The Time is Now for Private Construction Companies to Implement the New Revenue Recognition Standards
- Dec 19, 2018
- Edward Opall
In May 2014, Revenue Recognition for Contracts with Customers (ASC 606) was issued after approximately eight years of deliberation. The goal was to make accounting comparable across industries and around the world.
Previously, Generally Accepted Accounting Principles (U.S. GAAP) had separate industry-specific standards, of which the construction industry’s was in place since 1981 (ASC 605-35). The new standard not only merged all industries into one but also now resembles more closely the revenue recognition principles of International Financial Reporting Standards (“IFRS”). The new standards went into effect in 2018 for public companies and will now be effective for private companies with fiscal years beginning after December 15, 2018.
Edward Opall, a Partner in EisnerAmper’s Real Estate and Construction Services Group based in Philadelphia, discusses the measures that privately-held contractors should take immediately, if they haven’t already done so, to ensure they are prepared to adhere to the latest requirements for their financial reporting. First and foremost, they must take the time to understand the new standard and how it differs from the old standard. Second, they must analyze each of their contracts in light of the new standards and make key decisions. Third, they must develop systems and procedures to capture and take into account all the differences. And finally, they must have a clear and detailed plan of action along with robust systems in place to complete their financial reporting under the new standard.
“It is not too late to start planning for these changes, but it is certainly not too early because these pronouncements have been issued years ago and implementation for revenue recognition for private companies is 2019,” he said. “This is not a meaningless exercise. Despite the fact that certain key elements of the old standard remain intact, companies will need to go through an implementation process to make sure their accounting systems, procedures and ultimately financial reporting are in accordance with U.S. GAAP. Each business line and each individual contract will need to be analyzed. Implementing this correctly will involve leadership from top management and should involve input from key constituencies within each company. Many companies are engaging external experts to guide them through this process.”
WHAT ARE THE ISSUES THAT CONSTRUCTION COMPANIES ARE FACING?
Opall noted that contractors need to take into account each of the five core principals of the new standard. “Significant judgement needs to be made, which should be documented into company policy, on the inherent issues in each of the principles,” he said. “The decisions made will affect the timing of revenue recognition and ultimately the reported profitability and financial condition of the company.”
- Identify the contract with customers. Common practice in construction has been one contract, one profit center. It will be important for companies to consider:
- whether it will be necessary to combine certain contracts negotiated as a package with a single commercial objective and also
- when pricing and scope in one contract is dependent on pricing and performance of another contract.
- Identify the performance obligation(s) under each contract. Companies will need to evaluate each of their contract terms to identify all promises contained within the specifications. They should consider the need to account for multiple performance obligations as separate profit centers. According to ASC 606, contracts are allowed to combine all of the promises into one performance obligation when a contract provides a significant service of integrating separate goods and services to provide one combined output. Due to this provision in the new standard, construction companies would generally maintain their previous practice of recognizing one contract as one performance obligation. However, the determination needs to be made based on the facts and circumstances of each contract. Further, contracts that contain scope that could be seen as distinctly separate in the eyes of the customer may need to be accounted for as a separate profit center.
- Determine the contract price. The decision to use “variable consideration,” meaning pending change orders, unpriced change orders, claims or damages, savings bonuses and other unknown amounts in the contract price is now based on principles in ASC 606 rather than rules used in ASC 605-35. Companies may at times recognize revenue sooner under the new standard than they would have under the old standard. In implementing ASC 606, it will be necessary for companies to establish accounting policies around the principles outlined, document decisions made at each reporting period for each contract and maintain consistency across all contracts. These policies should include consideration of the history in dealing with each customer that will enable judgements on estimating the realization of variable consideration.
- Allocate the contract price under the performance obligations. If contracts are accounted for as multiple performance obligations, then a rational approach toward allocating the price to separate profit centers will be necessary.R
- Recognize revenue as performance obligations are satisfied. Although the output method is the preferable method of recognizing revenue, most contractors will be able to retain the percentage of completion and cost-to-cost method, which is an allowable input method. However, the mechanics of this method must take into account the principles under 606. Certain costs incurred under a contract will not create value for the customer and should not be considered in the cost to cost calculation. To implement ASC 606, companies will need to develop policies around the typical issues encountered, and adjust their closing processes to properly account for these under the new standards. Some of the things they must take into consideration include:
- Certain uninstalled materials;
- Mobilization costs;
- Selling or costs to obtain a contract; and
- Costs of wasted materials or labor.
WHAT ARE THE NEW DISCLOSURE REQUIREMENTS?
All construction companies will need to expand their accounting policy disclosures to note significant judgements used in revenue recognition. The disclosures will entail descriptions of their major product or service lines, types of contracts, how they determine to account for performance obligations, estimating transaction prices and other important estimates used.
- Tables will be required to show revenue disaggregated by contract types and revenue recognized over time or at one point in time.
- Expanded disclosures of contracts in progress will be required.
- Contract backlog table will no longer be optional
HOW WILL FINANCIAL REPORTING BE TRANSITIONED?
Most private companies will adopt the standards under a modified retrospective approach where the contracts in process at the beginning of the reporting period (January 1, 2019) would be restated and the cumulative effect would be adjusted to retained earnings.
Given the new financial reporting requirements for revenue recognition, many contractor companies have begun implementing them after educating themselves on the standard when it was announced a few years ago while others have taken a “wait-and-see” approach and observed what their peers have done. Many have decided to outsource the work to consultants to assist them while others have opted to manage the process themselves. Regardless of whether or not a company decides to outsource, it is imperative that company management have a plan and robust systems in place for their financial reporting to adhere to the enhanced disclosure requirements.
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Edward Opall is an Attest Partner in the firm’s Real Estate and Construction Services Group. His practice consists mainly of private company real estate developers, investors, and fund sponsors as well as homebuilders and construction industry clients. Ed also advises numerous clients on operational and accounting process reviews, general business consulting, and income tax planning.
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