Revenue Recognition

We enter into contracts with customers typically having multiple commitments of goods and services including any combination of designing, developing, manufacturing, modifying, installing and commissioning of flow management equipment and providing services and parts related to the performance of such products. We evaluate the commitments in our contracts with customers to determine if the commitments are both capable of being distinct and distinct in the context of the contract in order to identify performance obligations.

We recognize revenue when (or as) we satisfy a performance obligation by transferring control of the performance obligation to a customer. Control of a performance obligation may transfer to the customer either over time or at a point in time depending on an evaluation of the specific facts and circumstances for each contract, including the terms and conditions of the contract as agreed with the customer, as well as the nature of the products or services to be provided. Our larger contracts are typically completed within a one to three-year period, while many other contracts, such as “short cycle” contracts, have a shorter timeframe for revenue recognition.

Control transfers over time when the customer is able to direct the use of and obtain substantially all of the benefits of our work as we perform. This typically occurs when products have no alternative use and we have a right to payment for performance completed to date, including a reasonable profit margin. Our contracts often include cancellation provisions that require the customer to reimburse us for costs incurred up to the date of cancellation, and some contracts also provide for reimbursement of profit upon cancellation in addition to costs incurred to date.

Our primary method for recognizing revenue over time is the POC method. We measure progress towards completion by applying an input measure based on costs incurred to date relative to total estimated costs at completion (i.e., the cost-to-cost method). This method provides a reasonable depiction of the transfer of control of products and services to customers as it ensures our efforts towards satisfying a performance obligation, as reflected by costs incurred, are included in the measure of progress used for recognition of revenue. Costs generally include direct labor, direct material and manufacturing overhead. Costs that do not contribute towards control transfer are generally immaterial, but are excluded from the measure of progress in the event they are significant.

Historically, revenue recognized under the POC method has been 5% to 10% of our consolidated sales. Under the New Revenue Standard, we have experienced an increase in the amount of revenue recognized over time. This increase is primarily due to the application of the new “transfer of control” model for revenue recognition. Under this model, revenue for performance obligations subject to contractual transfer of control during the manufacturing process are recognized over time. This includes contracts with cancellation provisions that require reimbursement for costs incurred plus a reasonable margin and for which the performance obligation has no alternative use. Revenue from products and services transferred to customers over time accounted for approximately 23% and 3% of total revenue for the three month periods ended June 30, 2018 and 2017, respectively, and 23% and 3% of total revenue for the six month periods ended June 30, 2018 and 2017, respectively.

If control does not transfer over time, then control transfers at a point in time. We recognize revenue at a point in time at the level of each performance obligation based on the evaluation of certain indicators of control transfer, such as title transfer, risk of loss transfer, customer acceptance and physical possession. Revenue from products and services transferred to customers at a point in time accounted for approximately 77% and 97% of total revenue for the three month periods ended June 30, 2018 and 2017, respectively, and 77% and 97% of total revenue for the six month periods ended June 30, 2018 and 2017, respectively.

A contract modification, or “change order,” occurs when the existing enforceable rights and obligations of a contract change, such as a change in the scope, price or terms and conditions. We account for a change order as a new accounting contract when the change order is limited to adding new, distinct products and services that are priced in an amount consistent with standalone selling price. Other change orders are accounted for as a modification of the existing accounting contract. When a change order occurs for a contract having in-process over time performance obligations, the effect of the change order on the transaction price and the measure of progress for the performance obligations to which it relates is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) on a cumulative catch-up basis.

Freight charges billed to customers are included in sales and the related shipping costs are included in cost of sales in our consolidated statements of income. If shipping activities are performed after a customer obtains control of a product, we apply a policy election to account for shipping as an activity to fulfill the promise to transfer the product to the customer.

We apply a policy election to exclude transaction taxes collected from customers from sales when the tax is both imposed on and concurrent with a specific revenue-producing transaction.

In certain instances, we provide guaranteed completion dates under the terms of our contracts. Failure to meet contractual delivery dates can result in late delivery penalties or liquidated damages. In the event that the transaction price of such a contract is probable of experiencing a significant reversal due to a penalty, we constrain a portion of the transaction price. This reduction to the transaction price could potentially cause estimated total contract costs to exceed the transaction price, in which case we record a provision for the estimated loss in the period the loss is first projected. In circumstances where the transaction price still exceeds total projected costs, the estimated penalty generally reduces profitability of the contract at the time of subsequent revenue recognition.

Our incremental costs to obtain a contract are limited to sales commissions. We apply the practical expedient to expense commissions as incurred for contracts having a duration of one year or less. Sales commissions related to contracts with a duration of greater than one year are immaterial to our financial statements and are also expensed as incurred.

We have not identified any material costs to fulfill a contract that qualify for capitalization under ASC 340-40.

Performance Obligations

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account for recognition of revenue. Many of our contracts have multiple performance obligations as the promise to transfer the individual goods or services, or certain groups of goods and services, is separately identifiable from other promises in the contract.

We allocate the transaction price of each contract to the performance obligations on the basis of standalone selling price and recognize revenue when, or as, control of each performance obligation transfers to the customer. For standard products, we identify the standalone selling price based on directly observable information. For customized or unique products and services, we apply the cost plus margin approach to estimate the standalone selling price. Under this method, we forecast our expected costs of satisfying a performance obligation and then add an appropriate standalone market margin for that distinct good or service.

We have elected to use the practical expedient to not adjust the transaction price of a contract for the effects of a significant financing component if, at the inception of the contract, we expect that the period between when we transfer a promised good or service to a customer and when the customer pays for that good or service will be one year or less.

A material product warranty exists when a customer has specifically requested or negotiated a warranty period that is significantly longer than our standard warranty period (i.e., a “service-type warranty”) and where the warranty obligation is material in the context of the contract. It is not common for our contracts to contain material product warranties. However, when such a warranty exists, we account for it as a separate performance obligation. We estimate the standalone selling price of the warranty obligation utilizing a cost plus margin approach and allocate a portion of the transaction price to the warranty performance obligation on the basis of estimated standalone selling price. We recognize revenue for warranty performance obligations over time on a straight line basis over the extended warranty period.

A material right option is a benefit provided to a customer in a current contract, such as an option to receive future products or services for free or at a significant discount, that is incremental to benefits widely available to similar customers that do not enter into a specific contract. It is not common for our contracts to contain material right options. However, when a material right option exists, it is accounted for as a separate performance obligation and a portion of the transaction price is allocated to the performance obligation based on the estimated standalone selling price of the option. Revenue is recognized when (or as) the customer exercises the right to acquire future products and/or services.

On June 30, 2018, the aggregate transaction price allocated to unsatisfied (or partially unsatisfied) performance obligations was approximately $1,335 million. We estimate recognition of approximately $1,059 million of this amount as revenue in 2018 and an additional $276 million in 2019 and thereafter.

Revenue recognized for performance obligations satisfied (or partially satisfied) in prior periods for the three and six months ended June 30, 2018 was not material.

ASC 606 Adoption Impact

We applied ASC 606 only to contracts that were not substantially complete as of January 1, 2018 and reflected the aggregate impact of all contract modifications (“change orders”) that occurred before the beginning of the earliest period presented when accounting for modified contracts at transition. The following table presents the cumulative effect of the changes made to our condensed consolidated balance sheet as of January 1, 2018 related to the adoption of the New Revenue Standard:



	December 31, 2017	Adjustments due to adoption of New Revenue Standard		January 1, 2018
(Amounts in thousands)	December 31, 2017	Adjustments due to adoption of New Revenue Standard		January 1, 2018
Accounts receivable, net of allowance for doubtful accounts(1)	856,711	(49,247	)	807,464
Contract assets, net(2)	—	219,361		219,361
Inventories, net(3)	884,273	(238,573	)	645,700
Prepaid expenses and other	114,316	(4,457	)	109,859
Total current assets	2,558,745	(72,916	)	2,485,829
Deferred taxes	51,974	(2,706	)	49,268
Other assets, net	199,722	2,004		201,726
Total assets	4,910,474	(73,618	)	4,836,856
Accounts payable	443,113	11,784		454,897
Accrued liabilities(4)	724,196	(290,445	)	433,751
Contract liabilities(5)	—	178,515		178,515
Total current liabilities	1,242,908	(100,146	)	1,142,762
Retirement obligations and other liabilities	496,954	6,568		503,522
Retained earnings	3,503,947	19,642		3,523,589
Total equity	1,670,954	19,960		1,690,914
Total liabilities and equity	4,910,474	(73,618	)	4,836,856

_____________________________________

(1) Adjusted for contract assets accounted for under delivery based methods, previously reported in receivables, net.

(2) Represents our right of payment in advance of our contractual right to bill the customer.

(3) Adjusted for contract assets accounted under the over time method, previously reported in inventories, net.

(4) Adjusted for deferred revenue previously reported in accrued liabilities and reclassified to contract assets and contract liabilities.

(5) Represents contractual billings in excess of revenue recognized at the contract level, previously reported in accrued liabilities.

The modified retrospective approach requires a dual reporting presentation to be disclosed in the year of adoption. The dual reporting requirement outlines the impact amount by which a financial statement line is affected in the current reporting period by the adoption of the New Revenue Standard as compared with the previous standard in effect before the adoption.

The following tables present the dual reporting requirements:



	Three Months Ended June 30, 2018
(Amounts in thousands, except percentages)	Balances without Adoption of New Revenue Standard			Effect of Change			As Reported
Sales	$	962,630		$	10,499		$	973,129
Cost of sales	(684,749		)	(2,323		)	(687,072		)
Gross profit	277,881			8,176			286,057
Gross profit margin	28.9		%				29.4		%
Selling, general and administrative expense	(240,731		)	(60		)	(240,791		)
Net earnings from affiliates	1,445			—			1,445
Operating income	38,595			8,116			46,711
Operating income as a percent of sales	4.0		%				4.8		%
Interest expense	(14,939		)	—			(14,939		)
Interest income	1,330			—			1,330
Other expense, net	(4,680		)	(90		)	(4,770		)
Earnings before income taxes	20,306			8,026			28,332
Provision for income taxes	(14,412		)	867			(13,545		)
Net earnings, including noncontrolling interests	5,894			8,893			14,787
Less: Net earnings attributable to noncontrolling interests	(1,567		)	—			(1,567		)
Net earnings attributable to Flowserve Corporation	$	4,327		$	8,893		$	13,220



	Six Months Ended June 30, 2018
(Amounts in thousands, except percentages)	Balances without Adoption of New Revenue Standard			Effect of Change			As Reported
Sales	$	1,811,859		$	81,224		$	1,893,083
Cost of sales	(1,269,224		)	(66,369		)	(1,335,593		)
Gross profit	542,635			14,855			557,490
Gross profit margin	29.9		%				29.4		%
Selling, general and administrative expense	(469,966		)	—			(469,966		)
Net earnings from affiliates	4,613			—			4,613
Operating income	77,282			14,855			92,137
Operating income as a percent of sales	4.3		%				4.9		%
Interest expense	(29,818		)	—			(29,818		)
Interest income	2,968			—			2,968
Other expense, net	(11,624		)	(301		)	(11,925		)
Earnings before income taxes	38,808			14,554			53,362
Provision for income taxes	(20,958		)	(1,158		)	(22,116		)
Net earnings, including noncontrolling interests	17,850			13,396			31,246
Less: Net earnings attributable to noncontrolling interests	(2,883		)	—			(2,883		)
Net earnings attributable to Flowserve Corporation	$	14,967		$	13,396		$	28,363



	June 30, 2018
(Amounts in thousands)	Balances without Adoption of New Revenue Standard	Effect of Change		As Reported
Accounts receivable, net	884,179	(68,471	)	815,708
Contract assets, net	—	257,224		257,224
Inventories, net	985,776	(310,451	)	675,325
Prepaid expenses and other	115,957	(8,665	)	107,292
Total current assets	2,503,354	(130,363	)	2,372,991
Deferred taxes	57,282	(2,706	)	54,576
Other assets, net	189,537	409		189,946
Total assets	4,783,282	(132,660	)	4,650,622
Accounts payable	422,264	6,571		428,835
Accrued liabilities	729,554	(347,397	)	382,157
Contract liabilities	—	171,940		171,940
Total current liabilities	1,221,741	(168,886	)	1,052,855
Retirement obligations and other liabilities	497,723	3,546		501,269
Retained earnings	3,468,968	33,038		3,502,006
Total equity	1,608,871	32,680		1,641,551
Total liabilities and equity	4,783,282	(132,660	)	4,650,622

Disaggregated Revenue

We conduct our operations through three business segments based on the type of product and how we manage the business:


•	Engineered Product Division ("EPD") for long lead time, custom and other highly-engineered pumps and pump systems, mechanical seals, auxiliary systems and replacement parts and related services;


•	Industrial Product Division ("IPD") for engineered and pre-configured industrial pumps and pump systems and related products and services; and


•	Flow Control Division ("FCD") for engineered and industrial valves, control valves, actuators and controls and related services.

Our revenue sources are derived from our original equipment manufacturing and our aftermarket sales and services. Our original equipment revenues are generally related to originally designed, manufactured, distributed and installed equipment that can range from pre-configured, short-cycle products to more customized, highly-engineered equipment ("Original Equipment"). Our aftermarket sales and services are derived from sales of replacement equipment, as well as maintenance, advanced diagnostic, repair and retrofitting services ("Aftermarket"). Each of our three business segments generate Original Equipment and Aftermarket revenues.

The following table presents our customer revenues disaggregated by revenue source:



	Three Months Ended June 30, 2018
(Amounts in thousands)	EPD		IPD		FCD		Total
Original Equipment	$	130,949	$	115,521	$	238,977	$	485,447
Aftermarket	340,229		80,770		66,683		487,682
	$	471,178	$	196,291	$	305,660	$	973,129

	Three Months Ended June 30, 2017(1)
(Amounts in thousands)	EPD		IPD		FCD		Total
Original Equipment	$	121,273	$	111,700	$	211,089	$	444,062
Aftermarket	298,166		71,253		63,582		433,001
	$	419,439	$	182,953	$	274,671	$	877,063



	Six Months Ended June 30, 2018
(Amounts in thousands)	EPD		IPD		FCD		Total
Original Equipment	$	270,576	$	229,960	$	449,467	$	950,003
Aftermarket	657,391		153,582		132,107		943,080
	$	927,967	$	383,542	$	581,574	$	1,893,083

	Six Months Ended June 30, 2017(1)
(Amounts in thousands)	EPD		IPD		FCD		Total
Original Equipment	$	248,660	$	219,555	$	432,391	$	900,606
Aftermarket	587,849		133,400		121,526		842,775
	$	836,509	$	352,955	$	553,917	$	1,743,381

_____________________________________

(1) Prior periods are presented in accordance with Topic 605.

Our customer sales are diversified geographically. The following table presents our revenues disaggregated by geography, based on the shipping addresses of our customers:



	Three Months Ended June 30, 2018
(Amounts in thousands)	EPD		IPD		FCD		Total
North America(1)	$	184,533	$	79,717	$	133,564	$	397,814
Latin America(1)	37,054		6,620		5,319		48,993
Middle East and Africa	62,495		12,375		32,986		107,856
Asia Pacific	112,293		26,287		76,390		214,970
Europe	74,803		71,292		57,401		203,496
	$	471,178	$	196,291	$	305,660	$	973,129

	Three Months Ended June 30, 2017(2)
(Amounts in thousands)	EPD		IPD		FCD		Total
North America(1)	$	166,080	$	75,177	$	119,932	$	361,189
Latin America(1)	29,721		6,946		5,343		42,010
Middle East and Africa	46,410		12,659		28,492		87,561
Asia Pacific	99,599		24,010		57,036		180,645
Europe	77,629		64,161		63,868		205,658
	$	419,439	$	182,953	$	274,671	$	877,063



	Six Months Ended June 30, 2018
(Amounts in thousands)	EPD		IPD		FCD		Total
North America (1)	$	367,750	$	155,679	$	258,279	$	781,708
Latin America(1)	70,835		14,302		10,991		96,128
Middle East and Africa	124,183		27,511		66,045		217,739
Asia Pacific	220,376		46,319		132,573		399,268
Europe	144,823		139,731		113,686		398,240
	$	927,967	$	383,542	$	581,574	$	1,893,083

	Six Months Ended June 30, 2017(2)
	EPD		IPD		FCD		Total
North America (1)	$	325,319	$	145,324	$	233,105	$	703,748
Latin America(1)	63,082		14,062		19,295		96,439
Middle East and Africa	119,138		26,388		57,387		202,913
Asia Pacific	180,211		46,449		101,632		328,292
Europe	148,759		120,732		142,498		411,989
	$	836,509	$	352,955	$	553,917	$	1,743,381

_____________________________________

(1) North America represents United States and Canada; Latin America includes Mexico.

(2) Prior periods are presented in accordance with Topic 605.

Contract Balances

We receive payment from customers based on a contractual billing schedule and specific performance requirements as established in our contracts. We record billings as accounts receivable when an unconditional right to consideration exists. A contract asset represents revenue recognized in advance of our right to receive payment under the terms of a contract. A contract liability represents our right to receive payment in advance of revenue recognized for a contract.

The following table presents opening and closing balances of contract assets and contract liabilities, current and long-term, for the six months ended June 30, 2018:



( Amounts in thousands)	Contract Assets, net (Current)			Long-term Contract Assets, net(1)			Contract Liabilities (Current)			Long-term Contract Liabilities(2)
Beginning balance, January 1, 2018	$	219,361		3,990			$	178,515		$	3,925
Revenue recognized that was included in contract liabilities at the beginning of the period	—			—			(99,538		)	(659		)
Increase due to revenue recognized in the period in excess of billings	334,815			405			—			—
Increase due to billings arising during the period in excess of revenue recognized	—			—			107,080			—
Amounts transferred from contract assets to receivables	(279,360		)	(2,167		)	—			—
Currency effects and other, net	(17,592		)	(435		)	(14,117		)	(838		)
Ending balance, June 30, 2018	$	257,224		$	1,793		$	171,940		$	2,428

_____________________________________

(1) Included in other assets, net.

(2) Included in retirement obligations and other liabilities.