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Exploring the challenges

Aerospace & Defense Maintenance, repair, and overhaul: Revenue recognition and related issues

To my aerospace and defense industry colleagues

The market for maintenance, repair, and overhaul (MRO) activities continues to grow over time. Aging aircraft fleets and outsourcing of large portions of MRO activities by commercial airlines have increased the demand for MRO services. As a result, many of the original equipment manufacturers and independent MRO providers have focused on the MRO market as one area to help drive growth in their businesses. Based on recent statistics, the MRO market has grown from $37.8 billion in 2002 to an estimated $45.7 billion in 2009.1 Since no guidance in generally accepted accounting principles is specific to MRO activities, financial reporting depends on interpretation of GAAP for these arrangements. However, interpretation of how to apply GAAP to MRO arrangements can be complex. As a result, divergent practices have developed. Furthermore, recent accounting guidance may impact the financial reporting for MRO activities. Recently, we have seen the SEC comment on registrants' accounting for MRO activities. This paper explores some of the challenges in financial reporting for MRO arrangements. We hope that this discussion will assist companies in evaluating and improving their financial reporting for MRO activities.

Scott C. Thompson Aerospace & Defense Assurance Leader

1

Lee Ann Testmeier, "MRO Competition Becomes More Aggressive," Aviation Week, 2009.

Background

The maintenance, repair, and overhaul industry is growing rapidly. Global revenues are approximately $40 billion. Because of the demand for aviation and a trend toward airlines outsourcing MRO activities, the industry is expected to grow to $60 billion within a decade.2

Traditionally, MRO activities were provided under time and materials contracts. However, long-term maintenance contracts, sometimes referred to as "power by the hour" contracts, have become common. These contracts typically provide MRO activities for a fixed term, based on a price per flight hour, or some other variation, such as cycles. Additionally, it is common for MRO providers to maintain a rotable pool of used components, or lease pool assets, to minimize the customer's downtime during an overhaul or repair. Because of the growth in the MRO industry, the trend toward long-term contracts, and divergence in practices surrounding revenue recognition and related issues for MRO activities, this paper addresses the following topics: · Key accounting guidance for MRO activities. · Determination of the appropriate accounting model for MRO arrangements. · Revenue recognition and measurement for MRO arrangements. · Accounting for rotable pool assets and exchanges. · Consideration of embedded leases in MRO arrangements. · Accounting for depreciation and maintenance of airline equipment.

2

Paulo Prada, The Wall Street Journal, November 7, 2007.

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Key accounting guidance for MRO activities

· ASC 330, Inventory · ASC 360, Property, Plant, and Equipment · ASC 605, Revenue Recognition - ASC 605-20-25-1 through 25-6, Separately Priced Extended Warranty and Product Maintenance Contracts - ASC 605-25, Multiple Element Arrangements - ASC 605-35, Construction-Type and Production-Type Contracts - ASC 605-45, Principal Agent Considerations · ASC 820, Fair Value Measurements and Disclosures · ASC 840, Leases · ASC 845, Nonmonetary Transactions

Determination of the appropriate accounting model for MRO arrangements

MRO arrangements take various forms. Accordingly, judgment is sometimes required to determine the substance of these arrangements and the appropriate accounting model. The revenue recognition model should align with the economic substance of the transaction. In the aerospace and defense industry, MRO arrangements can include 1) product maintenance contracts, 2) product sales, and 3) other repair services. These arrangements may also include embedded leases or asset exchanges. Furthermore, each of these may be provided individually or in combination with other products or services.

Product maintenance contracts Many MRO arrangements include product maintenance contracts. ASC 605-20-20 defines a product maintenance contract as "an agreement to perform certain agreedupon services to maintain a product for a specified period of time. The terms of the contract may take different forms, such as an agreement to periodically perform a particular service a specified number of times over a specified period of time, or an agreement to perform a particular service as the need arises over the term of the contract." In the commercial aerospace sector, there are regulations by the Federal Aviation Administration and other global civilian aviation authorities surrounding the maintenance of aircraft and aircraft components, as well as MRO providers. Commercial aerospace MRO providers typically maintain certifications from civil aviation authorities.

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PwC observation We believe that it is acceptable to apply ASC 605-20-25 to separately priced extended warranty and product maintenance contracts offered by a service provider that is primarily obligated to fulfill such contracts, whether or not they also sell the underlying products. We understand, however, that at least some members of the SEC staff believe ASC 605-20-25 is applicable only to the original equipment manufacturer (OEM) or retailer/distributor that also sells the underlying products. For that reason, the use of ASC 605-20-25 by a non-OEM or reseller should be viewed as potentially subject to SEC challenge. We believe that application of SAB Topic 13 and other potentially relevant guidance, such as ASC 605-25 (Multiple-Element Arrangements), would be an acceptable alternative to ASC 605-20-25 for an MRO service provider that is not the OEM or otherwise the reseller of the equipment.

Contracts to "maintain" aerospace and defense equipment and components could be subject either to ASC 605-20-25 or SAB Topic 13 depending on the facts and circumstances. Both ASC 605-20-25 and SAB Topic 13 apply to the primary obligor under a maintenance contract. The primary obligor is the party that has the primary obligation to the equipment owner/lessor. MRO activities provided by a party that is not the primary obligor to the equipment owner/lessor (for example, a subcontractor of the primary obligor) would generally be accounted for under SAB Topic 13 and other applicable GAAP as the services are delivered. Product sales/fixed price overhauls Certain MRO arrangements may provide for a fixed-price overhaul or repair, with a trade-in allowance for the customer's core (the asset requiring overhaul). Such an arrangement may be, in substance, a product sale rather than a maintenance activity. Specifically, the MRO provider may

deliver and transfer the title of an overhauled asset to the customer in exchange for a fixed fee and title to the customer's core. At that point, the transaction is complete, without any further obligation by the MRO provider to overhaul the core. While the net price (arrangement fee less trade-in allowance) may represent the estimated overhaul cost, plus a profit, the earnings process in these arrangements is generally complete and revenue is earned at the time of delivery and title transfer of the overhauled asset, rather than over the period during which the overhaul services are performed on the customer's exchanged core. When the overhaul is performed in this type of arrangement, the MRO provider is overhauling its own equipment, rather than the customer's equipment. Other repair services An MRO activity that is outside the scope of ASC 605-20-25 should generally be accounted for under SAB Topic 13 and other applicable GAAP.

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Revenue recognition and measurement

Product maintenance contracts ASC 605-20-25 states, "Revenue from separately priced extended warranty and product maintenance contracts shall be deferred and recognized in income on a straight-line basis over the contract period except in those circumstances in which sufficient historical evidence indicates that the costs of performing services under the contract are incurred on other than a straight-line basis. In those circumstances, revenue shall be recognized over the contract period in proportion to the costs expected to be incurred in performing services under the contract." In the aerospace and defense industry, product maintenance is generally performed at intervals, rather than continuously. Accordingly, in many cases there will be sufficient historical evidence to indicate that costs are incurred on other than a straight-line basis. In those situations, revenue should be recognized in proportion to total estimated costs. For other contracts, in which such sufficient historical evidence does not exist, revenue should be recognized on a straight-line basis over the service period. Pursuant to ASC 605-20-25-4, costs of services performed under product maintenance arrangements should be charged to expense as incurred.

If a company qualifies to recognize revenue in proportion to total estimated costs, revenue should be recognized as MRO costs are incurred. ASC 605-20-25 does not provide explicit guidance on when costs should be considered incurred. One view would be to expense costs as expenditures are made or become payable. Another view would be to expense costs based on the same timing as would be appropriate outside the scope of ASC 605-20-25. For example, costs of an overhauled engine may be accumulated and expensed when the engine is delivered to the customer. We believe that either approach has merit and would be acceptable. ASC 605-20-25 does not specify how to account for changes in estimates. Therefore, MRO providers should follow the guidance in ASC 250, Accounting Changes and Error Corrections, which states that "a change in accounting estimate shall be accounted for in the period of change if the change affects that period only or the period of change and future periods if the change affects both." ASC 605-20-25 requires the recognition of losses, if expected, under the contract. Losses should first be applied to unamortized acquisition costs and then recognized as a liability.

PwC observation In practice, both the cumulative catch-up and prospective methods are used to account for changes in estimates. The guidance in ASC 250 is not clear with respect to recognition of a change in estimate in the "period of change," particularly as it relates to revenue recognition models based on longer-term estimates of either costs, revenues, or both. ASC 605-35 and ASC 980-605-25 (Revenue Recognition, Regulated Operations) provide for the use of the cumulative catch-up method. Additionally, certain life sciences companies use the cumulative catch-up method for revenue recognition on research and development contracts. We believe it is acceptable for MRO providers using the proportionate cost method of revenue recognition under ASC 605-20-25 to utilize the cumulative catch-up method by analogy because of the similarities to the cost-to-cost model under ASC 605-35. We also believe that the prospective method is acceptable and supported by GAAP.

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Product sales Product sales of aerospace and defense equipment generally include the design, development, and/or production of complex equipment to a buyer's specifications and, accordingly, are generally accounted for pursuant to ASC 605-35. Certain MRO arrangements are, in substance, product sales, which often include a trade-in allowance for a customer's core. A key issue for MRO providers is determining how to account for the trade-in and whether revenue should be measured on a gross basis or net of the trade-in value. The determination of gross versus net reporting requires careful consideration of the transaction economics and other factors, including the nature and classification of the assets exchanged and the applicable accounting guidance. Other repair services Arrangements where the MRO provider is not the primary obligor to the equipment owner/lessor should generally be accounted for as a services contract under SAB Topic 13 and other applicable GAAP. For a single repair, revenue would generally be recognized when the repaired part is delivered to the customer. Contracts for multiple repairs of this nature should also consider the accounting guidance related to multiple deliverable arrangements.

Rotable pool assets and exchanges

Classification of rotable pool assets used for maintenance activities The AICPA Airline Audit and Accounting Guide provides definitions of rotable parts and related assets. However, the accounting for rotable parts by an MRO provider is generally different than by an airline. Specifically, airlines generally establish rotable pool assets to install on their own equipment, while MRO providers establish rotable pool assets for the purpose of generating revenue by performing MRO activities. MRO providers should generally classify rotable pool assets as inventory because they are effectively sold to customers as part of their maintenance contracts. Accordingly, such assets are generally considered held for sale by MRO providers, whereas airlines generally consider them to be fixed assets because they are used to maintain their own equipment. Classification of an MRO provider's rotable parts as inventory is consistent with AICPA Technical Practice Aid 2140.12, Classification of Replacement Parts Under a Maintenance Agreement, which indicates that refurbished replacement parts should be classified as inventory. It further states, "Inventory costs should not be amortized; a loss in their utility should be reflected as a charge against revenues of the period in which it occurs, as discussed in ASC 330-10-35-2.

Because the market value of rotable parts diminishes over the product life cycle, MRO providers will need to periodically assess the net realizable value of their rotable parts inventory consistent with the lower of cost or market guidance in ASC 330. Rotable parts inventory should be reported as work-in-process or finished goods, consistent with its nature and the company's policy for classifying such items in its financial statements. Parts available for direct sales to customers should generally be classified as finished goods. Work-in-process would generally be the appropriate classification for parts in various stages of repair and those that are restricted for installation into customers' equipment as part of a maintenance contract. Classification of rotable pool assets used to support leased equipment If rotable pool assets are used for leasing or are used to support leased equipment, they should generally be classified as equipment and accounted for in accordance with ASC 840. If the leased equipment is classified as an operating lease, it should be depreciated in accordance with the company's normal depreciation policy for such equipment. If the rotable pool assets are classified as equipment, we believe that the AICPA Airline Audit and Accounting Guide definitions and treatments would generally apply, as follows (see Chapter 4):

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Rotable parts are significant in value and can be repaired. They typically have lives similar to the aircraft they support. Rotable parts are classified as fixed assets and depreciated over the estimated useful life of the asset. In accordance with the AICPA Airline Audit and Accounting Guide, rotable pool assets may be depreciated as a pool rather than based upon individual assets. Repair costs are charged to expense as incurred. Repairable parts are generally less valuable with shorter economic lives than the aircraft they support. Repairable parts may be classified as other assets or fixed assets and depreciated over the estimated useful life of the asset. Repair costs are charged to expense as incurred. Expendable parts are classified as assets and charged to expense as consumed. Materials and supplies may be expensed upon purchase or classified as assets and expensed when consumed.

take a variety of different forms, and the substance of the transactions needs to be carefully considered to determine the appropriate accounting. For example, an MRO provider may supply a customer with a refurbished asset while the customer's asset is being overhauled. Upon completion of the overhaul, the parties may exchange the loaned asset for the refurbished asset or, instead, may agree to swap titles to each asset rather than physically exchanging the assets. In other transactions, assets and titles may be exchanged at the agreements' inception based on a product sale with a trade-in allowance. These transactions are different in form but may have the same or similar economics. Accordingly, determining the appropriate accounting requires careful consideration of the facts and circumstances to evaluate whether the transaction includes a lease, a purchase and sale, or an MRO activity. ASC 845 generally provides that nonmonetary transactions are recorded at fair value, with few exceptions. Three exceptions are provided in ASC 845-10-30-3. The paragraph a exception is not discussed because it is rarely applicable. Paragraph b exception: Exchange transaction to facilitate sales to customers--The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange.

Under the guidance, an exchange of finished goods inventory for raw materials or work-in-process (WIP) inventory in the same line of business shall be accounted for at fair value and all other nonmonetary exchanges of inventory within the same line of business shall be recognized at the carrying amount of the inventory transferred. The classification of inventory as raw materials, WIP, and finished goods should generally be the same classification that an entity uses for external financial reporting purposes, and an entity should disclose the amount of revenue and costs (or gains and losses) associated with inventory exchanges recognized at fair value. Accordingly, the classification of assets being exchanged could impact whether the exchange is recorded at carryover basis or at fair value. Because maintenance agreements can take many different forms, the classification of assets being exchanged may not be clear. For example, if a refurbished asset is being exchanged for a customer's core as part of an MRO activity, it may not be clear whether the substance of the arrangement is the exchange of finished goods inventory for WIP inventory, the exchange of fungible core inventory (e.g., both considered WIP), or an exchange of fixed assets. Paragraph c exception: Exchange transaction lacks commercial substance--Commercial substance is defined as one in which the entity's future cash flows are expected to significantly change as a result of the exchange.

Rotable pool asset exchanges

Exchanges classified as inventory Many MRO providers maintain a rotable pool of equipment and parts to expedite their MRO activities and improve the asset availability to customers. It is common for MRO arrangements to provide for the exchange of the MRO provider's rotable asset for the customer's same asset type during the maintenance period. The exchange can

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This evaluation is based on the risk, timing, and amount of cash flows as well as the entity-specific values of the assets exchanged. However, it does not necessarily require a quantitative analysis. Although few transactions lack commercial substance in practice, companies will, nonetheless, also have to consider this guidance when evaluating exchanges related to maintenance contracts, including exchanges of fungible cores or fungible refurbished parts. Exchanges classified as fixed assets Pursuant to ASC 845, equipment (i.e., fixed assets as opposed to inventory) exchanges will generally be accounted for at fair value. While ASC 840 does not apply to inventory, if the rotable pool assets are treated as fixed assets, lease accounting may be required. When a rotable asset is provided to a customer for temporary use during the maintenance period, such an arrangement may represent a lease transaction, consistent with ASC 840. Because of the typically short duration of these transactions, we would expect that these transactions would generally be operating leases, if lease accounting is applicable. Such leases may be part of maintenance contracts that include multiple deliverables, which would require the application of ASC 605-25. In these cases, the deliverables and the contractual revenue would be separated and allocated, respectively, based on

that guidance. However, all of the revenue in such arrangements is often contingent upon the completion of the overhaul or the repair, which may require deferral of any lease revenue until completion of the overhaul.

Consideration of embedded leases in MRO arrangements

An MRO arrangement may provide a refurbished asset to the customer during the maintenance period. This type of transaction may represent a multiple element arrangement including both MRO and lease deliverables pursuant to ASC 605-25 and ASC 840. This paper considers only the lessor's accounting for operating leases. ASC 840 requires that "rent shall be reported as income over the lease term as it becomes receivable according to the provisions of the lease. However, if the rentals vary from a straight-line basis, the income shall be recognized on a straight-line basis unless another systematic and rational basis is more representative of the time pattern in which use benefit from the leased property is diminished, in which case that basis shall be used." From the standpoint of the lessor, the aforementioned "rent" comprises the minimum lease payments as defined by ASC 840 and includes, among other things, the contractual and non contingent rent payments, less executory costs such as insurance, maintenance, and taxes related to the leased property.

In the aerospace and defense industry, the determination of the rental charge may be complex. It may include various pricing mechanisms such as a base or flat charge, a duration charge (such as rent per day), and a maintenance charge based on hours, cycles, or some other usage-based measure. In accordance with ASC 840, we would generally expect the minimum lease payments related to aircraft and engines to be recognized on a straight-line basis. While ASC 840 provides for rent to be recognized on another basis if there is a more representative pattern of the use benefit to the lessee (i.e., if the utility of the leased property diminishes over time), we would expect these situations to be uncommon. Pursuant to ASC 840, contingent rental income is generally recognized when it becomes receivable/payable. MRO providers that lease equipment should have sufficient controls to properly report contingent rentals during the lease period. Because leases of aerospace equipment generally include a maintenance obligation (either explicit or implicit), the question sometimes arises as to whether the maintenance should be considered an executory cost and accounted for pursuant to ASC 840 or a product maintenance agreement within the scope of ASC 605-20-25 or SAB Topic 13. Determination of the appropriate accounting depends on the facts and circumstances.

7 Aerospace & Defense

Persuant to the AICPA Airline Audit and Accounting Guide, companies are allowed two accounting alternatives for the maintenance charge portion of the arrangement fee. One alternative is to recognize the maintenancerelated payments as a reimbursement of executory costs pursuant to ASC 840, while the other allows for the maintenance-related payments to be recognized pursuant to SAB Topic 13.

The three alternatives are: · Direct expensing method · Deferral method · Built-in overhaul method The direct expensing method simply recognizes as expense the cost of all maintenance activities as incurred. The deferral method allows for capitalization of qualifying maintenance expenses, which are then depreciated over the period until the next planned major maintenance activity. Under the built-in overhaul method, the cost of the airframe, engine, auxiliary power unit, or other equipment is segregated into its core and consumable components. The core is depreciated over its expected useful life, while the consumable portion is depreciated over the period until the next overhaul. Accordingly, the selection of a depreciation method and life is integral to the selection of a maintenance expense policy. We believe that the built-in overhaul method provides the best matching of revenues and expenses for MRO providers.

Accounting for depreciation and maintenance of airline equipment

Depreciation and maintenance expense of aircraft equipment are within the scope of the AICPA Airline Audit and Accounting Guide. The MRO costs for aircraft engines and certain other equipment, such as auxiliary power units, are significant in relation to the asset value. The AICPA Airline Audit and Accounting Guide provides for three alternatives for Planned Major Maintenance Activities.

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Appendix examples

The following examples are common MRO transactions within the industry. In these examples, we discuss the accounting for the common transactions. Example: Time and materials contract (assuming revenues and costs are recognized upon delivery of overhauled equipment): Facts Equipment Price of overhaul Estimated cost of overhaul Estimated period of overhaul

aircraft engine Time and materials (estimated at $5,000,000) $4,000,000 60 days

Entries Day 1 Engine induction--memo only Day 2­30 Work in process Cash/accounts payable (Overhaul costs: labor and overhead to disassemble, inspect, and repair engine components) Day 31­60 Work in process Cash/accounts payable/inventory (Overhaul costs: labor and overhead to reassemble engine including new, used, and repaired parts installed on customer's equipment) Accounts receivable Revenue Cost of sales Work in process (Delivery of overhauled engine to customer, recognize revenue and cost of sales and relieve work in process)

Debit

Credit

$2,000,000 $2,000,000

$2,000,000 $2,000,000

$5,000,000 $5,000,000 $4,000,000 $4,000,000

9 Aerospace & Defense

Appendix examples

Example: Power by the hour contract (assuming revenues and costs are recognized upon delivery of overhauled equipment): Facts Contract Equipment Scope Term 1 Price Period of overhaul Estimates Estimated hours during the contract Estimated revenue (50,000 x $100) Estimated contract costs

Aircraft engine All time and materials (limited exclusions) 10 years $100 per flight hour 60 days

50,000 $5,000,000 $4,000,000

Entries Years 1­4 The airline flies 20,000 hours. No maintenance was incurred: Cash Deferred revenue Year 5 The airline flies 5,000 hours: Cash Deferred revenue The MRO provider incurs $2,000,000 of costs for a planned overhaul that occurs over 60 days: Work in process Cash/accounts payable (Overhaul costs for 60 days: material, labor, overhead, repair costs) Deferred revenue Revenue Cost of sales Work in process (Delivery of overhauled engine to customer, recognize revenue and cost of sales and relieve work in process)

Debit

Credit

$2,000,000 $2,000,000

$500,000 $500,000

$2,000,000 $2,000,000

$2,500,000 $2,500,000 $2,000,000 $2,000,000

See revenue calculation on page 11.

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Appendix examples

Revenue calculation from page 10: Revenue is calculated as follows: Repair costs Total estimated repair costs Proportion of costs incurred to total costs Total estimated revenue Revenue in proportion to cost

$2,000,000 $4,000,000 50% $5,000,000 $2,500,000

Entries Years 6­7 The airline flies 10,000 hours. No maintenance was incurred: Cash Deferred revenue MRO provider incurred $500,000 for unplanned maintenance: Work in process Cash/accounts payable (Overhaul costs: material, labor, overhead, repair costs) Deferred revenue Revenue Cost of sales Work in process (Delivery of overhauled engine to customer, recognize revenue and cost of sales and relieve work in process)

Debit

Credit

$1,000,000 $1,000,000

$500,000 $500,000

$500,000 $500,000 $500,000 $500,000

Revenue is calculated under the prospective method as follows: Revised total estimated maintenance costs Previously recognized maintenance costs Remaining maintenance costs Incurred maintenance costs Proportion of costs incurred to remaining costs Remaining estimated revenue ($5M­$2.5M) Revenue in proportion to cost

$4,500,000 $2,000,000 $2,500,000 $500,000 20.00% $2,500,000 $500,000

See calculation of revenue under the cumulative catch-up method on page 12.

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Appendix examples

Revenue is calculated under the cumulative catch-up method as follows: Cumulative cost incurred $2,500,000 Estimate at completion $4,500,000 Percent complete 55.6% Revenue $5,000,000 Cumulative revenue $2,777,777 Less previously recognized revenue $2,500,000 Revenue adjustment $277,777

Entries Years 8­10 The airline flies 15,000 hours. No maintenance was incurred: Cash Deferred revenue MRO provider incurred $2,000,000 for planned maintenance: Work in process Cash/accounts payable (Overhaul costs: material, labor, overhead, repair costs) Deferred revenue Revenue Cost of sales Work in process (Delivery of overhauled engine to customer)

Debit

Credit

$1,500,000 $1,500,000

$2,000,000 $2,000,000

$2,000,000 $2,000,000 $2,000,000 $2,000,000

Revenue is calculated under the prospective method as follows: Revised total estimated maintenance costs Previously recognized maintenance costs Remaining maintenance costs Incurred maintenance costs Proportion of costs incurred to remaining costs Remaining estimated revenue ($5M­$3M) Revenue in proportion to cost Revenue under the cumulative catch-up method would be the balance of the unrecognized revenue calculated as follows: Total revenue $5,000,000 less $2,777,777 = $2,222,223

$4,500,000 $2,500,000 $2,000,000 $2,000,000 100.00% $2,000,000 $2,000,000

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Appendix examples

Examples: Firm fixed price exchange (substance of the arrangement results in reporting revenue net of the trade-in value): Assumptions: Exchange involves a fixed fee exchange Title exchange occurs at the beginning of the transaction All exchange assets are recorded as WIP inventory Facts: Firm fixed price: $25,000 Estimated cost of repair $20,000 Fair value of refurbished part $75,000 Carrying value of refurbished part: $50,000

Entries Accounts receivable Revenue (To record revenue upon delivery and title transfer of refurbished part) Cost of sales (at carrying value) Inventory (To relieve inventory) Inventory core (credit value assumed) Cost of sales (To record exchange) Inventory Cash/accounts payable (To record repair costs to customer core)

Debit $25,000

Credit

$25,000 $50,000 $50,000

$30,000 $30,000

$20,000 $20,000

Results: Revenue = $25,000, COGS = $20,000, Margin = $5,000, Return on sales = 20%

13 Aerospace & Defense

Appendix examples

Example: Time and materials exchange (substance of the arrangement results in reporting revenue net of the trade-in value): Assumptions: Time and materials contract Title exchange occurs at the end of the contract--no embedded lease All exchange assets are recorded as WIP inventory Facts: Firm fixed price: $25,000 Estimated cost of repair $20,000 Fair value of refurbished part $75,000 Carrying value of refurbished part: $50,000

Entries Memo only (To record receipt of customer core and shipment of refurbished part to customer--no title transfer) Work in process Cash/accounts payable (To record repair costs to customer core) Accounts receivable Revenue (To record revenue upon completion of repair and delivery to customer) Cost of sales WIP (To relieve inventory) Inventory (repaired core) Inventory (at carrying value) (To record title exchange)

Debit

Credit

$20,000 $20,000

$25,000 $25,000

$20,000 $20,000

$50,000 $50,000

Results: Revenue = $25,000, COGS = $20,000, Margin = $5,000, Return on sales = 20%

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For more information, please contact

Scott Thompson Partner, Aerospace & Defense Industry Practice Leader +1 703.918.1976 [email protected] Daniel DiPillo Senior Manager, Aerospace & Defense Practice +1 703.918.1415 [email protected]

www.pwc.com

© 2011 PwC. All rights reserved. "PwC" and "PwC US" refer to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisers. MW-11-0222

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