No, the sky isn’t falling.
Like a heavily anticipated major hurricane that thankfully veered out to
sea, the upcoming revenue recognition
standards are not expected to be the dramatic game-changer for the construction
industry that was originally expected.
In November 2011, the Financial
Accounting Standards Board (FASB) re-issued their exposure draft on Revenue
Recognition for Contracts with Customers (Topic 605). The reissued draft was in response to more
than 1,000 comment letters from the industry and the accounting profession, as
well as other stakeholders. The proposed
standards, as revised, are conceptually in line with the goals of standardizing
revenue recognition reporting across industries (in a principle-based
approach), while retaining many current construction industry practices.
Yes, certain terminology will change and certain project
costs need to be pulled out of the costs accumulated for calculation of
percentage of completion. And there are
still certain problematic issues that should be revised before the final
standards are issued. However, much of
the structure of companies’ current accounting methods and practices is
expected to be substantially unchanged after the proposed standards are
enacted.
For the last several years, the governing boards responsible
for Generally Accepted Accounting Standards in the United States (GAAS) and
International Financial Reporting Standards (IFRS) have been creating a single
set of international accounting standards.
The goal of the proposed revenue recognition standard is to eliminate
separate standards for particular industries and create one generic standard
applicable to all industries. The new
standard would replace ASC 605-35 Revenue Recognition for Construction Type
Contracts, which has been in effect since 1981.
The first exposure draft, issued in June 2010, introduced
the following core principles:
- Identify the contract with the customer
- Identify the separate performance obligations in
the contract
- Determine the transaction price
- Allocate the transaction price to the separate
performance obligations
- Recognize revenue when performance obligations
are satisfied
Major problems from the first exposure draft were as
follows:
- All contracts in the construction industry
contain multiple performance obligations.
Each building, phase, section, or subcontract could conceivably be
viewed as a separate performance obligation.
The proposed standards implied that companies would be required to
disaggregate each contract element/obligation for accounting purposes.
- It was unclear whether companies would be able
to use percentage of completion using a cost-to-cost approach as a means of
recognizing revenue over the course of a project.
- Accounting for variable contract prices
(unapproved or unpriced change orders, incentive payments, and claims) would
have been less conservative than current practice. The proposed standard required an estimate to
be recognized using a probability-weighted approach.
- Adding significant disclosure requirements to include
a tabular reconciliation of beginning and ending contract assets and
liabilities each year, the expectation of when ending performance obligations
will be satisfied, the opening and closing liabilities for onerous performance
obligations, and a summary of significant judgments and changes in judgments
used in determining the satisfaction of performance obligations.
- Warranties were deemed to be separate
performance obligations and hence a deferral of some portion of the total of
contract revenue would have been necessary.
These changes are considered to be major improvements for
the construction industry.
- The ability to bundle performance obligations
when multiple goods or services are highly interrelated and a business provides
a significant service of integrating multiple goods and services into the
combined item. This change allows for
the presumption for most entities in the construction
industry that the contract would remain the only profit center for revenue
recognition.
- The revised exposure draft eliminated the
presumption that the output method (units completed, progress toward
completion) is preferable to the input method (cost-to-cost, labor hours) for
measuring progress of satisfying performance obligations. Percentage of completion using cost-to-cost
(input method) would be allowed albeit with certain exceptions noted below.
- The standard for estimating the value of
unapproved change-orders, potential incentive payments, and claims in the total
contract value was revised to encourage conservative reporting of uncertain
elements of the contract amount. The
proposed standards allow these estimates to be determined using either a
probability-weighted approach or the “most likely” estimate. The “most likely” estimate method is
appropriate in the construction industry, where the outcome choices are likely
to be binary rather than a range of outcomes.
- In addition, the proposed standard states that entities use judgment in
determining when variable consideration is “reasonably assured.” This revision brings the proposed standard
more in line with the current standard.
- The revised exposure draft eliminated many of
the disclosure requirements for private reporting entities.
- The standard for accounting for warranties as a
separate performance obligation was relaxed.
If the customer has the option to purchase the warranty separately, then
it would be a separate performance obligation to be accounted for
separately. If warranty is merely
assurance that the entity’s past performance would be as specified in the
contract, it does not constitute a separate performance obligation.
- The following issues are fundamental changes from the
current standards. These have been
identified by industry stakeholders in their comment letters on the revised
exposure draft who have encouraged FASB to make modifications before the final
standard is released.
Contract Costs
The most significant change will affect all companies
calculating revenue using the percentage of completion on the cost-to-cost
approach. Under the proposed standard,
certain categories of costs are not included in the numerator and denominator
for the determination of the percent complete. The principle in the new standard is that
removing these costs from the percentage of completion calculation will defer
recognition of revenue on projects and make revenue reporting more
conservative. The result will be lower
profits recognized on early stages of projects.
Under the current standard, there is a self-correcting
mechanism for accounting for diminished profit due to unrecovered costs under
the percentage of completion method.
Once identified, the amount would have already been in the cost incurred
to date (numerator), and the total estimated project costs would have included
these costs also (denominator). The
percentage presumably would be higher due to the higher numerator. Thus when applied to the contract price, more
revenue would be recognized.
The proposed standard notes three categories of costs that
need to be excluded from the calculation:
i.
Costs which do not accurately depict the
transfer of control of goods or services (such as costs of wasted materials,
labor or other resources). Under this
standard, idle time charged to projects must be expensed to an allocated labor
account.
ii.
Costs to obtain a contract shall be expensed as
incurred. Under this standard, costs to
bid a project would need to be expensed.
iii.
Direct costs of fulfilling a contract (such as
commissions or mobilization costs) are capitalized and amortized if they relate
directly to a contract, relate to future performance, and are expected to be
recovered. This standard would require
companies to accumulate these early costs, remove from job costs and record as
a prepaid expense that will be written off over the life of the project.
The proposed standard is vague on its practical application,
but the principle is that costs are required to be excluded from both the
numerator and denominator in determining the cost-to-cost percentage. The practical application of this will be
difficult since most companies contract reporting and job cost reporting
systems do not allow for reductions for these items without manual journal
entries. For management purposes,
companies would not want to lose track of these costs and their association
with particular projects simply because of new revenue recognition
standards.
Onerous Performance Obligations
The proposed standard includes the requirement to record a
liability and an expense for each performance obligation that is satisfied over
a period of time greater than one year.
A performance obligation is onerous if it is expected to cost more to
finish or exit the performance obligation than the transaction price of the
performance obligation (i.e., contracts with losses).
The current standard requires evaluation of losses at the
contract level without regard to the length of the contract. If the presumption is that most construction
contracts will be one performance obligation, then the proposed standard, as
written, would be less conservative than the current standard.
Time Value of Money
The proposed standard includes a provision wherein contract
revenue should reflect the time value of money whenever the contract includes a
significant financing component. As a
practical expedient, this standard would only apply to contracts whose duration
exceeds one year. For a commercial
contractor building for third parties, it is unclear that retention receivables
or overbillings would be subject to imputed interest adjustments. It remains to be seen whether this provision
would remain as written in the final standard.
Collectability and Transaction Price
It is sometimes difficult to distinguish true bad debts from
compromises made on individual projects.
Under the current standards, contract concessions are an adjustment to
the contract amount (revenue to be recognized); while provisions for bad debts
are presented as an operating expense.
The first exposure draft included the requirement that each
customer’s credit risk be initially evaluated and reflected in the contract
price using a probability-weighted approach.
The revised exposure draft reiterates the current standard that revenue
from contracts is calculated without regard for the credit worthiness of the
customer. The proposed standard states
that the transaction price is what companies “expect to be entitled” and is
reported as revenue. Provisions for bad
debts based on the impairment of receivables would be presented as a separate
line item adjacent to revenue. Bad debts
expense would no longer be classified in the general & administrative
expense section of the statement of income.
Example of
presentation of Bad Debts Expense under proposed standard
Contract Revenues $ 5,000
Less Provision for Doubtful
Accounts $ (200)
Total Revenues $ 4,800
The industry appears to be accepting of this change, however
more guidance has been requested on distinguishing between contract concessions
and true bad debts.
Like the storm chasers in the movie “Twister,” many in the
industry have been following the developments closely over the years and gotten
involved by commenting on the proposed standards. It is gratifying that this effort has
affected positive change. The industry
comment letters on the latest exposure draft are substantially down in numbers
and are primarily appreciative of the changes to the reissued exposure draft
while suggesting additional changes to important but less fundamental
issues. The final standards are
ultimately expected to be similar to the latest exposure draft. For those contractors hunkered down in their
basements waiting out the storm, it’s time to step outside and start preparing
for the new standards that will be coming,
You have some time still to get ready – the standards are not expected
to be effective before January 1, 2015 at the earliest.
For more information, please contact
Chuck Landers at
(800) 477-7458.
© 2012 EisnerAmper LLP
