December 13, 2010
By Ed Opall, CPA, CCIFP
As a result of increasing globalization of capital markets and industries, the G20 leadership has made convergence of International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) a top priority. The goal is to develop one set of worldwide accounting standards and disclosure requirements in order to bring consistency and comparability of financial information across industries and across borders. Ultimately, this would benefit domestic business owners and investors, who have stakeholders operating in global markets (banks, sureties, and many of their clients).
The accounting convergence project has been ongoing for several years. The Financial Accounting Standards Board (FASB), the governing body issuing US GAAP pronouncements, issued a discussion paper, “Preliminary Views on Revenue Recognition in contracts with Customers,” in December 2008. This paper brought forth significant comments from the construction industry as well as CPAs practicing in the industry. On June 24, 2010, the FASB and the International Accounting Standards Board (IASB) issued an exposure draft on Revenue Recognition (Topic 605). Revisions are likely before the final standards are issued. However, it is widely acknowledged that a new revenue recognition standard will eventually be adopted.
As most domestic contractors issue financial statements under GAAP, they must be informed of the proposed changes in revenue recognition concepts and accounting rules. We believe that this proposed accounting standard, if adopted as final, will require significant changes in internal accounting practices to properly apply the new recognition and measurement standards for revenue, costs, and gross profit on projects.
The proposed standards would supersede the construction industry’s accounting guidance on revenue recognition in Topic 605-35 of the FASB Accounting Standards CodificationTM (formerly SOP 81-1). These standards have been in effect for almost 30 years and have served the industry and its stakeholders well. The proposed standards are principles-based, not a series of rules. As noted, these principles are applicable to any industry with contract revenue, not simply the construction industry. Therefore, it is important to understand the general nature of the principles, and then determine their practical application to construction contractors.
Contract – Based Asset & Liability Model
A core principle in the new standards is the asset & liability model for each contract. Upon the award of a contract, the contractor has a right to receive payment (the asset) upon performance of specific performance obligations (the liability). These assets and liabilities are not recorded, they are simply concepts. As the satisfaction of performance obligations occur during the project, revenue can be recognized. The concept puts an end to percentage of completion accounting under the current standards, but it allows for broadly similar accounting outcomes for the majority of construction projects. However, there are several significant variations that contractors need to prepare for when the new standard is enacted.
The term “satisfaction of performance obligations” is defined as transferring a promised good or service to a customer when the customer obtains control of that good or service. For contractors building for customers on customer’s property, the “transfer” may occur continuously during the course of the work. This concept may become problematic for home-builders or other build-to-suit contractors since it can be argued that they retain control until the project is complete and transfer of ownership occurs. This would make revenue recognition similar to the completed contract method, where revenues and related costs are deferred until the project is complete. Under the current standards, completed contract accounting is a less desirable, and in many cases, a disallowed method.
De-Aggregate Contracts for Separate Performance Obligations
Another core principle in the proposed standards is the identification of separate performance obligations in each contract. The current standard notes that a contract is the profit center and notes specific rules for combining or segmenting contracts for accounting purposes. Under the exposure draft, each contract should be segmented into separate performance obligations if the activities are distinct. Each performance obligation that is segmented will have its own profit estimate, so that revenue and gross profit can be recognized as those specific activities are completed. This has been the source of significant confusion in the industry as it could have meant the separation of trade line items into separate “jobs” for purposes of GAAP accounting. Taken to an extreme, contracts would be segmented to each line item in the schedule of values and even by each change order.
The proposed standard states that the determination of whether activities are distinct is if the business sells these services as separate activities to other customers. Their frequent example has been design-build or EPC (engineering, procurement, and construction) contracts, where the major activities are distinct, have separate schedules, and carry separate profit estimates. We believe that most contractors would consider these contracts to be bundled, and not consider the separateness of these elements. These delivery methods have become popular for precisely the reason that the services are bundled and integrated: segmenting these elements appears to be arbitrary and unnecessary.
The standard also requires combining separate contracts when they are considered interdependent. Indicators of interdependence are:
- Contracts are entered into at or near the same time
- Contracts are negotiated as a package with a single commercial objective
- Contracts are performed either concurrently or consecutively
We believe that more clarification and industry guidance will be needed in this area. As the new standard requires combining contracts meeting this criteria, it is likely that single contracts would not be required to be segmented when the commercial intent is a combined delivery method. Contractors and their stakeholders do not want to segment their contracts and we believe there will be wide variations in the interpretation of this portion of the proposed standards.
De-Coupling the Contract Costs as a measure of Contract Revenue
The proposed standard allows revenues to be recognized based on measurement of required outputs (such as miles of highway completed), or inputs (such as costs to date as a percentage of total estimated cost, or the passage of time (such as service or maintenance contracts), in certain cases. Most contractors will continue to use the cost-to-cost method, for its practicality, but with certain changes. Since the overriding principle is that revenue is recognized as performance obligations are completed, only certain costs that accomplish the performance obligation should count toward the determination of revenue earned. The following costs would be excluded from the percentage completion calculation under the new standard of input measurement:
- Procurement costs – will need to be expensed as incurred
- Mobilization costs –can be capitalized as prepaid expenses if costs are recoverable under an active contract, and then amortized ratably as contract revenue is earned
- Costs of inefficiency or waste – should be expensed as incurred as these would not satisfy performance obligations
The separate nature of these costs from other project costs is the most significant change that will affect day-to-day work for a contractor. We believe this principle will be in the final version of the pronouncement, requiring contractors to identify these costs in accordance with these categories so that proper treatment can be affected.
Variable Contract Prices (early completion bonuses or other incentives)
The current standard states that incentives, bonuses, or other contingent payments should be estimated in the determination of revenue. Recognizing these contingencies in earnings should be based on what is “most likely to occur.” If contractors are not certain that early completion bonuses or other incentives will be earned, which usually is evidenced by a signed change order or outright collection, then the standard requires that recognition is deferred until such time it is certain. In practice, contractors deferred recognition until the customer paid or similarly acknowledged liability.
The proposed standard requires that variable elements of the contract be reasonably estimated as a condition for revenue recognition. It states that the contract price “should consider the terms of the contract and its customary business practice”. This would “include probability-weighted amount of the variable consideration, such as incentives, performance bonuses/penalties, contingencies…” This standard requires that a faithful estimate of all of the pending issues be assessed with a probability weighting assigned to each item. Applying these proposed standards in practice would allow contractors to recognize revenue and profits on incentive payments calculated on probabilities, rather than outright certainty. The result would be recording estimated earnings at a reduced amount, when it should really be either 100% or zero.
As noted previously, these proposed standards have been written for other industries besides construction. This broad approach is one of the more problematic features, and has provoked serious push-back from the construction industry, practitioners, and the surety industry. In our opinion, it is unlikely that FASB would want to make revenue reporting less conservative than recognized industry practice.
Losses on Contracts (Onerous Performance Obligations)
The current standards require an estimated loss on a contract to be immediately recognized. The current standard for determining the loss is simply the total estimated costs of the contract less the total anticipated revenues. The new standard also requires losses to be immediately recognized, however the test for determining the loss is more complicated. Under the proposed standards, calculations will be required to determine the present value of probability-weighted costs to determine the total estimated costs, but only before recognizing an impairment loss on any assets related to the contract. These standards are logical, but its practical application would likely lean back to the current standard, where the most conservative estimate of losses should be recorded.
Unapproved Change Orders and Claims
The current standards provide specific rules for recognizing revenue and profits when change orders are unapproved, unpriced, or for claims. Under certain circumstances, unapproved change orders can be accounted for at zero profit (when the likelihood of approval is probable) until such time it is approved or realization is likely. With the new standard, the same principle of evaluating variable transaction prices (above) with the required assessment of probabilities and recording an estimated amount will be required.
It is likely that more clarity will be forthcoming, since most users of contractor financial statements would not be comfortable with this method.
The goal of bringing US GAAP and International Standards together is worthwhile. After all, it’s important for our capital markets and companies doing business internationally to have one global set of standards. We will continue to monitor the developments in this area and keep our clients informed on significant changes to come.
It is anticipated that the final pronouncement will be issued in the 2nd quarter of 2011, and require retrospective application. We believe that the effective date would be two or three years later. As currently proposed, private companies do not have an extra year to implement these changes. We expect to see significant industry guidance developed by the AICPA to supplement the principles enumerated in these proposed standards. It is important for each industry affected by these standards to develop consistency in practice to avoid abuses in varying interpretations.
That being said, new accounting rules need to help business owners provide reasonable means of creating management reports that will determine their profitability and financial position. These proposed accounting principles require significant judgement, and could undermine management’s ability to produce reliable financial information within a reasonable time-frame. If the revenue recognition standard allows for too- much arbitrary interpretation, we are concerned that the credibility and effectiveness of GAAP may suffer. Users would then seek to report using methods other than GAAP.
At any time, construction companies may have dozens, hundreds, or even thousands of complex contracts to continuously evaluate for cost estimates, schedules, change management, and customer service. Arbitrarily segmenting the contracts for accounting purposes will not help companies achieve their objectives. In addition, we foresee that the proposed changes to existing practices will not help sophisticated users of construction industry financial statements, who make credit decisions based on this information. If these standards become effective as presented, we believe that sureties and other creditors may require a reconciliation of the “old GAAP” for the Contracts in Progress and Completed Contract Schedule with reconciliation to the “new GAAP” method. At present, FASB is evaluating the feedback it has received on this controversial proposal. As they do not want to see industry-wide rejection of the standards, we expect further clarification to be forthcoming before the proposed standards are implemented. Stay tuned.
Comparison of Key Features of the
Proposed Standard vs. Current Standard
Revenue Recognition - Construction-Type and Production-Type Contracts
ASC 605-35 (Formerly SOP 81-1)
Revenue Recognition from Contracts with Customers
||Basic presumption is that each contract is the profit center for revenue recognition, cost accumulation, and income measurement. Segmented is allowed under certain strict conditions.
||Evaluate distinct performance obligations within each contract for separate revenue, cost accumulation, and income measurement. Combined obligations are allowed when activities are interdependent.
|Method of Recording Revenue
||Recognize income as work on a contract progresses. Incurred costs in relation to total estimated costs or other such measure of progresss toward completion. Presumes ability to estimate total contract costs.
||Recognize income when it satisfies a performance obligation by transferring a promised good or service to a customer. The transfer occurs when the customer obtains control of that good or service.
|Variable Contract Prices
||Use most conservative estimate of revenue that is assured and likely to occur. When in doubt, use lowest probably level of profit until results can be estimated more precisely.
||If the transaction price cannot be reasonably estimated, do not recognize revenue. If transaction can be reasonably estimated, recognize revenue from satisfied performance obligations when it can be estimated. Recommended to use weighted probability measures to determine transaction if entity has sufficient history of similar transactions.
||Accumulated in same manner as inventory and charged to operations as related revenue from contracts is recognized. Includes direct and indirect costs.
||Same as current standard with exceptions for procurement, mobilzation, and inefficiency
||Costs should be expensed unless they are recoverable under an active contract
||Costs of obtaining a contract, including bid and proposals, and negotiations are expensed when incurred.
||Costs may be deferred and included in contract costs on receipt of anticipated contract.
||Recognize these costs as an asset when they related directly to a contract, generate or enhace resouces used for satisfying performance obligations, and are expected to be recovered. Amortize this asset ratably over the duration of the project.
||Contract Price Adjusted, cummulative catch up of revenue
||Contract Price Adjusted, cummulative catch up of revenue
||If recovery probable (events necessary for recovery likely to occur), recognize revenue to extent of cost until approved. If changes are in dispute, evaluate as a claim.
||Evaluated as variable consideration
||Recognizition appropriate only if probable that the claim will be sustained and amount can be reliably estimated. Record only to the extent of contract costs. In practice, not typically recorded until amounts have been received or awarded. May record as adjustment to contract if realization is beyond a reasonable doubt.
||Evaluated as variable consideration
The material contained in this presentation is for general information and should not be acted upon without prior professional consultation.