each.

Based on the specific facts and circumstance, the entity may conclude that the modification to sell the additional 500 rocket launchers at $10,000 each should be accounted for as a separate contract in accordance with FASB ASC 606-10-25-12. The additional rocket launchers are distinct because the modification will be managed separately due to the existing contract being substantially complete and the price for the additional rocket launchers reflect their standalone selling price.

Part 2 — Option is not distinct

In this example, if the customer exercises the option in month one, the entity may conclude that the modification to sell the additional 500 rocket launchers at $10,000 each should be accounted for as part of the existing single performance obligation because of the significant integration service that will be provided to manufacture and produce the 1,500 rocket launchers over the same period of performance.

Example 3-1-8 — Modification — Extending a Services Contract at a Price That Doesn’t Represent Standalone Selling Price

An entity enters into a contract to provide a customer with logistic support services for three years for $450,000 per year. For the purposes of this example, it is assumed that the entity determines that based on the nature of the service (that is, providing a service that is available for a customer to use as and when the customer decides) it was providing the customer a series of distinct services that are substantially the same and have the same pattern of transfer. Therefore, the entity concludes that, for the purposes of this example, it should recognize the three years of service as a single performance obligation (that is, a series of distinct services). The original contract does not provide the customer the option to renew the contract after the three years. The standalone selling price for the service at inception of the contract is $450,000 per year.

At the end of the second year, the parties agree to modify the contract as follows: (1) the fee for the third year is reduced to $360,000; and (2) customer agrees to extend the contract for another three years for $900,000 ($300,000 per year). The standalone selling price of the services at the time of modification is $360,000.

Based on the specific facts and circumstances in this example, the entity believes that the modification should not be accounted for as a separate contract. The price of the contract did not increase by an amount of consideration that reflects the standalone selling price of the additional services, even though the additional services are distinct.

Revenue for the modified contract is recognized prospectively over the modified service period (which is the last year remaining under the original contract plus the three additional years). The entity should reallocate the remaining consideration to all the remaining services to be provided. This results in $315,000 (calculated as $360,000 re-negotiated fee for the final year of the original contract plus $900,000 contract modification divided by 4 years) being recognized in each of the remaining years.

An entity will account for a contract modification prospectively if the contract contains a single performance obligation that is made up of a series of distinct goods or services. To account for the modification prospectively, the entity’s performance completed to date must be separable from its remaining performance obligations (that is, the remaining promised goods or services in the modified contract are distinct from goods or services previously provided to the customer).

Example 3-1-9 — Modification — Additional Promise Is Not Distinct

A contractor enters into a contract to design an unmanned aerial vehicle and manufacture ten identical prototype units for $2 billion. The new design includes certain key functionality that has not been proven. It is expected that the design will be modified during production of the prototypes and that any given prototype might be modified based on the design changes and learnings from another prototype. The deliverable to the customer is the prototype units; the customer does not obtain rights to the new design apart from the units. The contractor has evaluated the design services and manufacturing of the prototypes (design and build) as a single performance obligation as the contractor provides a significant service of integrating goods or services promised in the contract and some of these goods and services could significantly modify or customize others in the contract. In this particular fact pattern, the entity expects to continually modify the prototypes due to design changes that are expected to occur during production. Although the design and production might have benefits on their own, in the context of the contract, the contractor has determined that they are not separable. This is because the entity has determined both the design and production are highly dependent on and highly interrelated with each other. At the end of year one, the contractor and customer agree to modify the original design plan, which increases the expected revenue and expected cost by approximately $300M and $275M, respectively.

Based on the specific facts and circumstances in this example, the entity believes that the modification does not create a distinct good or service and the remaining design and production of prototypes to be provided under the modified contract are not distinct from the services already provided. The contractor should account for the modification as if it were part of the original contract and update its measure of progress and estimates to account for the effect of the modification. This will result in a cumulative catch-up adjustment at the date of the contract modification.

Example 3-1-10 — Modification — Unpriced Change Order

A contractor enters into a contract with a customer to develop a satellite. After development starts, the customer changes the specifications of the satellite. The contractor is asked to process the changes; however, the price has not yet been approved and is not expected to be approved before the development is completed. These types of changes are common and the contractor has a history of executing unpriced change orders with this customer that it believes is predictive of future prices.

The changes in the satellite specifications will be accounted for when a contract modification exists. A contract modification, such as an unpriced change order, exists when the parties to the contract approve a modification that creates or changes the enforceable rights and obligations of the parties. Determining whether there is a valid expectation that the price for the modification will be approved is based on specific facts and circumstances. The contractor may be able to determine that it expects the price of the scope change to be approved based on its experience with a particular customer. If so, the contractor will estimate the change in transaction price based on a probability-weighted or most likely amount approach (whichever is most predictive), provided that it is probable that a significant reversal in the cumulative amount of revenue recognized will not occur when the price of the change order is approved. Estimates of unpriced change orders need to be re-evaluated at each reporting period.

Example 3-1-11 — Modification — Claims

A contractor enters into a contract for the deployment and installation of radar systems for the government. The contractor has concluded that the contract has one performance obligation at contract inception due to the significant integration service provided by the contractor in developing and installing the radar systems. Due to reasons outside of the contractor's control (for example, customer-caused delays), the cost of the contract far exceeds original estimates. The additional costs do not result in the addition of distinct goods or services. The contractor submits a claim against the government to recover a portion of these costs. The claim process is in its early stages, but the contractor has a long history of successfully negotiating claims with the government.

Based on the contractor’s history of successfully negotiating claims with the government, it assesses the legal basis of the claim and determines that it has enforceable rights. The contractor would account for the claim as a contract modification. The contractor determines that because the modification did not result in the addition of distinct goods or services, the adjustment to revenue should be made on a cumulative catch-up basis. The contractor updates the transaction price and the calculation of progress toward completion for the performance obligation. The contractor also considers the constraint on estimates of variable consideration when estimating the transaction price.

In making the preceding assessments, the contractor would evaluate factors such as whether the amount of consideration is highly susceptible to factors outside of their control, relevant experience with similar claims, the period of time before resolution of the claim, past practice of negotiating an amount less than the entire claim, and so on. to determine the likelihood or magnitude of a revenue reversal for the variable consideration. The contractor may need to obtain advice from legal counsel regarding the likelihood of prevailing on its claim. Some or the entire variable consideration for the claim is included in the transaction price if the contractor believes that it is probable that cumulative revenue recognized would not be subject to significant reversal in future periods. For performance obligations satisfied over time, this results in some or the entire claim amount being included in the calculation of revenue when the measure of progress is applied. Amounts included in the transaction price will be updated until resolution of the claim.

Example 3-1-12 — Modification — Sale of Additional Products

Part 1

A contractor enters into an arrangement with the government to sell two highly customized and specialized radars engineered and produced for the customer for $10M ($5M per radar). It is anticipated that two additional radars will be added to the contract through a contract modification. The radars are developed to replace and improve existing functionality and function with an original radar system already owned by the government so the network is operational continuously (that is, not all four radars are needed for a functional system). Radars 1 and 2 were produced concurrently, on the same production line, with shared labor, materials, logistics and program management over a four-year period and thus were determined to represent one performance obligation.

The contractor received a modification for an additional radar (Radar 3) for $5 million, with the same customizations and specifications as the radars under the initial arrangement. Radar 3 will be produced concurrently and will share labor, materials, and program management with Radars 1 and 2.

Based on the specific facts and circumstance in this example, the entity believes that the modification to sell the additional radar does not represent a distinct good or service due to the additional radar not being distinct in the context of the contract and should be combined with the original contract. The production of the three radars are considered highly interdependent and highly interrelated to each other. The measure of progress and estimates to account for the effect of the modification should be updated, resulting in a cumulative catch-up adjustment at the date of the contract modification.

Part 2

In year four of the contract, a modification for two additional radars is secured for $5M each, which represents standalone selling price on the modification date. When the contract is modified to add two additional radars, Radar 1 is already in full operational use and Radars 2 and 3 are in the final stages of testing before deployment. Due to the timing of the modification, the two additional radars will be produced separately with no overlapping materials, logistics, testing or program management with the original three radars.

Based on the specific facts and circumstance in this example, the entity believes that the modification to sell the additional two radars at $5M each should be accounted for as a separate contract because the additional radars are distinct, the price for the additional radars reflects standalone selling price, and the existing contract would not be affected by the modification.

Example 3-1-13 — Modification — Additional Services Are Not Distinct

A contractor enters into a contract to develop a global security program to be used at points of entry across the globe for the customer. The new program has certain key functionality that has not been proven. The contract is structured with a base phase 1 and options to execute additional phases to complete the fully integrated program as the customer obtains funding. The first phase includes the design of the security program. After phase 1 begins, the customer issues three modifications that exercise the options for including the development, production, and initial support phases of the program. The activities in each phase overlap each other and are highly inter-related (that is, production begins during development, issues during development lead to changes in design, the support phase could lead to changes in design and development, and so on). Although the phases might have benefits on their own, in the context of the contract, the contractor has determined that they are not separable because they are highly inter-related. For the customer to have a functioning global security network, all modifications and phases are required. The contractor has concluded that none of the options contain a material right at contract inception.

Based on the specific facts and circumstances in this example, the entity believes that each modification is accounted for as if it were part of the original contract upon exercise. As the phases are highly inter-related, they are not distinct from each other. Each modification should be treated as part of the existing contract. The adjustment to the contract price and measure of progress should be accounted for as a cumulative catch-up adjustment at the date of the modification.

Example 3-1-14 — Option — Material Right

A contractor is awarded a contract to design and qualify a new product, with an option for full rate production of the new product. Profit margin is bid at 10 percent for the non-recurring design and qualification effort, but at a loss of (2 percent) for the full rate production. Full rate production for similar products for similar customers is typically priced at 15 percent. In this example, the option for full rate production is likely a material right because the entity agreed to a reduced margin on the full rate production compared to similar contracts for similar customers, and it is assumed that this discount is material in the context of the contract. It is also assumed in this example that the effort expended by the contractor under the full rate production option and full rate production for similar products for similar customers are the same, and excludes non-recurring design and qualification work in each case.

Therefore, the contractor should consider the material right to be a separate performance obligation, and should allocate the transaction price between the two accordingly, in accordance with paragraphs 41–45 of FASB ASC 606-10-55 and paragraphs 28–41 of FASB ASC 606-10-32.

Example 3-1-15 — Option — Material Right With Low Probability of Exercise

An entity enters into a contract to sell two helicopters to a large metropolitan police force, with an option for a third helicopter with a discount of 20 percent off the selling price, which is not offered to similar customers for similar products. The customer has never owned and operated more than two helicopters at one time due to operational needs and budgetary constraints. Further, the entity believes it is unlikely that the customer will exercise the option for the third helicopter. In this example, the low probability of the exercise does not eliminate the customer’s material right. The option to purchase the third helicopter at a discount represents a material right because paying the full price for the first two helicopters results in the customer effectively paying in advance for the discounted third helicopter.

In accordance with FASB ASC 606-10-55-44, the low probability that the customer will exercise the option should be factored into the determination of the amount to be allocated to the material right related to the option. In other words, the low probability of the option’s exercise should result in a much lower allocation of the transaction price to the material right.

3.2.01 Paragraphs 14–22 of FASB ASC 606-10-25 discuss how to determine whether promised goods and services in the contract represent separate performance obligations.

3.2.02 FASB ASC 606-10-25-16A and BC12 of FASB ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606)—Identifying Performance Obligations and Licensing, first establish that immaterial items are not required to be assessed as promised goods or services for purposes of identifying performance obligations. A contractor should consider the relative significance or importance of a particular promised good or service at the contract level rather than at the financial statement level, considering both the quantitative and the qualitative nature of the promised good or service in the contract. Although this assessment is expected to be straightforward in many cases, applying this notion will often require judgment. FASB ASC 606-10-25-16B also clarifies that this approach to materiality does not apply to customer options and related material rights, where specific guidance in FASB ASC 606-10-55-41 through 55-45 applies. When goods or services are assessed as immaterial in the context of the contract and are not treated as performance obligations, any transaction price charged for those items will be allocated to the performance obligations in the contract and recognized when those performance obligations are satisfied. FASB ASC 606-10-25-16A indicates that the costs of these immaterial goods and services should be accrued if the related revenue is recognized in advance of the immaterial goods or services being transferred to the customer.

3.2.03 FASB ASC 606-10-25-14 establishes that a contractor should assess goods or services promised in a contract (unless immaterial as seen previously) and identify as performance obligations each promise to transfer to the customer either:

a.     A good or service (or bundle of goods or services) that is distinct; or,

b.     A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

3.2.04 FASB ASC 606-10-25-15 explains that a series of distinct goods or services has the same pattern of transfer to the customer if both the following criteria are met:

a.     Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria in ASC 606-10-25-27 to be a performance obligation satisfied over time; and

b.     In accordance with ASC 606-10-25-31 through 25-32, the same method would be used to measure the entity’s progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.

3.2.05 Determining whether goods and services are distinct is a matter of judgment. BC29 of FASB ASU No. 2016-10 clarifies that a contractor should evaluate whether the multiple promised goods or services in the contract are outputs or, instead, are inputs to a combined item (or items). The inputs to a combined item (or items) concept might be further explained, in many cases, as those in which an entity’s promise to transfer the promised goods or services results in a combined item (or items) that is greater than (or substantively different from) the sum of those promised (component) goods and services. A combined output may include more than one phase, element, or unit.

3.2.06 Although FASB ASC 606-10-25-19a effectively looks to the economic substance of each good or service to determine whether a customer can benefit from that good or service either on its own or with readily-available resources or those available to the customer in the marketplace, FASB ASC 606-10-25-19b requires the contractor to evaluate whether the promised good or service is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract) and FASB ASC 606-10-25-21 provides a nonexclusive list for the contractor to consider. A contractor’s evaluation of the indicators may vary depending on the specific circumstances of the contract, and one contractor’s evaluation may not coincide with another’s.

3.2.07 In many aerospace and defense contracts, the finished deliverable consists of a number of subcomponents that normally provide benefit to the customer on their own or together with other readily available resources. Therefore, the contractor’s evaluation regarding whether a promised good or service is distinct will likely depend more on meeting the criteria in FASB ASC 606-10-25-19b.

3.2.08 FASB ASC 606-10-25-21 includes certain factors for consideration in determining whether a contractor’s promise to transfer a good or service to a customer is separately identifiable; however, it does not limit a contractor’s consideration only to those factors identified. As a result, an entity’s evaluation of the indicators in FASB ASC 606-10-25-21 will be largely driven by the nature of the transaction and the specific facts and circumstances of the contract.

3.2.09 For instance, BC30 of FASB ASU No. 2016-10 acknowledges that the notion of ‘separable risks’ can influence the separately identifiable concept analysis. Therefore, understanding whether the risk that an entity assumes to fulfill its obligation to transfer one of those promised goods or services to the customer is a risk that is inseparable from the risk relating to the transfer of the other promised goods or services, may help the analysis under FASB ASC 606-10-25-21.

3.2.10 As explained in BC32 of FASB ASU No. 2016-10, the contractor should evaluate whether two or more promised goods or services (for example, a delivered item and an undelivered item) each significantly affect the other (and, therefore, are highly interdependent or highly interrelated) in the contract. The contractor should not merely evaluate whether one item, by its nature, depends on the other (for example, an undelivered item that would never be obtained by a customer absent the presence of the delivered item in the contract or the customer having obtained that item in a different contract).

3.2.11 According to BC33 of FASB ASU No. 2016-10, a contractor should also consider the utility of the promised goods or services (that is, the ability of each good or service to provide benefit or value). This is because a contractor may be able to fulfill its promise to transfer each good or service in a contract independently of the other, but each good or service may significantly affect the other’s utility to the customer. The "capable of being distinct" criterion also considers the utility of the promised good or service, but merely establishes the baseline level of economic substance a good or service must have to be "capable of being distinct." Therefore, utility also is relevant in evaluating whether two or more promises in a contract are separately identifiable because even if two or more goods or services are capable of being distinct because the customer can derive some economic benefit from each one, the customer’s ability to derive its intended benefit from the contract may depend on the entity transferring each of those goods or services.

3.2.12 Another important judgment in interpreting FASB ASC 606-10-25-21a is whether the integration service is significant. BC107 of FASB ASU No. 2014-09 explains that the risk of transferring individual goods or services is inseparable from an integration service because a substantial part of the entity’s promise to a customer is to ensure the individual goods or services are incorporated into the combined output. BC107 continues to explain that this factor may be relevant in many construction contracts in which the contractor provides an integration (or contract management) service to manage and coordinate the various construction tasks and to assume the risks associated with the integration of those tasks.

3.2.13 An integration service may be evident when combining several subcomponents into a single deliverable (for example, a single ship). However, many aerospace and defense contracts are for the provision of multiple units of the same (or similar) end product (such as multiple ships, vehicles, and the like). In these arrangements, additional judgment will be required when evaluating whether there is a substantial integration service across the multiple units and not just within each individual unit.

3.2.14 FASB ASC 606-10-25-21b states that two or more promises to transfer goods or services to a customer are not separately identifiable when "one or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised by the contract." BC108 of FASB ASU No. 2014-09 indicates that the factor described in FASB ASC 606-10-25-21a could apply to industries other than the construction industry and provided an example of a software development contract with significant integration services. As a result, the Boards clarified the factor discussed in FASB ASC 606-10-25-21b. BC108 of FASB ASU No. 2014-09 further explains that it was not intended for this factor to be applied too broadly to software integration services for which the risk that the entity assumes integrating the promised goods or services is negligible.

3.2.15 Some aerospace and defense companies enter into arrangements for IT-related goods and services and consistent with BC107 and BC108 of FASB ASU No. 2014-09, this factor should be considered with respect to such contracts. This factor might also be applicable to other circumstances where a good or service is being modified or customized. For example, an aerospace and defense company might promise to deliver to a customer a standard vehicle that has been substantially modified for the customer’s purposes (for example, replacing quarter panels with armor, modifying the engine, frame and suspension to accommodate additional weight, installing bulletproof glass). In this circumstance, FinREC believes that these services are significantly modifying or customizing the vehicle and those services should be combined with the vehicle into a single distinct performance obligation. If the contract was to deliver multiple standard vehicles with customization services, the entity would need to consider the factors in FASB ASC 606-10-25-21 in assessing if the promise to transfer each separate vehicle is distinct within the context of the contract.

3.2.16 The factor in FASB ASC 606-10-25-21c explains that two or more promises to transfer goods or services to a customer are not separately identifiable if the goods and services are highly interdependent or highly interrelated. BC111 of FASB ASU No. 2014-09 indicates that, in some cases, it might be unclear whether the entity is providing an integration service or whether the goods or services are significantly modified or customized.

3.2.17 Example 10 — Goods and Services are Not Distinct, Case B: Significant Integration Service, in FASB ASC 606-10-55-140A through 55-140C, provides an example to illustrate a circumstance where the manufacturing of multiple units of a highly complex, specialized device is considered one performance obligation because the activities required to produce those units are highly interdependent and highly interrelated.

3.2.18 Consistent with example 10, Case B of FASB ASC 606-10-55-140A through 55-140C, FinREC believes an entity should consider the following factors that indicate that multiple units of a product in a production only arrangement are not separately identifiable in accordance with FASB ASC 606-10-25-19b and therefore not distinct:

a.     The product specifications are complex and customized to the customer’s needs

b.     A manufacturing process specific to this contract is established in order to produce the contracted units

c.     The entity is responsible for the overall management of the contract, including performance and integration of various activities including procurement of materials; identifying and managing subcontractors; and performing manufacturing, assembly, and testing.

3.2.19 FinREC believes an entity should consider the following factors that indicate that the promised goods and services in a design, development, and production contract are not separately identifiable in accordance with FASB ASC 606-10-25-19b and therefore not distinct:

a.     During the bidding process, the customer did not seek separate bids on the design and production phases.

b.     The contract involves design and production services for a new or experimental product.

c.     The specifications for the product include unproven functionality.

d.     The contract involves the production of prototypes or significant testing of initial units produced for the purpose of refining product specifications or designs.

e.     The design of the product will likely require revision during production based on the testing of initial units produced.

f.     It is likely that initial units produced will require rework to comply with final specifications.

3.2.20 If after having considered the factors in FASB ASC 606-10-25-21 a contractor has determined that promised goods or services are distinct, the contractor would then consider whether those distinct goods or services represent a series that are treated as a single performance obligation. As part of this analysis, the contractor would consider whether those distinct goods or services are substantially the same and have the same pattern of transfer to the customer as required by FASB ASC 606-10-25-14b. FASB ASC 606-10-25-15 states that

3.2.21 The following examples are meant to be illustrative, and the actual determination of the performance obligation(s) in the contract should be based on the facts and circumstances of an entity’s specific situation.

Example 3-2-1 — Illustration of FASB ASC 606-10-25-21a

Aerospace and Defense Corp. (A&D) has contracted with the U.S. Navy to finalize design, develop and construct a warship. The U.S. Navy has specified various aspects of the warship, including the speed at which it must be able to travel, and that it must use nuclear power. No warship of this nature exists in the world today.

Nearly all the component goods and services that will be assembled into the new warship either provide benefit to customers on their own or with other readily available resources.

The component goods, materials, and services to this contract (for example, steel plates, computer systems, elevators, welding services, nuclear power generators) are not separable, and therefore not distinct, in this contract because A&D is providing a significant integration service of using the various individual materials and services (and subcontractors under its direction) as inputs to deliver the combined item for which the customer has contracted (for example, the warship).

As a result, A&D concludes that this contract contains only one performance obligation — the warship.

Example 3-2-2 — Illustration of ASC 606-10-25-21c (Consistent With Example 10 — Goods and Services Are Not Distinct, Case B: Significant Integration Service, in FASB ASC 606-10-55-140A Through 55-140C)

Aerospace and Defense Corp. (A&D) has contracted with the U.S. Army to deliver multiple units of a complex and specialized armored vehicle. The U.S. Army has specified various aspects of the vehicle, including speed, weight, weaponry, and other specifications. The specifications are unique to the customer based on a specified design that is owned by the customer and was developed under a separate contract. A&D has previously produced an initial production lot of these vehicles under a separate contract and A&D has entered into a new contract for the production of multiple units. A&D is responsible for the overall management of the contract, which requires the performance and integration of various activities including procurement of materials; identifying and managing subcontractors; and performing manufacturing, assembly, and testing.

A&D assesses the promises in the contract and determines that each of the promised vehicles is capable of being distinct in accordance with FASB ASC 606-10-25-19a because the customer can benefit from each vehicle on its own. This is because each vehicle can function independently of the other vehicles.

A&D then assesses whether the vehicles are distinct within the context of the contract in accordance with FASB ASC 606-10-25-19b. A&D observes that the nature of its promise is to establish and provide a service of producing the full complement of vehicles for which the U.S. Army has contracted in accordance with the customer’s specifications. A&D considers that it is responsible for overall management of the contract and for providing a significant service of integrating various goods and services (the inputs) into its overall service and the resulting vehicles (the combined output) and, therefore, the vehicles and the various promised goods and services inherent in producing those vehicles are not separately identifiable in accordance with paragraphs 19(b)–21 of FASB ASC 606-10-25. In this case, the nature of A&D’s performance and, in particular, the significant integration service of the various activities mean that a change in one of A&D’s activities to produce the vehicles has a significant effect on the other activities required to produce the highly complex specialized vehicles such that A&D’s activities are highly interdependent and highly interrelated. Because the criterion in FASB ASC 606-10-25-19b is not met, the goods and services that will be provided by A&D are not separately identifiable, and, therefore, are not distinct.

As a result, A&D accounts for all the goods and services promised in the contract as a single performance obligation.

Example 3-2-3

In addition to the delivery of the armored vehicles described in example 3-2-2, the contract also includes maintenance of the armored vehicles after delivery to the customer for a period of three years. A&D determines that the maintenance component is material in the context of the contract. The maintenance promise does not significantly modify or customize the production of the specialized vehicles and the production is not highly dependent upon the maintenance activities. A&D will satisfy the maintenance without using shared material, subcontractor, manufacturing, assembly or testing components from those used in the production of the vehicles, and the maintenance activities will be performed after the vehicles are delivered. In this case, a change in one of A&D’s activities under either of these promises would not have a significant effect on the other. As such, the two promises are not highly interdependent or highly interrelated. Because the criterion in FASB ASC 606-10-25-19b is met, A&D’s promise to provide maintenance on the vehicles is separately identifiable, and, therefore, distinct from production of the vehicles. As a result, A&D would account for the delivery of the vehicles as a single performance obligation separate from the maintenance.

A&D would then evaluate the maintenance activities to determine whether they consist of distinct goods or services. If the maintenance activities consist of only one distinct good or service, for example because under FASB ASC 606-10-25-21c A&D concludes that it provides a significant integration service between the different maintenance activities, then the maintenance activities would be treated as a single performance obligation. If A&D concludes that there are more than one distinct goods or services within the maintenance activities, for example because none of the criteria in FASB 606-10-25-21a–c are met, A&D would then consider FASB ASC 606-10-25-14b and 606-10-25-15 to determine whether those distinct goods or services represent a series that are treated as a single performance obligation. As discussed at the July 2015 TRG meeting, in making this assessment, A&D would consider whether the nature of its promise for the maintenance service is a specified quantity of maintenance service or the act of standing ready to perform the maintenance service. If the nature of the promise is the delivery of a specified quantity of a service, then the evaluation should consider whether each service is distinct and substantially the same. If the nature of A&D’s promise is the act of standing ready or providing a single service for a period of time (that is, because there is an unspecified quantity to be delivered), the evaluation would likely focus on whether each time increment, rather than the underlying activities, are distinct and substantially the same.

Example 3-2-4

Subcontractor Y has a long-term arrangement to exclusively produce for A&D the engines used on the armored vehicles described in example 3-2-2. The engines are procured through multiple individual purchase orders which may include the volume for an entire year at a time. Each of Y’s purchase orders is a separate contract with its customer.

In contrast to example 3-2-2, in this example the engines are specific to the vehicle but not highly specialized, and Subcontractor Y does not manage other subcontractors. Subcontractor Y produces engines for other specialized vehicles that have many similar characteristics to the engines being produced for A&D. Although the engines required investment in non-recurring engineering, such investment was not considered significant. Y is responsible for the management of the engines contract, which requires some degree of integration across engines (for instance, Y may have to integrate certain upgrades or changes); however, this type of integration is not seen as significant in the context of the contract, which is seen primarily as the production of a quantity of known equipment. Although the engines may be produced on a dedicated manufacturing line, the manufacturing process itself is similar to how Y produces unrelated engines for unrelated products for different customers. As such, the manufacturing process is not so specific as to have no transferable use on other products.

Because Y is in the business of producing specialized engines and typically contracts with its customers for limited incremental volumes, Y does not view a single engine as being significantly interrelated or dependent on the other engines delivered in ways that are significant. That is, Y’s contracts with A&D are not contemplative of a single solution, therefore the individual engines are viewed as being distinct in the context of the contract. Because the engines are also "capable of being distinct," Y concludes that the engines are individually distinct.

As the engines have been determined to be individually distinct, Y would then consider FASB ASC 606-10-25-14b and 606-10-25-15 to determine whether those distinct engines represent a series that are treated as a single performance obligation. As part of this analysis, Y would consider whether those engines are substantially the same and have the same pattern of transfer to A&D (that is, does each engine meet the criteria to be a performance obligation satisfied over time and would the same method be used to measure Y’s progress toward complete satisfaction of the performance obligation to transfer each distinct engine in the series).

Example 3-2-5 — Illustration of ASC 606-10-25-21c

A&D Corp. entered into a contract with the U.S. Air Force on January 1, 20X0 to design and build a next generation unmanned aerial vehicle (UAV). The performance and system requirements requested of A&D are new and advanced and will require significant research and development (R&D), a new design for the UAV, as well as the creation of a special production process for these new machines.

The initial contract calls for A&D to produce fifteen of the UAVs for testing and use in limited real-life scenarios. A&D expects it will take approximately three years to design and develop the first UAV, but that the remaining fourteen initial order UAVs will be delivered over a period of two years after completion of the prototype unit. At the time of delivery of the first UAV, the remaining fourteen UAVs will be in various stages of production. Any changes in design made during the three years of designing and developing the first UAV will also be required to be made to the remaining 14 in process UAV units.

Although the customer can benefit from each UAV independently of the others (each UAV will fly and perform reconnaissance and other functions independent of the other fourteen units), A&D has determined that the design and production services and the 15 UAVs are a single performance obligation because they are not distinct in the context of the contract. In reaching this determination, A&D observed that the contract involved a new and experimental design, the production of prototypes, significant testing and redesign efforts, and the potential for rework of all 15 units to comply with final specifications. As a result, the design and production services and UAVs are considered highly interdependent and highly interrelated to each other.

3.3.01 Aerospace and defense contracts often contain provisions for variable consideration from the customer in the form of incentives and award fees that adjust either the fee for cost-reimbursement contracts or the target profit for fixed-price contracts. These provisions for incentives and award fees generally are based on (a) the relationship of actual contract costs to an agreed-upon target cost or (b) some measure of contract performance (for example, speed, distance, or accuracy) in relation to agreed-upon performance targets. Consequently, the contractor's profit is increased when actual costs are less than agreed-upon cost targets. Similarly, the profit is increased when actual performance meets or exceeds agreed-upon performance targets. Conversely, the contractor's profit is decreased when actual results (in terms of either cost or performance targets) do not meet the established cost or performance targets. See paragraph 3.3.26 for examples of variable consideration in this industry.

3.3.02 FinREC believes that the mere existence of contractual provisions for incentives or award fees would not be considered presumptive evidence that such incentives or award fees are to be automatically included in the transaction price. In the case of performance incentives, assessing whether actual performance will produce results that meet targeted performance objectives may require substantial judgment and experience with the types of activities covered by the contract. In many circumstances, these estimates of performance relative to targeted performance are not unlike the processes used to estimate completion on long-term contracts.

3.3.03 In accordance with FASB ASC 606, entities are required to estimate variable consideration in determining the transaction price, subject to the guidance on constraining estimates of variable consideration. As discussed in FASB ASC 606-10-32-9:

Estimating Variable Consideration

3.3.04 FASB ASC 606-10-32-8 discusses two methods for estimating variable consideration. The selection of a method is not intended to be a free choice and is dependent on which method an entity expects to better predict the amount of consideration to which the entity will be entitled. The two methods are as follows:

a.     The expected value method. This method estimates variable consideration based on the sum of probability-weighted amounts in a range of possible consideration amounts. This method may be appropriate when an entity has a large number of contracts with similar characteristics.

b.     The most likely amount. This method estimates the variable consideration based on the single most likely amount in a range of possible consideration amounts. This method may be appropriate if the estimate of variable consideration has only two possible outcomes (for example, an entity is entitled to all variable consideration upon achieving a performance milestone or none if the performance milestone is not achieved).

3.3.05 FASB ASC 606-10-32-9 requires an entity to apply one method consistently throughout the contract when estimating the amount of variable consideration to which it is entitled. Per FASB ASC 606-10-10-3, the method selected should be applied consistently to contracts with similar characteristics and in similar circumstances.

3.3.06 However, a single contract may have more than one uncertainty related to variable consideration (for example, a contract with both cost and performance incentives) and, depending on the method the entity expects to better predict the amount of consideration to which it is entitled, the entity may use different methods for different uncertainties. In estimating the amount of variable consideration under either of the methods, as discussed in FASB ASC 606-10-32-9, an entity can use a reasonable basis for estimation and is not required to consider all possible outcomes using unnecessarily complex methods or techniques.

3.3.07 The following examples are meant to be illustrative, and the actual determination of the method for estimating variable consideration, as stated in FASB ASC 606-10-32-8, should be based on the facts and circumstances of an entity’s specific situation.

Example 3-3-1

A contract is negotiated with a fixed price of $100 million plus an award fee of $10 million that is contingent on delivery by a specified date. The entity has subcontracted a portion of the work. The entity estimates that it will achieve the award fee because the production schedule is not considered challenging, the subcontractor has delivered on similar timelines in the past, and both the entity and subcontractor currently have three months of schedule cushion. In this instance, the entity determines that the expected value method may not provide a predictive estimate of the variable consideration because the contract has only two possible outcomes (that is, no award fee or a $10 million award for timely delivery). The entity’s estimate of the total transaction price is $110 million, including the award fee at the most likely consideration amount.

Example 3-3-2

An entity contracts to build a satellite system for a customer and receives an incentive fee from the customer that varies depending on the period of time that the system is fully operational before a failure. The entity has extensive experience determining the likelihood of failure under various possible conditions in space for the various subcomponents that compose the satellite system. To estimate the incentive fee, management calculates the expected value by using the estimated failure rates under the various environmental conditions to determine the expected length of time the system will be fully operational before a failure. The entity believes that the estimate determined using this expected value method is predictive of the amount to which it will be entitled because of its experience gained from other contracts and test data.

Constraining Estimates of Variable Consideration

3.3.08 After estimating the transaction price using one of the two methods, an entity is required to evaluate the likelihood and magnitude of a reversal of revenue due to a subsequent change in the estimate. FASB ASC 606-10-32-11 discusses when to include variable consideration in the transaction price and notes that an entity should include in the transaction price some or all of the variable consideration amount estimated in accordance with FASB ASC 606-10-32-8 only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

3.3.09 As discussed in BC215 of FASB ASU No. 2014-09, if the process for estimating variable consideration already incorporates the principles on which the guidance for constraining estimates of variable consideration is based, then it is not necessary for an entity to evaluate the constraint separately from the estimate of variable consideration.

3.3.10 As discussed in FASB ASC 606-10-32-12, determining the amount of variable consideration to include in the transaction price should consider both the likelihood and magnitude of a revenue reversal. An estimate of variable consideration is not constrained if the potential reversal of cumulative revenue recognized is not significant. As explained in TRG Agenda Ref. No. 25, January 2015 Meeting — Summary of Issues Discussed and Next Steps, paragraph 49 states the following:

3.3.11 The levels of revenue reversals that are deemed significant will vary across entities depending on the facts and circumstances. If the entity determines that it is probable that the inclusion of its estimate will not result in a significant revenue reversal, that amount is included in the transaction price.

3.3.12 As discussed in BC218 of FASB ASU No. 2014-09, in some cases, when an entity applies the guidance for constraining estimates of variable consideration when there is a range of possible consideration amounts, the entity might determine that it should not include the entire estimate of the variable consideration in the transaction price when it is probable that doing so would result in a significant revenue reversal. However, the entity might determine that it is probable that including some of the estimate of the variable consideration in the transaction price would not result in a significant revenue reversal. In these instances, the entity should include some, but not all, of the variable consideration in the transaction price. That is, the entity is required to estimate the amount of variable consideration applying the constraint guidance and cannot just determine that it would not include any amount of variable consideration in the transaction price.

3.3.13 As indicated in FASB ASC 606-10-32-12, factors that could increase the likelihood and magnitude of a revenue reversal include, but are not limited to, the following:

3.3.14 The following example is not all-inclusive, and any other relevant indicators that could result in a significant reversal in the amount of cumulative revenue recognized on the contract should be considered. An entity also should consider positive and mitigating factors that support the assertion that a significant reversal of cumulative revenue recognized will not occur.

Example 3-3-3

An entity has a fixed fee contract for $1 million to develop a product that meets specified performance criteria. Estimated cost to complete the contract is $950,000. The entity will transfer control of the product over five years, and the entity uses the cost-to-cost input method to measure progress on the contract. An incentive award is available if the product meets the following weight criteria:

The entity has extensive experience creating products that meet the specific performance criteria. Based on its experience, the entity has identified five engineering alternatives that will achieve the 10 percent incentive and two that will achieve the 25 percent incentive. In this case, the entity determined it has 95 percent confidence that it will achieve the 10 percent incentive and 20 percent confidence that it will achieve the 25 percent incentive. Based on this analysis, the entity believes 10 percent to be the most likely amount when estimating the transaction price. Therefore, the entity includes only the 10 percent award in the transaction price when calculating revenue because the entity has concluded it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved due to its 95 percent confidence in achieving the 10 percent award.

The entity reassesses its production status quarterly to determine whether it is on track to meet the criteria for the incentive award. At the end of year four, it becomes apparent that this contract will fully achieve the weight-based criterion. Therefore, the entity revises its estimate of variable consideration to include the entire 25 percent incentive fee in year four because, at this point, it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when including the entire variable consideration in the transaction price.

The following illustrates the impact of changes in variable consideration in example 3-3-3.²

Updating Estimates of Variable Consideration

3.3.15 Given the long-term nature of many aerospace and defense contracts, it is common for circumstances to change throughout the contract. Circumstances change as contract modifications occur, more experience is acquired, additional information is obtained, risks are eliminated, or additional risks are identified, and performance progresses on the contract. The nature of accounting for long-term contracts is a process of continuous refinements of estimates for changing conditions and new developments. FASB ASC 606-10-32-14 discusses when to update the estimated transaction price for changes in circumstances during the reporting period. As part of updating the transaction price, an entity would evaluate the factors listed in FASB ASC 606-10-32-12. In addition, when updating the estimated transaction price, an entity should consider whether there is a revision to the measure of progress (for example, estimated costs to complete the contract) as stated in FASB ASC 606-10-25-35.

3.3.16 The following examples are meant to be illustrative, and the determination of the method for updating estimates of variable consideration should be based on the facts and circumstances of an entity’s specific situation.

Example 3-3-4

An entity enters into a contract to develop ABC, a new system, in exchange for a fixed price of $100 million plus an award fee of $30 million that is contingent on successful tests of the first three trials (that is, all tests need to be successful to get the award fee). When bidding for the contract, the entity did not expect successful testing due to a lack of experience in developing this type of system and, therefore, the entity did not have a reasonable basis to estimate the award fee. The first tests are technically complex, and the entity has a history that a majority of first tests are not successful for new products or capabilities. Subsequently, the first two tests were successful, and the entity now expects the third test to be successful. Based on this updated information, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue will not occur when the uncertainty is resolved and, therefore, includes the $30 million award fee in the transaction price.

Example 3-3-5

A company enters into a contract to produce and deliver XYZ radar. The contract is for a target cost of $90 million and a fixed fee of $10 million on those costs ($100 million total contract price). The entity and customer will share any over- or underruns of cost 50/50 as an incentive fee or penalty. The entity bases the total fee on its estimate of total cost, which is the way the contract is bid. The entity has a sophisticated estimating system that is audited by the customer. The customer approves the cost estimate as part of the bid and award. The cost estimate will also be used to measure progress towards complete satisfaction of the performance obligation because the entity has concluded it is the best measure of progress to depict the transfer of control of the work in process to the customer. At contract inception, the incentive fee or penalty is not included in the transaction price because the entity expects to perform with a target cost of $90 million, as bid, with no over- or underruns. Subsequently, based on revised engineering estimates, the entity expects to underrun the original estimate by $5 million. At the end of the reporting period, the entity concludes that the most likely amount of transaction price is $97.5 million ($100 million reduced by the customer’s share of underrun [$2.5 million]). The entity believes, based on its updated estimate, that it is probable that a significant reversal in the cumulative amount of revenue will not occur when the uncertainty is resolved.

Example 3-3-6

A company enters into a contract to produce and deliver a defense system in three years. The contract is for a fixed price of $900 million plus an award fee of $30 million, payable as $20 million in year two and $10 million in year three, based upon achievement of certain production targets throughout the three-year contract term. Costs to complete the contract are estimated to be $800 million. The company uses the cost-to-cost input method to measure progress on the contract and will transfer control over the three years. The company has been making similar products for many years and has a history of earning all variable fees. At contract inception, based on its experience, the entity concludes its most likely estimate of variable consideration is $30 million and that it is probable that a significant reversal in the cumulative amount of revenue will not occur when the uncertainty is resolved and, therefore, includes the entire award fee in the transaction price. In year two, there were some unexpected events, and the entity earned only $10 million of the $20 million expected award fee and, at this point, the contract is 50 percent complete. As a result of this change, the entity reduces the transaction price by $10 million, which, when factoring in that the contract is 50 percent complete, results in the reversal of revenue of $2.5 million. The entity determined that there is no impact to its estimate of earning the remaining award fee in year three.

The following illustrates the impact of changes in variable consideration in example 3-3-6.³

3.3.17 The following are examples of types of variable consideration for aerospace and defense entities:

Assessing Significance

3.3.18 In accordance with FASB ASC 606-10-32-15, aerospace and defense companies should consider whether each of their contractual arrangements with customers provide a significant benefit of financing to either party of the contract. The financing component may be explicitly identified in the contract or may be implied by the contractual payment terms of the contract. FASB ASC 606-10-32-15 states, "in determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer."

3.3.19 An entity must first determine at what level significance is required to be assessed. BC234 of FASB ASU No. 2014-09 states the following:

3.3.20 Based on FASB ASC 606-10-32-15 and BC234 of FASB ASU No. 2014-09, the assessment of whether the financing component is significant would be made at the contract level and does not need to be made at the business level, portfolio level, segment level, or entity level, nor would any assessment be required at the performance obligation level. Only in situations in which the financing component is significant in relation to the contract would the transaction price be adjusted.

3.3.21 The assessment of what constitutes "significant" requires judgment. BC234 of FASB ASU No. 2014-09 states, "that for many contracts an entity will not need to adjust the promised amount of customer consideration because the effects of the financing component will not materially change the amount of revenue that should be recognized in relation to a contract with a customer."

3.3.22 The assessment of what constitutes "significant" will be based upon individual facts and circumstances for each entity. If an entity concludes the financing component is not significant, the entity does not need to apply the provisions of paragraphs 15–30 of FASB ASC 606-10-32 and adjust the consideration promised in determining the transaction price.

3.3.23 The following examples are meant to be illustrative, and the actual determination of the existence of a significant financing component in the contract as stated in paragraphs 15–17 of FASB ASC 606-10-32 should be based on the facts and circumstances of an entity’s specific situation.

Example 3-3-7

A commercial airplane component supplier enters into a contract with a customer for promised consideration of $100,000. Based on an evaluation of the facts and circumstances, the supplier concluded that $2,000 represented a financing component because of an advance payment received in excess of a year before the transfer of control of the product. In these facts, the entity concluded that $2,000, or 2 percent of the contract price, was not significant, and the entity does not need to adjust the consideration promised in determining the transaction price.

Example 3-3-8

Consider the same facts as in example 3-3-7, except the advance payment was larger and received further in advance, such that the entity concluded that $20,000 represented the financing component based on an analysis of the facts and circumstances. In this case, the entity concluded $20,000, or 20 percent of the contract price, was significant, and the entity should adjust the consideration promised in determining the transaction price.

In these examples, the entity’s conclusion that 2 percent of the transaction price was not significant and 20 percent was significant is a judgment based on the entity’s facts and circumstances. An entity may reach a different conclusion based on its facts and circumstances.

When to Assess a Contract for a Significant Financing Component

3.3.24 FASB ASC 606-10-32-15 provides that an entity should adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing. The guidance in FASB ASC 606-10-32-15 does not explicitly provide for when and how often an entity should assess whether a significant financing component is present. However, FASB ASC 606-10-32-19 does imply that it should be assessed at contract inception as it provides guidance that when adjusting the promised consideration for a significant financing component an entity should use the discount rate that would be reflected in a separate financing transaction with the entity and its customer at contract inception.

3.3.25 When a contract is modified (including contract modifications, change orders, and contract options that materially alter the timing of the completion of performance obligations or the timing in which payments are received), the terms and conditions of the revised contract could alter the timing of satisfaction of the performance obligations or payments, or both, in such a way that explicitly or implicitly provides for a significant financing component. Because a contract modification could change whether a contract contains a significant financing component, FinREC believes an entity may determine it is necessary to reassess whether a significant financing component is present based on the terms and condition of the newly modified contract, regardless of whether it is accounted for as a separate contract or a part of the same contract based on guidance in paragraphs 12–13 of FASB ASC 606-10-25.

3.3.26 FASB ASC 606-10-32-19 also states, "after contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk)."

3.3.27 As a result, once an entity determines a significant financing component is present and adjusts the promised consideration, the entity would continue to use the same assumed discount rate for the specific contract assessed. If an entity is required to reassess whether a significant financing component is present as a result of a contract modification, an entity may need to assess whether the contract modification resulted in a separate contract or part of the same contract. In situations in which the contract modification resulted in a separate contact, FinREC believes the entity is required to update assumptions for the discount rate used.

Applying the Practical Expedient

3.3.28 FASB ASC 606-10-32-18 also provides a practical expedient, whereby an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less. The practical expedient may be applied in instances in which the contract is greater than one year, but within that contract, the period between performance (transfer of a good or service) and payment is one year or less.

3.3.29 The following example is meant to be illustrative, and the actual determination of whether the practical expedient can be applied as stated in FASB ASC 606-10-32-18 should be based on the facts and circumstances of an entity’s specific situation.

Example 3-3-9

Company H enters into a five-year contract with Company C to develop, manufacture, and deliver 15 surveillance systems. The entity has concluded that the goods and services in this contract constitute a single performance obligation (this conclusion is not the purpose of this example). Based on the terms of the contract, Company H has determined that it transfers control over time and recognizes revenue based on a cost-to-cost method. Also, Company C agrees to provide Company H progress payments on a monthly basis. In this case, Company H must assess whether any timing difference between the transfer of control and payment from Company C is indicative of a significant financing component. Based on the expectation of the timing of costs to be incurred, Company H concludes that progress payments are being made such that the timing between the transfer of control and payment is never expected to exceed one year. Therefore, FinREC believes Company H would not need to further assess whether a significant financing component is present and should not adjust the promised consideration in determining the transaction price, as Company H is electing the practical expedient under FASB ASC 606-10-32-18.

Determining Whether the Transaction Price Contains a Significant Financing Component

3.3.30 Advance payments. Many times within commercial contracts and direct foreign sales, entities receive consideration in advance of the transfer of goods to the customer. An entity should consider all facts and circumstances in assessing whether the advance payment from the customer represents a significant financing component.

3.3.31 BC232a of FASB ASU No. 2014-09 states that one of the factors to consider in evaluating whether a contract includes a significant financing component is as follows:

3.3.32 BC233 of FASB ASU No. 2014-09 explains that the difference between the promised consideration and the cash selling price of the good or service may arise for reasons other than the provision of financing to either the customer or the entity. The examples in BC233(a) (prepaid phone cards and customer loyalty points) illustrate when a payment in advance or in arrears in accordance with the typical payment terms of an industry or jurisdiction may have a primary purpose other than financing. A commercial contract or direct foreign sale often requires customers to pay in advance for reasons other than to secure financing, such as to mitigate risk of default.

3.3.33 BC237 and BC238 of FASB ASU No. 2014-09 explain that FASB ASC 606 does not include an exemption for advance payments because there may be situations in which a significant financing component is present, and to ignore the impact would skew the amount and pattern of revenue recognition. This point was also discussed in the March 2015 TRG meeting.⁴ Although the TRG members agreed that there is no presumption about whether advance payments do or do not contain significant financing components and that advance payments should be assessed under the new revenue standard, they did discuss that an advance payment arrangement would be more likely to contain the factor described in FASB ASC 606-10-32-17c that the difference in promised consideration and cash selling price is for a reason other than financing.

3.3.34 The following example is meant to be illustrative, and the actual determination of the existence of a significant financing component in the contract should be based on the facts and circumstances of an entity’s specific situation.

Example 3-3-10

Company A directly enters into a contract with a foreign government for the production of a military jet for total consideration of $150 million. The entity has concluded it should recognize revenue at a point in time upon delivery of the jet to the customer (this conclusion is not the purpose of this example). Also, Company A estimates it will deliver the military jet in 18 months from the date the contract is executed with the foreign government. In negotiations with the foreign government, Company A required the foreign government to make an advance payment of $20 million upon execution of the contract in order to mitigate risk of default and the additional consideration ($130 million) is due upon delivery. Company A sells similar military jets for a similar price, with variance only due to unique specifications selected by the ultimate customer. Based on the facts and circumstances, Company A determined that there were substantive business reasons for the advance payment beyond provision of financing and, therefore, has concluded there is no significant financing component present.

Example 3-3-11

Consider the same facts as described in example 3-3-10, except for the fact that Company A sells similar military jets to other foreign countries for $156 million. In negotiating the contract with the foreign government, Company A agreed to a $6 million discount as compared to the normal cash selling price of $156 million in exchange for the advance payment to assist with the investment in the purchases required to manufacture the military jet. In these facts and circumstances, Company A determined the transaction price contained a significant financing component.

3.3.35 Milestone or progress payments. FASB ASC 606-10-32-17c explains that a contract would not have a significant financing component if

3.3.36 BC233c of FASB ASU No. 2014-09 expands on this by stating, for example, a customer may retain or withhold some consideration that is payable only on successful completion of the contract or on achievement of a specified milestone.

3.3.37 Entities in the aerospace and defense industry may structure contracts in which payment is received from customers based on the achievement of certain milestones, or in relation to the work that has been performed.

3.3.38 BC233b of FASB ASU No. 2014-09 goes on to further state:

3.3.39 Based on the nature of the performance obligations, and the terms and conditions within the contract, it is possible payment may be made by the customer to the entity either more than 12 months prior to or after the transfer of control. Consistent with the example provided in FASB ASC 606-10-32-17c and BC233 of FASB ASU No. 2014-09, FinREC believes that, generally, these withheld payments are intended to provide the customer with assurance that the entity will successfully complete the milestones on the contract and are not indicative of a significant financing component. However, careful consideration of the nature of the payments as compared to the timing of transfer of control is needed in making this determination.

3.3.40 Many contracts with the USG are governed by provisions of the Federal Acquisition Regulation (FAR). Contracts under these provisions often provide for progress payments based on a percentage of costs incurred and a final liquidation payment upon completion. The withheld final payment provides the customer the opportunity to perform a quality assessment prior to the completion of the contract and the ability to withhold payment if the quality is not satisfactory. FinREC believes that, generally, in these cases, the intention of the payment terms is not to provide a financing component.

3.3.41 The following example is meant to be illustrative, and the actual determination of the existence of a significant financing component in the contract should be based on the facts and circumstances of an entity’s specific situation.

Example 3-3-12

Company H enters into a five-year contract with the United States Department of Defense (DoD) to develop, manufacture, and deliver 15 surveillance systems. The DoD will provide progress payments intended to compensate Company H for work performed, based on 80 percent of costs incurred, with the remainder due upon final delivery. Based on the terms of the contract, Company H has determined that it transfers control over time for a single performance obligation (this conclusion is not the purpose of this example) and recognizes revenue based on a cost-to-cost method. The terms of payment by the DoD are based on the provisions of FAR, the laws governing such payments made by the USG. As a result, Company H determined the intention of the parties was not to provide any financing component in the contract, but instead, is intended to provide payment for progress completed and provide the DoD with the ability to withhold final liquidation payment if the quality is not satisfactory, and as a result, Company H determined no significant financing component was present.

3.3.42 Award and incentive fee contracts. Contracts with award fees or incentive fees are sometimes negotiated in such a manner that, based upon the method of recognition, can result in recognition of revenue more than a year before cash is received from customers in relation to the award or incentive fee. Many times, the award or incentive fee relates to the entity’s successful achievement of certain contract provisions (for example, weight restrictions, accuracy, speed). As discussed within the section, "Variable Consideration and Constraining Estimates of Variable Consideration," these types of provisions are typically treated as variable consideration pursuant to paragraphs 5–9 of FASB ASC 606-10-32.

3.3.43 In these situations, an entity should assess whether a significant financing component has been provided by the entity to the customer. FASB ASC 606-10-32-17b provides that a significant financing component is not present within a contract when a substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event that is not substantially within the control of the customer or the entity.

3.3.44 BC231 of FASB ASU No. 2014-09 states the following:

3.3.45 BC233b of FASB ASU No. 2014-09 also states the following:

3.3.46 Based on the explanation within BC231 and BC233 of FASB ASU No. 2014-09 with respect to a significant financing component, the consideration of all facts and circumstances would be necessary in assessing whether a significant financing component exists within contracts that contain award or incentive fees. Based on specific facts and circumstances, an entity may conclude that although an award or incentive fee is typically contingent on the occurrence or nonoccurrence of some future event controlled by the entity and not a third party, the intention of the customer in including the award or incentive fee is to provide incentives to the entity to manufacture high performing products and is not intended to be a significant financing component.

3.3.47 The following example is meant to be illustrative, and the actual determination of the existence of a significant financing component in the contract should be based on the facts and circumstances of an entity’s specific situation.

Example 3-3-13

Company Z is a developer and manufacturer of defense systems that is primarily a Tier-II supplier of parts and integrated systems to original equipment manufacturers (OEMs) in the commercial markets. Company Z enters into a contract with Company X for the development and delivery of 5,000 highly technical, specialized missiles for use in one of Company X’s platforms. As a part of the contract, Company X has agreed to pay Company Z for their cost plus an award fee up to $10 million. Assume consideration will be paid by the customer related to costs incurred near the time Company Z incurs such costs. However, the $10 million award fee is awarded upon successful completion of the development and test fire of a missile to occur in 16 months from the time the contract is executed. The contract specifies Company Z will earn up to the $10 million based on Company X’s assessment of Company Z’s ability to develop and manufacture a missile that achieves multiple factors, including final weight, velocity, and accuracy. Partial award fees may be awarded based on a pre-determined scale based on their success.

Assume Company Z has assessed the contract under FASB ASC 606-10-32-6 and determined the award fee represents variable consideration. Based on their assessment, Company Z has estimated a total of $8 million in the transaction price related to the variable consideration pursuant to guidance within FASB ASC 606-10-32-8. Further, the entity has concluded it should recognize revenue over time for a single performance obligation using a cost-to-cost input method (these conclusions are not the purpose of this example).

Because Company Z will transfer control over time beginning shortly after the contract is executed, but will not receive the cash consideration related to the award fee component from Company X for more than one year in the future, Company Z should assess whether the award fee represents a significant financing component. Because the intention of the parties in negotiating the award fee due upon completion of the test fire, and based on the results of that test fire, was to provide incentive to Company Z to produce high functioning missiles that achieved successful scoring from Company X, it was determined the contract does not contain a significant financing component, and Company Z should not adjust the transaction price.

3.3.48 As required by FASB ASC 606-10-32-20, if an entity concludes a contract contains a significant financing component, the entity should present the effects of financing (interest income or interest expense) separately from revenue from contracts with customers in the statement of comprehensive income. Interest income or interest expense is recognized only to the extent that a contract asset (or receivable) or a contract liability is recognized in accounting for a contract with a customer.

3.3.49 The following example is meant to be illustrative, and the actual determination of the existence of a significant financing component in the contract and presentation of the effects of financing should be based on the facts and circumstances of an entity’s specific situation.

Example 3-3-14

Company A signs a contract with Company B for a business aircraft for a total promised consideration of $100 million. In negotiating the contract, Company A was willing to accept $100 million for the business aircraft provided that Company B paid in full in advance on the date the contract is signed. If Company B elected to pay when control of the aircraft transfers, the cash selling price would have been $109 million.

Company A concludes that based on the contract terms, revenue will be recognized upon delivery of the aircraft (this conclusion is not the purpose of this example). Further, Company A concludes that the contract contains a significant financing component based on the length of time between when the customer pays for the assets and when the entity transfers the assets to the customer is greater than one year, the significance of the financing component, as well as the prevailing interest rates in the market. Company A has also determined that, in accordance with FASB ASC 606-10-32-19, the rate that should be used in adjusting the promised consideration is 6 percent, which is the entity’s incremental borrowing rate.

The following journal entries illustrate how Company A would account for the significant financing component:

At contract inception $100 million is received from Company B

During the 18-month term between the signing of the contract and the transfer of the aircraft, the entity adjusts the promised amount of the consideration (in accordance with FASB ASC 606-10-32-20) and accretes the contract liability by recognizing interest on $100,000,000 at 6 percent for 18 months.

At the time, Company A transfers the aircraft

General Principle

3.4.01 When a contract contains more than one performance obligation, an entity will need to allocate the transaction price to each performance obligation. As explained in FASB ASC 606-10-32-29, the transaction price should be allocated to each performance obligation identified in the contract based on the relative stand-alone selling prices of the products or services being provided to the customer. As noted in FASB ASC 606-10-32-43, the transaction price is not reallocated to reflect changes in stand-alone selling prices after contract inception.

3.4.02 As explained in FASB ASC 606-10-32-36, except when an entity has observable evidence that the entire discount relates to only one or more, but not all, performance obligations in a contract, the discounts should be allocated proportionally to all the separate performance obligations in the contract on the basis of the stand-alone selling prices of the underlying distinct goods or services. An entity should allocate discounts or variable consideration to a single or only certain performance obligations, if the specified criteria in FASB ASC 606-10-32-37 (discounts) or FASB ASC 606-10-32-40 (variable consideration) are met.

Estimating Stand-alone Selling Prices

3.4.03 As stated in FASB ASC 606-10-32-32, "the best evidence of stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers."

3.4.04 Although many purchases made by the U.S. federal government are for standard commercial products and services for which an observable price may be available, a substantial amount of purchases are made by the U.S. federal government for which the purchasing federal agency may be the only customer for the products and services it acquires. In these circumstances, prices most likely have not been established by the marketplace and, therefore, the stand-alone selling prices may not be readily observable.

3.4.05 As discussed in FASB ASC 606-10-32-33, entities should estimate the selling price of goods or services that do not have an observable stand-alone selling price. When estimating the stand-alone selling price, entities should consider all information, including market conditions, entity-specific factors, and information about the customer or class of customer, that is reasonably available to the entity.

3.4.06 FASB ASC 606-10-32-34 explains that suitable methods for estimating the stand-alone selling price include the following:

a.     Adjusted market assessment approach

b.     Expected cost plus a margin approach

c.     Residual approach (specific criteria must be met to use this approach)

3.4.07 FASB ASC 606-10-32-35 explains that an entity may need to use a combination of these methods to estimate a stand-alone selling price of the goods or services promised in the contract if two or more of those goods or services have highly variable or uncertain stand-alone selling prices.

3.4.08 The estimation methods discussed in FASB ASC 606-10-32-34 are not the only methods permitted. The standard allows any reasonable estimation method as long as it is consistent with the notion of a stand-alone selling price, maximizes the use of observable inputs, and is applied on a consistent basis for similar products and services and customers.

Expected Cost Plus Margin Approach

3.4.09 An expected cost plus a margin approach may be an appropriate estimation method for contracts with the U.S. federal government. Costs included in the estimate should be consistent with those an entity would normally consider in setting stand-alone prices, including both direct and indirect costs. This approach focuses on internal factors (for example, the entity’s cost basis) but has an external component as well. That is, the margin included in this approach must reflect the margin the market would be willing to pay, not just the entity’s desired margin.

3.4.10 The expected cost plus margin approach may be useful in many situations, especially when the performance obligation has a determinable, direct fulfillment cost. However, this approach may be less useful when there are no clearly identifiable direct fulfillment costs or the amount of those costs is unknown.

3.4.11 Factors an aerospace and defense entity may consider when assessing whether a margin is reasonable could include the following:

a.     Internal cost structure

b.     Nature of proposal process (for example, competitive or sole source); Competitive bid process (assuming competitors were similarly priced [if known]) could be an indicator that contract value approximates stand-alone selling price

c.     Pricing practices (including contracts that are negotiated pursuant to the Truth in Negotiations Act, which require certified cost or pricing data to be provided to the customer)

d.     Pricing objectives (including desired and historical gross profit margin)

e.     Effects of customization on pricing

f.     Pricing practices used to establish pricing of bundled products

g.     Effects of a proposed transaction on pricing (for example, the size of the deal, the characteristics of the targeted customer)

h.     The expected technological life of the product, including significant vendor-specific technological advancements expected in the near future

i.     Margins earned on similar contracts with different customers (agencies)

Adjusted Market Assessment Approach

3.4.12 The adjusted market assessment approach focuses on the amount that the entity believes the market is willing to pay for a product or service. This approach is based primarily on external factors, rather than the entity’s own internal influences.

3.4.13 Applying this approach will likely be easier in situations in which an entity has sold a standard product or service for a period of time (so it has data about customer demand) or a competitor offers similar products or services that the entity can use as a basis for its analysis. For example, through the U.S. federal government proposal process an entity may obtain useful market data from the competitive proposals for standard commercial products and services that are reviewed and negotiated with the customer. Conversely, applying this approach may be difficult in situations in which an entity is selling a new product or service, or when the product or service is significantly customized to meet specifications required by the customer. In such situations, entities may want to use the adjusted market assessment approach in combination with other approaches to maximize the use of observable inputs.

3.4.14 Although this is not an all-inclusive list, the following are examples of market conditions to consider:

a.     Competitor pricing for a similar or identical product

b.     Market awareness of and perception of the product

c.     Current market trends that will likely affect the pricing

d.     The entity’s market share and position (for example, the entity’s ability to dictate pricing)

e.     Effects of the geographic area on pricing

f.     Effects of customization on pricing

g.     Expected technological life of the product

Residual Approach

3.4.15 As explained in FASB ASC 606-10-32-34c, the residual approach may be used to estimate stand-alone selling price only in situations in which the entity sells the same product or service to different customers for a broad range of prices, making them highly variable, or the entity has not yet established a price for a product or service because it has not been previously sold on a stand-alone basis. As explained in FASB ASC 606-10-32-35, an entity may use a residual approach to estimate the aggregate stand-alone selling price for those promised goods or services with highly variable or uncertain stand-alone selling prices and then use another method to estimate the stand-alone selling price of the individual goods or services relative to that estimated aggregated stand-alone selling price determined by the residual approach.

3.4.16 The following example is meant to be illustrative, and the actual determination of the appropriate method for estimating the stand-alone selling price in accordance with paragraphs 33–35 of FASB ASC 606-10-32 should be based on the facts and circumstances of an entity’s specific situation.

Example 3-4-1

An entity enters into a fixed price contract with a customer to sell an integrated missile defense system, which includes 200 missiles for $400 million ($2 million per missile), 3 missile launchers for $3 million ($1 million per launcher), and a communication shelter for $10 million. In addition, the contract includes ongoing operation and maintenance for the missile system for three years for the customer for an estimated price of $5 million. The entity concluded that there were two separate performance obligations, the first for the integrated missile defense system and the second for the operation and maintenance services (this conclusion is not the purpose of this example).

The entity determines there is no observable market data available because the integrated missile system and ongoing operations and maintenance are customized specifically for the customer and have unique performance capabilities (as such, no similar competitor product exists).

Based on these facts and circumstances, the entity determines the most appropriate of the three allocation approaches to determine the stand-alone selling price for the integrated missile defense system and ongoing operations and maintenance is the expected costs plus margin approach.

Allocating Discounts

3.4.17 As explained in FASB ASC 606-10-32-36, "a customer receives a discount for purchasing a bundle of goods or services if the sum of the stand-alone selling prices of those promised goods or services in the contract exceeds the promised consideration in a contract." Under the relative stand-alone selling price method, this discount would typically be allocated proportionately to all the separate performance obligations. However, if an entity determines that a discount in an arrangement is not related to all the products and services, it may be required to allocate the discount to only those products or services for which the discount relates. A discount should be allocated to only certain products or services in an arrangement if all the criteria in FASB ASC 606-10-32-37 are met.

3.4.18 Typically, discounts will be allocated only to bundles of two or more performance obligations in an arrangement. As stated in BC283 of FASB ASU No. 2014-09, "the [b]oards noted it may be possible for an entity to have sufficient evidence to be able to allocate a discount to only one performance obligation in accordance with the criteria in ASC 606-10-32-37, but the [b]oards expected that this could occur in only rare cases."

3.4.19 The following example is meant to be illustrative, and the actual determination of the appropriate allocation of a discount in accordance with paragraphs 36–38 of FASB ASC 606-10-32 should be based on the facts and circumstances of an entity’s specific situation.

Example 3-4-2

An entity enters into a fixed priced arrangement to sell two communication satellites for $500 million (Sat A for $250 million and Sat B for $250 million) and provide training services to the customer’s employees on how to assemble and integrate future communication satellites for $20 million. The arrangement is a direct commercial sale with an international customer. The entity determined that there were three separate performance obligations: (1) Sat A, (2) Sat B, and (3) training on assembly and integration (this conclusion is not the purpose of this example).

The regular selling price for Sat A and Sat B is $300 million and $275 million, respectively, and the entity regularly sells Sat A and Sat B as a bundle for $500 million. The pricing for the training services represents the entity’s cost plus its standard margin of 10 percent, which is consistent with what competitors charge in the marketplace. Therefore, the customer received an overall discount of $75 million based on the stand-alone selling prices.

Based on the facts and circumstances, the entity would allocate the discount directly to Sat A and Sat B because

a.     the entity regularly sells each satellite, and training on a stand-alone basis.

b.     the entity regularly sells on a stand-alone basis Sat A and Sat B as a bundle at a discount to the stand-alone selling price for Sat A and Sat B.

c.     the discount attributable to Sat A and B as a bundle ($75 million) is the same as the discount in the contract, and there is observable evidence that the discount in the contract is attributable to Sat A and Sat B.

Allocation of Variable Consideration

3.4.20 Contracts with the U.S. federal government may contain an element of variable consideration depending on the contract type involved. For example, U.S. federal government contracts could contain incentives or award fees depending on the entity achieving certain future events, agreed-upon performance targets, or cost objectives.

3.4.21 As stated in FASB ASC 606-10-32-40,

a.     The terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service).

b.     Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective in paragraph 606-10-32-28 when considering all of the performance obligations and payment terms in the contract.

3.4.22 If the criteria in FASB ASC 606-10-32-40 are not met, the variable consideration (and any subsequent changes in the measurement of the variable consideration) that is determined to be in the total transaction price, is allocated to all performance obligations in a contract based on their relative stand-alone selling prices. As explained in FASB ASC 606-10-32-43, subsequent changes in the total transaction price are generally allocated to the separate performance obligations on the same basis as the initial allocation (based on stand-alone selling prices determined at contract inception). However, changes in the amount of variable consideration will need to be evaluated to determine if the variable consideration relates to one or more specific performance obligations. In addition, pursuant to FASB ASC 606-10-32-43, situations could arise in which changes in variable consideration (upward or downward) could pertain to a satisfied performance obligation. A change in the amount of consideration related to a satisfied performance obligation is recognized on a cumulative catch-up basis.

3.4.23 The following example is meant to be illustrative, and the actual determination of the appropriate allocation of variable consideration in accordance with paragraphs 39–41 of FASB ASC 606-10-32 should be based on the facts and circumstances of an entity’s specific situation.

Example 3-4-3

An entity enters into a fixed price plus incentive fee contract to modernize and operate a U.S. government flight operation center. In addition, the entity will operate the network and provide customer service (IT help desk) for three years. The entity has the ability to earn two types of incentive fees under the arrangement. The first is a cost incentive, which is determined based on the relationship of total costs for the entire contract to the total target costs. The second is a customer satisfaction incentive in which the entity is measured based on response time for operating the IT help desk.

The entity determined there were two performance obligations for this arrangement, one to modernize the network, and the second to operate the network and provide customer service. The estimated cost to install the network is $100 million and estimated cost to operate and provide customer service for three years is $50 million for total costs of $150 million. Using the expected value method, the entity estimated that it would earn $10 million related to the cost incentive for the entire contract, and $3 million for the customer satisfaction incentive related to the IT help desk. The entity has determined that the cost incentive pertains to the total cost of the entire contract and, therefore, the $10 million is allocated to both performance obligations based on stand-alone selling prices of each. The customer satisfaction incentive is directly related to the performance obligation to operate network and provide customer service as described in the terms of the customer satisfaction incentive agreement and, therefore, the entire $3 million of variable consideration was allocated to this performance obligation in accordance with the requirements on FASB ASC 606-10-32-40.

3.5.01 Commercial aerospace and defense contracts encompass many different types of transactions: manufacturing of standardized products; rendering of services, such as maintenance or training, or construction-type contracts to design, develop, manufacture, or modify complex aerospace or electronic equipment to a buyer's specification.

3.5.02 FASB ASC 606-10-25-23 states the following:

3.5.03 FASB ASC 606 explains that revenue should be recognized when (or as) an entity satisfies a performance obligation by transferring control of a good or service to a customer. Control of a good or service can transfer over time or at a point in time. If a performance obligation is satisfied over time, revenue allocated to that performance obligation will be recognized over time. FASB ASC 606-10-25-30 explains that if a performance obligation does not meet the criteria to be satisfied over time, it is deemed to be satisfied at a point in time.

3.5.04 Aerospace and defense companies should determine whether a performance obligation meets the criteria to be satisfied over time or if satisfaction occurs at a point in time. As noted in FASB ASC 606-10-25-24, this assessment is performed at contract inception and may only be revised during the contract in the event of certain contract modifications, for instance, change to rights to payment, change to contract scope that affects the alternative use of the assets being produced, and so on.

Performance Obligations Satisfied Over Time

3.5.05 FASB ASC 606-10-25-27 states that

a.     The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;

b.     The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced;

c.     The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

3.5.06 Aerospace and defense entities will need to examine at contract inception the facts and circumstances to determine whether performance obligations in aerospace and defense contracts meet any of the criteria in FASB ASC 606-10-25-27.

Simultaneous Receipt and Consumption of the Benefits of the Entity’s Performance

3.5.07 Assessing the criterion in FASB ASC 606-10-25-27a can be straightforward as explained in FASB ASC 606-10-55-5 for routine or recurring services or situations in which the entity’s performance is immediately consumed by the customer. FASB ASC 606-10-55-6 also notes that the criterion in FASB ASC 606-10-25-27a could be met if an entity determines that another entity would not need to substantially reperform the work that the entity has completed to date, if that other entity were to fulfill the remaining performance obligation to the customer. FinREC believes that this criterion is likely to be relevant for certain commercial aerospace and defense service performance obligations, such as maintenance, training or transportation services.

Customer Controls the Asset As It Is Created or Enhanced

3.5.08 The criterion in FASB ASC 606-10-25-27b addresses situations in which the customer controls any work in process, either tangible or intangible, as it is created or enhanced.

3.5.09 FASB ASC 606-10-25-25 states the following:

a.     Using the asset to produce goods or provide services (including public services)

b.     Using the asset to enhance the value of other assets

c.     Using the asset to settle liabilities or reduce expenses

d.     Selling or exchanging the asset

e.     Pledging the asset to secure a loan

f.     Holding the asset.

3.5.10 Judgment will be required to determine if control of the asset transfers to the customer while the asset is being created or enhanced. Aerospace and defense contracts in which the entity performs on or enhances the customer’s asset may transfer control to the customer over time. Management should analyze the contract’s terms and conditions and other facts and circumstances to determine, for example, if the entity has a right to payment for its performance to date, if the legal title, physical possession, or risks and rewards of ownership related to the asset pass to the customer as the asset is created or enhanced, if the customer accepts the asset as it is created or enhanced, or if the customer controls the underlying land or asset that the entity is enhancing.

Entity’s Performance Does Not Create an Asset With an Alternative Use

3.5.11 The criterion in FASB ASC 606-10-25-27c includes both the assessment of whether the entity’s performance does not create an asset with an alternative use to the entity and whether the entity has an enforceable right of payment for performance completed to date.

3.5.12 As discussed in BC134 of FASB ASU No. 2014-09, when the asset has an alternative use to the entity, the customer does not control the asset as it is being created. This is expected to be the case in standard inventory-type items for which the entity has the discretion to substitute items or units across different contracts with customers.

3.5.13 Some assets, such as commercial aircrafts or engines and components and parts to that equipment, may be less customized when manufactured under non-U.S. government contracts than assets produced under U.S. government contracts. However, BC137 of FASB ASU No. 2014-09 explains that the level of customization is not the only criterion to determine whether the asset has an alternative use. As stated in FASB ASC 606-10-25-28, "an asset created by an entity’s performance does not have an alternative use to an entity if the entity is either restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another use.” An example would be if the entity cannot sell the asset to another customer without significant rework.

3.5.14 As discussed in FASB ASC 606-10-55-8, assessment of the "no alternative use" criteria should be made assuming the contract with its customer is not terminated.

3.5.15 In accordance with FASB ASC 606-10-25-28, an entity should also consider at contract inception the characteristics of the asset in its complete form because it will ultimately transfer to the customer. BC136 of FASB ASU No. 2014-09 provides the example of an asset that has the same basic design as many other assets that the entity sells to other customers. However, customization is substantial and would prevent the entity from redirecting the asset in its complete state to another customer without significant rework. Although the asset may likely have an alternative use to the entity in the early stage of its manufacturing process, (that is before customization activities start), the entity should conclude from inception that the asset has no alternative use.

3.5.16 FASB ASC 606-10-55-10 states that "a practical limitation on an entity’s ability to direct an asset for another use exists if an entity would incur significant economic losses to direct the asset for another use." FinREC believes that situations that may create practical limitations include, but are not limited to, significant level of customization and rework necessary to redirect the asset to another use, resale at a significant loss, limited production slots that may limit the capability of the entity to redirect the asset while still meeting its obligations (such as contractual deadlines) under the contract with the customer, and the asset is located in a remote location where significant transportation costs would be incurred to redirect the asset for another use.

3.5.17 As stated in FASB ASC 606-10-55-9, "a contractual restriction on an entity’s ability to direct an asset for another use must be substantive for the asset not to have an alternative use to the entity." For instance, if a contract prevents the entity from substituting the asset for another asset, but, in practice, the entity manufactures other similar assets and those assets are interchangeable, have no serial number or other way of being individually identified, and the entity would not incur significant costs by substituting the asset, the contractual clause would likely be assessed as non-substantive. When assessing whether a contractual restriction confers a "non-alternative use" to the asset, the entity should consider whether the contractual restriction represents only a protective right to the customer and whether the customer could enforce its rights to the promised asset. As discussed in BC138 of FASB ASU No. 2014-09, a protective right typically results in the entity having the practical ability to physically substitute or redirect the asset without the customer being aware of or objecting to the change.

Enforceable Right to Payment for Performance Completed to Date

3.5.18 When the asset created has no alternative use to the entity, the entity still needs to demonstrate it has an "enforceable right to payment for performance completed to date" in order to satisfy the criteria in FASB ASC 606-10-25-27c and meet the requirements to conclude that satisfaction of a performance obligation and revenue should be recognized over time. Both of the criteria in FASB ASC 606-10-25-27c need to be met; a right to payment for performance to date alone does not, in itself, demonstrate that control has transferred.

3.5.19 As per FASB ASC 606-10-55-11, the entity needs to demonstrate that if the contract was to be terminated early for reasons other than the entity’s failure to perform as promised, it would be entitled to an amount that compensates the entity for its performance to date. An amount that would compensate an entity for performance completed to date would be an amount that approximates the selling price of the goods or services transferred to date rather than compensation for only the entity’s potential loss of profit if the contract were to be terminated. For example, an entity could evidence an enforceable right to payment based on the ability to recover the costs incurred to date in satisfying the performance obligation plus a reasonable profit margin. In this case, the entity needs to demonstrate that the margin recovered for the goods or services transferred to date represents a reasonable margin. Significant judgment will be required, particularly in circumstances in which the entity is entitled to a margin that is proportionally lower than the one it would expect to obtain if the contract is completed.

3.5.20 Although it would generally be expected that entities would price their contracts to obtain a reasonable profit, there are circumstances in which an entity would be willing to sell a good or service at a loss. For example, an entity might be willing to incur a loss on a sale if the entity has a strong expectation of obtaining a profit on future orders from that customer, even though such orders are not contractually guaranteed. The objective of the “right to payment” criterion in FASB ASC 606-10-25-27c as described in BC142 of FASB ASU No. 2014-09 is to assess whether the customer is obligated to pay for performance to date. Compensation for the entity’s performance for a contract negotiated at a loss, is an amount that is less than the entity’s costs. FinREC believes the principle for assessing the enforceable right to payment for performance completed to date as described in FASB ASC 606-10-25-27c is based on whether the entity has a right to an amount that approximates the selling price; therefore, an entity does not need to have a profit in order to meet this criterion. Accordingly, FinREC believes certain contracts priced at a loss may qualify for over time recognition under FASB ASC 606-10-25-27c if the enforceable right to payment for performance completed to date is based on the selling price, which may not contain a profit. This section does not address or change the requirements for when an entity would be required to record a loss accrual related to a contract.

3.5.21 Under the termination for convenience clause in most U.S. federal government contracts, the government typically has a right to the goods or work in progress produced, and the contractor is entitled to payment for its performance to date if the contract is terminated early for reasons other than default. Non-U.S. federal government contracts may operate under different terms.

3.5.22 As described in FASB ASC 606-10-55-14, management should analyze the terms and conditions of the contract as well as any laws that govern the transaction in order to determine if the entity’s performance gives rise to an enforceable right to payment for performance completed to date at any given time. Legal precedents as well as customary business practices should also be considered in case they alter the capacity of the entity to enforce their right to payment.

3.5.23 The following example is meant to be illustrative of when a contract negotiated at a loss at inception meets the criteria for satisfaction of performance obligations over time. The actual determination of whether the performance obligation is satisfied over time or at a point in time should be based on facts and circumstances of an entity’s specific situation.

Example 3-5-1

Country (the customer) puts out a request for bids for the design of a highly customized defense system. Country expects to award subsequent contracts for tens of thousands of systems over the next ten years from whoever wins the design contract. There are four contractors bidding for this contract. Contractor A is aware of the competition and knows that in order to win the design contract it must bid it at a loss. Contractor A is willing to bid the design contract at a loss due to the significant value in expected orders over the next ten years.

Contractor A wins the contract with a value of $100 and estimated costs to complete of $130. The contract is noncancellable; however, the contract terms stipulate that if Country attempts to terminate the contract, Contractor A would be entitled to payment for work done to date. The payment amount would be equal to a proportional amount of the price of the contract based on the performance of work done to date. For example, if, at the termination date, Contractor A had completed 50 percent of the contracted work or had incurred $65 of costs, it would be entitled to a $50 payment from Country, based on the contract value of $100 and the estimated total cost of $130.

For the purposes of this example, Contractor A has determined that the contract contains a single performance obligation and performance of work is done ratably over the contract period. Contractor A has also determined that its performance does not create an asset with an alternative use due to the highly customized design of the defense system. Thus, the conclusion regarding whether Contractor A has an enforceable right to payment will determine whether revenue should be recognized over time or at a point in time. This example does not address or change the requirements regarding whether Contractor A would be required to record a loss accrual related to the contract.

In this example, Contractor A has an enforceable right to payment for performance completed to date in accordance with FASB ASC 606-10-25-27c because it is entitled to receive a proportionate amount of the contract price in the event that Country terminates the agreement. FASB ASC 606-10-55-11 refers to “an amount that approximates the selling price of the goods or services transferred to date” and cites “cost plus a reasonable profit margin” as an example of an amount that would represent selling price for performance completed to date. Compensation for the entity’s performance in this example, as negotiated by the parties, is an amount that is less than the entity’s costs. Therefore, in this example, the analysis is focused on whether the entity has a right to a proportionate amount of the selling price (reflecting performance to date) rather than whether such amount is greater than or less than the entity’s costs to fulfill the contract.

3.5.24 In measuring progress toward complete satisfaction of a performance obligation, FASB ASC 606-10-25-31 states that "the objective when measuring progress is to depict an entity’s performance in transferring control of goods or services promised to a customer (that is, the satisfaction of an entity’s performance obligation)."

3.5.25 As discussed in FASB ASC 606-10-25-33, there are various appropriate methods of measuring progress that are generally categorized as output methods and input methods. FASB ASC 606-10-55-17 explains that "output methods include surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units produced or units delivered." FASB ASC 606-10-55-20 explains that input methods include resources consumed, labor hours expended, costs incurred, time lapsed, or machine hours used relative to the total expected inputs to the satisfaction of that performance obligation. Considerations for selecting those methods are discussed in paragraphs 16–21 of FASB ASC 606-10-55. As required in FASB ASC 606-10-25-32, for each performance obligation, the entity should apply a single method of measuring progress that is consistent with the objective in FASB ASC 606-10-25-31 and should apply that method consistent with similar performance obligations and in similar circumstances.

3.5.26 For aerospace and defense entities, a careful evaluation of the facts and circumstances is required to determine which method best depicts the entity’s performance in transferring control of goods or services to the customer. The entity should carefully consider the nature of the product or services provided and the terms of the customer contract, such as contract termination rights, the rights to demand or retain payments, and the legal title to work in process in determining the best input or output method for measuring progress toward complete satisfaction of a performance obligation.

United States Federal Government Contracts

3.5.27 Aerospace and defense contracts with the United States federal government typically provide the government the ability to terminate a contract for convenience, which is the unilateral right to cancel the contract whenever the federal buying agency deems the cancellation is in the public interest. In a termination for convenience, the contractor generally is entitled to recover all costs incurred to the termination date, plus other costs not recovered at termination (such as ongoing costs not able to be discontinued, for example, rental costs) as well as an allowance for profit or fee. The U.S. federal government also typically has the right to the goods produced and in-process under the contract at the time of a termination for convenience.

3.5.28 FASB ASC 606-10-55-17 states the following:

3.5.29 BC165 of FASB ASU No. 2014-09 further notes that

3.5.30 A distinction between the cost-to-cost method and the output methods of units-of-delivery or units-of-production is that the cost-to-cost method includes work in process in the measurement towards complete satisfaction of the performance obligation.

3.5.31 A termination for convenience clause that gives the customer the right to the goods produced and in-process under the contract at the time of termination may indicate that the customer has effective control over the goods produced and work-in-progress, even if not in the customer’s physical possession. Based on the guidance cited in paragraph 3.5.29, FinREC believes in these circumstances, an output method, such as units of delivery or units of production, would not be an appropriate measure of the progress toward complete satisfaction of the performance obligation because an output method would ignore the work in process that belongs to the customer. Therefore, an input method would typically be more appropriate in these circumstances.

3.5.32 Accordingly, the contractor would evaluate the specific circumstances to determine if an input method, such as cost-to-cost, is an appropriate measure of the progress toward complete satisfaction of the performance obligation that faithfully depicts the activity for which control is transferred to the U.S. federal government.

Commercial Aerospace and Defense Supply Contracts

3.5.33 Because commercial aerospace and defense products are typically complex and highly specialized, a supplier may enter into a long-term contract with its customer to supply a product that has no alternative use other than use in the manufacture of a specific aerospace or defense product, and the supplier may have an enforceable right to payment from the customer for performance performed to date. If the supplier determines that revenue should be recognized over time for such a commercial contract, the supplier must determine the acceptable measure of progress towards complete satisfaction of the performance obligations.

3.5.34 Circumstances in which the costs incurred are related exclusively to satisfying the obligations under the supply agreement for a product with no alternative use could be an indicator that the customer effectively controls the work in process. FinREC believes in these circumstances that an input measure, such as the cost-to-cost method, may provide a faithful depiction of progress towards complete satisfaction of the performance obligation.

Aerospace and Defense Service Contracts

3.5.35 As the nature of aerospace and defense service contracts varies widely, the selection of the best method of measuring progress toward complete satisfaction of a performance obligation requires knowledge of the services provided to the customer as well as the contractual terms of the performance obligation, particularly those terms involving the timing of service delivery.

3.5.36 FASB ASC 606-10-55-18 states that

3.5.37 Aerospace and defense companies should consider whether the practical expedient in FASB ASC 606-10-55-18 would be applicable for its service contracts that specify the right to invoice, and the amount of the invoice corresponds directly with the value to the customer of the entity’s performance completed to date.

3.5.38 For certain service contracts, it may be appropriate to use an output method related to the number of instances homogeneous services are provided to the customer relative to the number of instances the services are expected to be performed over the life of the service contract.

3.5.39 For other service contracts, it may be appropriate to use input methods for measuring progress towards complete satisfaction of a performance obligation depending on the facts and circumstances. FASB ASC 606-10-55-20 states that, "if the entity’s efforts or inputs are expended evenly throughout the performance period, it may be appropriate for the entity to recognize revenue on a straight-line basis." In service contracts for which output methods are not an appropriate measure of the complete satisfaction of the performance obligation, and when the performance obligation is not satisfied evenly throughout the performance period, the cost-to-cost method may be more appropriate.

3.5.40 The following examples are meant to be illustrative of aerospace and defense service contracts for which the related performance obligations are satisfied over time. The actual determination of the method for measuring complete satisfaction of a performance obligation as stated in FASB ASC 606-10-25-31 should be based on the facts and circumstances of an entity’s specific situation.

Example 3-5-2

An aircraft maintenance provider may enter into a contract that provides routine daily maintenance for a fleet of aircraft for equal monthly payments over 24 months of service, with no contract provisions to adjust the transaction price based on the condition of the aircraft. The contractor may consider straight-line revenue recognition to be a reasonable depiction of the amount of the entity’s performance and transfer of control of the goods or services to the customer as the efforts are expended evenly throughout the performance period.

Example 3-5-3

The same aircraft maintenance provider may provide major aircraft maintenance overhauls. In this circumstance, the level of effort necessary for the overhaul varies depending upon the condition of the aircraft. In these circumstances, an input method, such as cost-to-cost, may be a reasonable depiction of the amount of the entity’s performance and transfer of control of the goods or services to the customer.

Use of Units-of-Delivery Method to Measure Progress

3.5.41 If the entity determines that revenue should be recognized over time and the customer has control of the goods as the performance occurs, based on the guidance in FASB ASC 606-10-55-17, output methods, such as units-of-delivery or units-of-production method, that have not been modified to take into account the assets that are created before delivery occurs or production is complete, may not result in the best depiction of an entity’s performance because such unmodified methods ignore the work in process for which control has been transferred to the customer.

3.5.42 BC166 of FASB ASU No. 2014-09 states, "the [b]oards also observed that a units-of-delivery or a units-of-production method may not be appropriate if the contract provides both design and production services because, in this case, each item produced or delivered may not transfer an equal amount of value to the customer." It is common for aerospace and defense contracts to provide design and production services.

3.5.43 BC166 of FASB ASU No. 2014-09 goes on to further state, "however, a units-of-delivery method may be an appropriate method for measuring progress for a long-term manufacturing contract of standard items that individually transfer an equal amount of value to the customer on delivery."

3.5.44 FinREC believes a units-of-delivery method may be appropriate in situations in which the entity has a production only contract producing homogenous products, and the method would accurately depict the entity’s performance. When selecting a method for measuring progress and considering whether a units-of-delivery method is appropriate, an entity should consider its facts and circumstances and select the method that depicts the entity’s performance and the transfer of control of the goods or services to the customer. For example, contracts for ammunition in which thousands of units are produced and inventory is immaterial in relation to the size of the contract, a units-of-delivery method may be a reasonable depiction of the amount of the entity’s performance and transfer of control of the goods or services to the customer.

3.5.45 Inputs that do not depict an entity’s performance. Paragraphs 20–21 of FASB ASC 606-10-55 provide guidance about measuring progress toward complete satisfaction of a performance obligation using input methods. It states that the entity should exclude from an input method the effects of inputs that do not depict the entity’s performance in transferring goods or services to the customer.

Consideration of Significant Inefficiencies in Performance

3.5.46 For entities using a cost-based input method for measuring progress towards complete satisfaction of performance obligations, an adjustment to the measure of progress may be required in certain circumstances. FASB ASC 606-10-55-21a states that "an entity would not recognize revenue on the basis of costs incurred that are attributable to significant inefficiencies in the entity’s performance that were not reflected in the price of the contract (for example, the costs of unexpected amounts of wasted materials, labor, or other resources which were incurred to fulfill the performance obligation)."

3.5.47 Determining which costs represent "wasted" materials, labor or other resources requires significant judgment and varies depending upon the facts and circumstances. For example, there are many aerospace and defense contracts that relate to engineering, manufacturing, and design (EMD) and low-rate initial production units for which there is an expectation that there will be significant inefficiencies experienced while fulfilling the performance obligations due to the nature of the work performed. As manufacturing of a product matures over its life-cycle, there often is an expectation that such inefficiencies would decline over time. At the time of entering into the contracts, the varying risks of inefficiencies are understood by the management of aerospace and defense companies and are reflected in the pricing of the contract. Therefore, FinREC believes the variability in performance on the contract is typically not "unexpected inefficiencies" that would be excluded from the cost-based input measure of progress.

3.5.48 In some circumstances, however, unexpected inefficiencies may occur that were not considered a risk at the time of entering into the contract, such as severe weather, extended labor strikes, or manufacturing accidents that result in significant wasted resources that may require adjustment to a cost-based input method for measuring progress. These wasted materials and efforts should be excluded from the measure of progress towards completion.

Costs Incurred That Are Not Indicative of Performance

3.5.49 There may also be circumstances whereby the cost incurred on an aerospace and defense contract is not proportionate to the entity’s progress in satisfying the performance obligation. For example, aerospace and defense entities may enter into contracts to procure products, such as major sub-assemblies, and then add features to make the products suitable for use in aerospace or military applications. The procurement alone of those products may not be indicative of the entity’s performance.

3.5.50 FASB ASC 606-10-55-21 states

a.     When a cost incurred does not contribute to an entity’s progress in satisfying the performance obligation. For example, an entity would not recognize revenue on the basis of costs incurred that are attributable to significant inefficiencies in the entity’s performance that were not reflected in the price of the contract (for example, the costs of unexpected amounts of wasted materials, labor, or other resources that were incurred to satisfy the performance obligation).

b.     When a cost incurred is not proportionate to the entity’s progress in satisfying the performance obligation. In those circumstances, the best depiction of the entity’s performance may be to adjust the input method to recognize revenue only to the extent of that cost incurred. For example, a faithful depiction of an entity’s performance might be to recognize revenue at an amount equal to the cost of a good used to satisfy a performance obligation if the entity expects at contract inception that all of the following conditions would be met:

3.5.51 Applying the guidance in FASB ASC 606-10-55-21b and determining whether the cost of a good is proportionate to the entity’s progress in satisfying a performance obligation may require considerable judgment for aerospace and defense companies. For example, many aerospace and defense companies are significantly involved in designing and manufacturing the products that they procure such that condition 4 in FASB ASC 606-10-55-21b is not met, and the cost of procurement would be a faithful depiction of an entity’s performance and, therefore, a valid cost to be considered in measuring progress towards completion of the contract. This significant involvement is one of the reasons that many aerospace and defense contracts provide the entity with the right to payment from the customer for the cost of procurement plus a reasonable profit in the event of termination for convenience by the customer.

3.5.52 In those circumstances in which a contractor is using a cost-based input method for measuring progress towards complete satisfaction of performance obligations and the purchase of the product meets all the conditions in FASB ASC 606-10-55-21b, an entity should exclude the costs incurred for the product from the measurement of progress for the performance obligation in accordance with the objective of measuring progress in FASB ASC 606-10-25-31. In such circumstances, progress would be measured based on the other costs. In accordance with the discussion in BC172 of FASB ASU No. 2014-09, this accounting method would result in zero margin recognition for the purchase of the product and contract margin recognition over the remaining costs incurred to satisfy the performance obligation.

3.5.53 Example 3-5-4 that follows is meant to be illustrative of an aerospace contract with uninstalled materials. The actual determination of the method for measuring complete satisfaction of a performance obligation as stated in FASB ASC 606-10-55-21b should be based on the facts and circumstances of an entity’s specific situation.

Example 3-5-4

On July 1, 20xy, an aerospace company entered into a contract to provide a product to a customer for $20 million. The company has determined that the contract represents a single performance obligation, and revenue should be recognized over time using a cost-based input method. The total cost for the product is $18 million, including $12 million to purchase materials and $6 million for the remaining activities associated with manufacturing the product. The material is purchased at inception of the contract and the customer obtains control of the material significantly before receiving services related to the product. The company has determined that the material meets the conditions of FASB ASC 606-10-55-21b and should be accounted for as uninstalled materials. As of December 31, 20xy, the company has incurred costs of $2 million towards completion of the manufacturing. The remaining costs are incurred during the following year.

In this example, the company would record revenue equal to cost when the uninstalled materials are purchased and control of those materials has transferred to the customer and record the remaining revenue of $8 million ($20 million less $12 million) ratably as the costs related manufacturing are incurred.

Consequently, the entity recognizes the following:

3.7.03 Paragraphs 1–3 of FASB ASC 340-40-25 explain that the costs of obtaining a contract should be recognized as an asset if the costs are incremental and expected to be recovered. Incremental costs of obtaining a specific contract are those costs that the entity would not have incurred if the contract had not been obtained (that is, the payment is contingent upon obtaining the contract). For example, sales commissions paid to sales personnel solely as a result of obtaining the contract would be eligible for capitalization as long as they are expected to be recovered. Costs that would have been incurred regardless of whether the contract was obtained, such as salaries related to sales personnel, would most likely not be capitalized unless those costs were explicitly chargeable to the customer (for example, through overhead rates).

3.7.04 As a practical expedient, FASB ASC 340-40-25-4 notes that an entity may recognize the incremental costs of obtaining a contract as an expense when incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less.

3.7.05 Pre-contract costs, or costs incurred in anticipation of a contract, may arise in a variety of situations. Costs may be incurred in anticipation of a specific contract (or anticipated follow-on order) that will result in no future benefit unless the contract is obtained.

3.7.06 Pre-contract costs may consist of the following:

a.     Engineering, design, mobilization, or other services performed on the basis of commitments or other such indications of interest

b.     Costs for production equipment and materials relating to specific anticipated contracts (for example, costs for the purchase of production equipment, materials, or supplies)

c.     Costs incurred to acquire or produce goods in excess of contractual requirements in anticipation of follow-on orders for the same item

d.     Start-up or mobilization costs incurred for anticipated but unidentified contracts

3.7.07 Pre-contract costs that are incurred for a specific anticipated contract, such as engineering, design, mobilization or other services or production equipment, materials, or supplies, should first be evaluated to determine if they are included in the scope of other authoritative literature, such as FASB ASC 330, Inventory; FASB ASC 360, Property, Plant and Equipment; or FASB ASC 985, Software. Pre-contract costs that are not included in the scope of other authoritative literature but are incurred for a specific anticipated contract would be recognized as an asset only if they meet all of the criteria in paragraphs 5–8 of FASB ASC 340-40-25.

3.7.08 Costs to fulfill a contract that are incurred prior to the time the customer obtains control (as contemplated in paragraphs 23–26 of FASB ASC 606-10-25) of the good or service are first assessed to determine if they are within the scope of other standards (such as FASB ASC 330, FASB ASC 360, or FASB ASC 985), in which case, the entity should account for such costs in accordance with those standards (either capitalize or expense) as explained in FASB ASC 340-40-15-3. For example, costs incurred to acquire or produce goods in excess of contractual requirements for an existing contract in anticipation of future orders for the same items would likely be evaluated under FASB ASC 330.

3.7.09 FASB ASC 340-40-25-5 states that costs to fulfill a contract that are not addressed under other authoritative literature would be recognized as an asset only if they meet all of the following criteria:

a.     The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (for example, costs relating to services provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved).

b.     The costs will generate or enhance resources that will be used in satisfying (or in continuing to satisfy) performance obligations in the future.

c.     The costs are expected to be recovered.

3.7.10 For aerospace and defense contracts, costs that relate directly to a contract could include direct labor, direct materials, and allocations of costs that are explicitly chargeable to the customer under the contract and other costs that were incurred only because the entity entered into the contract (for example, subcontractor arrangements). As discussed in FASB ASC 340-40-25-8a, general and administrative costs are expensed as incurred if they are not explicitly chargeable in the contract.

3.7.11 Aerospace and defense contracts with the U.S. federal government may provide the contractor with the explicit ability, usually through the provisions of the federal acquisition regulations, to charge general and administrative costs directly to the U.S. federal government. In such circumstances, the entity would then apply the criteria in FASB ASC 340-40-25-5 to determine if recording an asset for these costs is appropriate. Contracts with commercial entities or direct foreign government sales (that is, not a contract structured as a foreign military sale through the U.S. federal government), should be carefully evaluated to determine if general and administrative costs are explicitly chargeable and recoverable under the terms of the contract.

3.7.12 FASB ASC 340-40-25-8b explains that costs of "wasted" materials, labor, or other resources to fulfill the contract that were not reflected in the price of the contract should be expensed when incurred. Determining which costs are "wasted" will require significant judgment and will vary depending on the facts and circumstances.

3.7.13 FASB ASC 340-40-25-8c explains that costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (costs that relate to past performance) should be expensed when incurred.

3.7.14 For example, entities measuring progress towards complete satisfaction of a performance obligation satisfied over time using a cost-to-cost measure will generally not have inventoried costs.

3.7.15 Certain types of aerospace and defense contracts often have learning or start-up costs that are sometimes incurred in connection with the performance of a contract or a group of contracts. As discussed in BC312 of FASB ASU No. 2014-09, a learning curve is the effect of efficiencies realized over time when an entity’s costs of performing a task (or producing a unit) declines in relation to how many times the entity performs that task (or produces that unit).

3.7.16 Such costs usually consist of materials, labor, overhead, rework, or other special costs that must be incurred to complete the existing contract or contracts in progress and are distinguished from research and development costs. As manufacturing of a product matures over its life cycle, the expectation is that these costs would decline over time. These costs are often anticipated and contemplated between the contractor and customer, and considered in negotiating and establishing the aggregate contract price. As discussed in BC313 and BC314 of FASB ASU No. 2014-09, if an entity has a single performance obligation to deliver a specified number of units and the performance obligation is satisfied over time, an entity would probably select a method under FASB ASC 606 (such as cost-to-cost) that results in the entity recognizing more revenue and expense for the early units produced relative to the later units.

3.7.17 For example, assume a contractor is engaged for the manufacture of aerospace components. This is the contractor’s first production contract for aerospace components. The contractor determined there is a single performance obligation that is satisfied over time and that revenue will be recognized using an input measure (for example, a cost-to-cost input method). The first components produced are expected to cost more than the later components due to the learning curve costs involved. Therefore, the contractor will recognize more revenue and contract costs for the first components produced as compared to the later components.

3.7.18 If the contractor determined that revenue should be recognized at a point in time, a different conclusion could be reached. As discussed in BC315 of FASB ASU No. 2014-09, if the contractor incurs costs to fulfill a contract without also satisfying a performance obligation over time, the contractor could be creating an asset that is within the scope of other standards, such as the inventory guidance in FASB ASC 330. For example, the costs of producing the components would accumulate as inventory, and the contractor would select an appropriate method of measuring that inventory and recognizing it as revenue when control of the inventory transfers to the customer.

3.7.19 In accordance with the requirements of FASB ASC 340-40-25-5a, start-up or learning costs incurred for anticipated but unidentified contracts would not be capitalized before a specific contract was identified.

3.7.20 FASB ASC 340-40-35-1 notes that costs to fulfill a contract or incremental costs to obtain a contract recorded as an asset should be amortized on a systematic basis consistent with the transfer to the customer of the goods or services to which the asset relates.

3.7.21 In addition, FASB ASC 340-40-35-2 requires that "an entity shall update the amortization to reflect a significant change in the entity’s expected timing of transfer to the customer of the goods or services to which the asset relates." FASB ASC 250-10 requires such a change to be accounted for as a change in accounting estimate. Such change could be indicative of impairment of the related assets, and entities should evaluate the facts and circumstances to determine the appropriate conclusions.

3.7.22 FASB ASC 340-40-35-5 explains that an asset recorded should also be evaluated for impairment under other accounting standards (for example, an asset recorded under FASB ASC 330 should be evaluated for impairment under the inventory impairment guidance).

3.7.23 For assets accounted for under paragraphs 1–8 of FASB ASC 340-40-25, FASB ASC 340-40-35-3 requires the recognition of an impairment loss if the carrying amount of the asset exceeds

a.     the remaining amount of consideration that the entity expects to receive in exchange for the goods or services to which the asset relates,⁵ less

b.     the costs that relate directly to providing those goods or services and have not been recognized as expenses (as described in FASB ASC 340-40-25-7).

3.7.27 If the project(s) to fulfill the offset obligation is specifically identified within the contract, aerospace and defense companies will need to assess when entering into the contract whether the obligation represents a distinct performance obligation within the contract.

Assessment of a Distinct Performance Obligation

3.7.28 In accordance with FASB ASC 606-10-25-14, to identify performance obligations, entities should first identify the promised good or service. If the obligation does not represent a good or service, it would not be evaluated as a separate performance obligation under the contract but, rather, companies should consider the guidance in accounting for costs, including the guidance related to contract costs. Refer to “Contract Costs” in paragraphs 3.7.01–3.7.23 for guidance on accounting for contract costs.

3.7.29 If the obligation does represent a good or a service, entities should next consider if the good or service represents a distinct performance obligation in the contract. Consistent with the guidance outlined in “Identifying the Unit of Account in Design, Development, and Production Contracts” in paragraphs 3.2.01–3.2.21, when analyzing the offset obligations within a contract, the entity will determine whether the good or service that is promised to a customer is distinct if both of the criteria in FASB ASC 606-10-25-19 are met:

a.     The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).

b.     The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).

3.7.30 The analysis of offset obligations within a contract will be specific to each set of facts and circumstances. A key piece of this assessment will be the factors outlined within FASB ASC 606-10-25-21 that indicate when an entity’s promise to transfer a good or service to a customer is not separately identifiable. The objective in FASB ASC 606-10-25-21 is to determine whether the nature of the promise within the context of the contract is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs. For example, the fact that a customer could decide to not purchase the good or service without significantly affecting the other promised goods or services in the contract might indicate that the good or service is not highly dependent on, or highly interrelated with, those other promised goods or services.

3.7.31 If the offset obligation is determined to be a distinct performance obligation, entities would need to allocate the appropriate amount of revenue to the obligation. Refer to paragraphs 3.4.01–3.4.23 for guidance related to the allocation of revenue to the performance obligations.

Obligation Is Not Considered to Be a Distinct Performance Obligation

3.7.32 If the obligation is a good or service but is not determined to be a distinct performance obligation based on the assessment described previously, in accordance with FASB ASC 606-10-25-22, entities should combine the good or service with the other obligation under the contract until it identifies a bundle of goods or services that is distinct and determine the appropriate recognition model to apply to the obligation as a whole.

3.7.33 If the entity does not intend to provide the good or service, but instead, pays the penalty, the entity should consider the guidance for payments made to a customer.

3.7.34 If the project(s) to fulfill the offset obligation are not specifically identified within the contract or required to be selected at the inception of the contract, the entity should consider how they intend to fulfill the obligation and evaluate it accordingly. Further, as the contract proceeds, entities will need to continue to consider how they intend to fulfill the obligation and evaluate and account for any changes to that intent accordingly. Entities will need to evaluate the manner in which the offset obligation will be fulfilled to determine whether it is a cost of the contract or a separate performance obligation.

3.7.35 If the entity does not intend to fulfill the offset obligation, but instead, pay any portion of the penalty, the entity should consider the guidance for payment made to a customer and update the transaction price accordingly.

3.7.37 As discussed in BC335 of FASB No. ASU 2014-09, the intention of the disaggregation of revenue disclosure as outlined in FASB ASC 606-10-50-5 is to provide users of the financial statements with additional insight into the composition of a company’s revenues. This may be most effectively achieved by providing a disaggregation based on risk profile. Companies in the aerospace and defense industry may wish to consider the following categories of disaggregation when determining how to construct their disclosures in accordance with paragraphs 5–6 of FASB ASC 606-10-50. For each of the following categories, companies should consider whether the disclosure would be meaningful or useful to financial statement users based on the nature of its business, as well as whether such level of detail is already frequently disclosed or discussed, either internally or externally.

a.     Geographic region. For aerospace and defense companies that have significant operations outside of the U.S., disaggregation by geographic region may be appropriate, as the nature, amount, timing, and uncertainty of revenues and cash flows is dependent on both domestic and international priorities and budgets, which may differ. Furthermore, performance and collection risk on international programs is generally more significant than on domestic programs. Because priorities and risk can also vary significantly by country depending on geopolitical and economic factors specific to those countries, disaggregating revenue solely by U.S. and international may not be as meaningful as disaggregating by geographic region.

b.     Customer type. For aerospace and defense companies that have different classes of customers, disaggregation by customer type may be appropriate. Revenue and collection risk can vary significantly by customer type. For example, sales to the U.S. federal government generally have a low risk of collection due to U.S. federal government procurement rules, regulations, and business practices that are in place, whereas sales outside of the United States are subject to foreign government laws, regulations, and procurement policies and practices, which may differ from U.S. federal government regulations and generally carry a higher risk of collection. Direct commercial sales and other commercial sales (within the United States and outside the United States) are subject to fewer regulations and also have a different collection risk profile compared to U.S. federal government sales.

c.     Contract type. For aerospace and defense companies that perform under different contract types, disaggregation by contract type may be appropriate. Generally, customer contracts can be categorized as either fixed-price or cost-type contracts. Companies should consider whether separate disclosure of time and materials (T&M) contracts is meaningful or whether they should be classified as fixed-price or cost-type contracts for disclosure purposes. There may be diversity in practice as to how T&M contracts are classified. Performance and collection risk can vary by contract type. Because aerospace and defense companies carry the burden of cost overruns (and receive the benefit of cost underruns) on fixed-price contracts, fixed-price contracts generally have greater risk than cost-type contracts, especially because many aerospace and defense contracts involve advanced designs and technologies that may experience unforeseen technological difficulties and cost overruns.

d.     Product type or product line. In determining whether disaggregation by product type or product line may be meaningful, aerospace and defense companies should consider how their product lines are organized and whether a similar risk profile applies to an entire product type or product line. In other words, is the performance of that product line driven by all or most of the same economic factors? Aerospace and defense companies should also consider whether performance of specific product types, services, or product lines is typically disclosed or discussed.

e.     Development and production contracts. Aerospace and defense companies may want to consider whether disaggregation of revenue by development and production contracts is meaningful, as development contracts generally carry greater risk than production contracts. However, due to the inability to oftentimes distinguish between the development and production phases (and related revenues) of aerospace and defense contracts, it may not be meaningful to arbitrarily separate them for disaggregation purposes. In addition, companies should consider what portion of their business this disaggregation would apply to in determining whether it would be meaningful.

Refer to Examples 3-7-1 and 3-7-2 for illustrative examples of the disaggregation of revenue disclosure.

3.7.38 As required by FASB ASC 606-10-50-3, a disaggregation of revenue should be presented for all periods for which an income statement is presented.

3.7.39 FASB ASC 606-10-50-7 indicates that the quantitative disaggregation disclosure guidance in paragraphs 5–6 of FASB ASC 606-10-50 and 89–91 of FASB ASC 606-10-55 is not required for entities that are neither a public business entity nor a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market. However, if an entity that is neither a public business entity nor a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market elects not to provide those disclosures it must provide, at a minimum, revenue disaggregated according to the timing of transfer of goods or services (for example, revenue from goods or services transferred to customers at a point in time and revenue from goods or services transferred to customers over time) and qualitative information about how economic factors (such as type of customer, geographical location of customers, and type of contract) affect the nature, amount, timing, and uncertainty of revenue and cash flows.

3.7.40 Although FASB ASC 912-310-25-1 was updated to state that unbilled amounts on cost-plus fixed-fee contracts with the U.S. federal government may be receivables or contract assets (unbilled amounts on fixed-type contracts are not specifically addressed in the update), if more than just the passage of time is required before payment, the asset related to unbilled amounts on both cost-type and fixed-price contracts should be presented as a contract asset. Contractors may consider the following factors when determining whether it is just the passage of time that makes payment unconditional:

•     For fixed-price contracts with performance-based payments, because a contractor can only bill when a performance-based milestone is met or upon customer acceptance for retainage, there are events other than the passage of time required before amounts can be billed.

•     For cost-type contracts and fixed-price contracts with progress payments, the right to payment is not unconditional until costs are invoiced or billed because there are requirements beyond the passage of time that must be met before amounts can be billed, including maintaining accounting systems that are in compliance with Federal Acquisition Regulation (FAR) cost principles and applicable Cost Accounting Standards (CAS) requirements, customer acceptance (for billing of retainage), and customer agreement on award and incentive fees.

3.7.41 Presentation of a contract as a contract asset or a contract liability was discussed at the October 2014 TRG meeting. Paragraph 12 of TRG Agenda Ref. No. 11, October 2014 Meeting — Summary of Issues Discussed and Next Steps, discussed how an entity should determine the presentation of a contract that contains multiple performance obligations:

3.7.42 Thus, in accordance with the discussion at the October 2014 TRG meeting on presentation of a contract as a contract asset or a contract liability, aerospace and defense companies should aggregate performance obligations at the contract level when determining the total contract asset balance and total contract liability balance for both presentation and disclosure purposes. Entities should also consider the appropriate classification (current versus noncurrent) of each contract asset and each contract liability. For example, a company determines that there are two performance obligations related to a single contract. The company received a $100 million advance on the first performance obligation and has performed no work to date. The company has performed $150 million of work on the second performance obligation, which remains to be billed. When aggregated at the contract level for presentation and disclosure purposes, the company has a contract asset of $50 million.

3.7.43 To address the requirement to disclose the opening and closing balances of receivables, contract assets, and contract liabilities in accordance with FASB ASC 606-10-50-8a and provide an explanation of the significant changes in the contract asset and contract liability balances in the reporting period in accordance with FASB ASC 606-10-50-10, companies may consider disclosing a rollforward of the contract balances for the reporting period. Alternatively, companies may choose to disclose the opening and closing balances in a narrative or tabular format with enhanced narrative around the significant drivers of the changes in the balances.

3.7.44 Related to the requirement to disclose revenue recognized in the reporting period that was included in the contract liability balance at the beginning of the period in accordance with FASB ASC 606-10-50-8b, FinREC believes that aerospace and defense companies should disclose total revenue recognized in the reporting period related to contracts that were in a net liability position as of the beginning of the fiscal year, but not in excess of the net liability balance for a specific contract. Refer to example 3-7-3 for an illustrative example of this calculation for disclosure purposes.

3.7.45 In addition, for contracts in a liability position at the beginning of the period that receive additional advances in the subsequent reporting period, FinREC believes one acceptable method would be to assume that all revenue recognized in the reporting period first applies to the beginning contract liability as opposed to a portion applying to the new advances for the period. Companies should consider disclosing the method that they are applying to calculate this disclosure.

3.7.46 The disclosure requirements outlined in paragraphs 8(a), 8(b), and 10 of FASB ASC 606-10-50 relate to contract balances and changes in those balances. Accordingly, the disclosures would capture year-to-date information (that is, using the periods on the comparative balance sheet), although an entity may provide supplemental quarterly information.

3.7.47 FASB ASC 606-10-50-11 indicates that the disclosure requirements in paragraphs 8–10 and paragraph 12A of FASB ASC 606-10-50 related to contract balances and certain changes affecting revenue, timing of the satisfaction of its performance obligations, and explanation of the significant changes in the contract asset and liability balances during the reporting period are not required for entities that are neither a public business entity nor a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market. However, if an entity that is neither a public business entity nor a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market elects not to provide these disclosures, the entity should provide the disclosure in FASB ASC 606-10-50-8a, which requires the disclosure of the opening and closing balances of receivables, contract assets, and contract liabilities from contracts with customers, if not otherwise separately presented or disclosed.

3.7.48 In accordance with FASB ASC 606-10-50-13b, a company may choose to disclose when it expects to recognize revenue on its remaining performance obligations on either a quantitative or qualitative basis. Potential options for structuring this disclosure include (a) a tabular rollout of revenue to be recognized on remaining performance obligations, by year; (b) disclosure of the percentage of remaining performance obligations that is expected to be recognized as revenue over the following years; (c) a qualitative discussion of a company’s average contract duration; or (d) a combination of these approaches.

3.7.49 For companies that choose to disclose a tabular rollout of revenue to be recognized on remaining performance obligations, by year, if a substantial portion of the revenues will be recognized in the upcoming year, one option could be to disclose for only the upcoming year (or two) and include the remaining revenue in a "thereafter" period.

3.7.50 The descriptive disclosures of an entity’s performance obligations as outlined under FASB ASC 606-10-50-12 are required for entities that are neither a public business entity nor a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market, but FASB ASC 606-10-50-16 indicates that the disclosure requirements of paragraphs 13–15 of FASB ASC 606-10-50 related to remaining performance obligations are not required for entities that are neither a public business entity nor a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.

3.7.51 The following examples are meant to be illustrative, and the determination of the most appropriate disclosures in accordance with FASB ASC 606-10-50 should be based on the facts and circumstances specific to an entity.

Example 3-7-1 — Disaggregation of Revenue — By Geographic Location, Customer Type, and Contract Type

A contractor is a global entity that generates approximately 40 percent of its sales outside of the United States. The economic environment of each of the regions in which the contractor does business is very different. In addition, the contractor performs on contracts for the U.S. federal government and foreign governments, as well as commercial customers, and the company has assessed the risk profile of these customers to be very different. The company’s contracts are generally structured as either fixed price or cost type, and the company has also assessed the risk profile associated with these two contract types to be very different. The company’s product lines are organized by capabilities and, as a result, the risk profile of the programs within a single product line can vary significantly. The following example illustrates the disaggregation of revenue disclosure for this contractor based on its assessment that the most meaningful disaggregation is by geographic location, customer type, and contract type.

Example 3-7-2 — Disaggregation of Revenue — By Product Type, Geography, and Major Customer

A contractor is a global entity that generates approximately 50 percent of its sales outside of the United States. The economic environment of each of the regions in which the contractor does business is very different. In addition, the contractor performs on contracts for the U.S. federal government and foreign governments, as well as commercial customers, and the company has assessed the risk profile of these customers to be very different. The contractor organizes its segments and product lines based on major products and services, and the risk profile of the contracts within each individual major product or service area is generally similar; however, risk profile differs significantly across major products or services. The majority (almost 100 percent) of the company’s contracts are structured as cost-type. The following example illustrates the disaggregation of revenue disclosure for this contractor based on its assessment that the most meaningful disaggregation is by major product or service, geographic location, and customer type.

Example 3-7-3 — Revenue Recognized Included in the Contract Liability Balance at the Beginning of the Period

A contractor has one contract, for which an advance of $100 million was issued by the customer and $50 million of work has been performed to date by the contractor, for a net contract liability balance of $50 million at year-end. In the following quarter, the contractor performs an incremental $60 million of work on this contract, which is recognized as revenue, resulting in an ending contract asset balance of $10 million. For purposes of the disclosure under FASB ASC 606-10-50-8b, the company would only disclose $50 million of revenue recognized in the reporting period related to the contract liability balance at the beginning of the period, as the additional $10 million relates to revenue recognized once the contract flipped to an asset position.