MAY 2013 UPDATE: For Contractors, Revenue Recognition Standards Come Back to Reality
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 that the construction industry was originally expecting. Yes, certain terminology will change, new disclosures will be required, and certain changes in accounting for project revenue will be required. But the fundamentals of construction industry accounting will remain intact.
For the last several years, the governing boards responsible for Generally Accepted Accounting Standards in the United States (GAAP) 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, creating one generic standard applicable to all industries. This new standard would replace ASC 605-35 Revenue Recognition for Construction Type Contracts, which has been in effect since 1981.
In November 2011, the Financial Accounting Standards Board (FASB) re-issued their exposure draft, originally issued in 2010 on Revenue Recognition for Contracts with Customers (Topic 605). The reissued draft was in response to over one thousand comment letters from industry leaders 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), but retain many current construction industry practices.
At a meeting on March 20, 2013, the FASB Board continued their review of the 2011 exposure draft and deliberated certain issues. FASB then tentatively accepted the 2011 exposure draft with some minor modifications. The final standards are expected to be issued in the second quarter of 2013, and will become effective for periods beginning after December 31, 2016 for public entities and December 31, 2017 for private entities.
The June, 2010 exposure draft 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 as the output method (units produced) was recommended.
- 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, including 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.
The 2011 revised exposure draft, along with tentative decisions of the Board during the March 2013 meeting, retained the same core principles, but included many clarifications and revisions. These changes are considered to be major improvements for the construction industry:
- Bundled performance obligations: 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.
- “Input” also important: 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.
- Conservative reporting encouraged: The standard for estimating the value of unapproved changed-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. Additionally, the proposed standard states that entities use judgment in determine when variable consideration is “reasonably assured”. This revision brings the proposed standard more in line with the current standard.
- Disclosure requirements scaled back: Revised revenue recognition disclosures will be required for both public and non-public companies, most of which will be general and qualitative in nature. The requirement of tabular reconciliations of beginning and ending contract information has been eliminated for private reporting entities.
- Warranties handled differently: 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 entities 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.
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 will not be 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 project.
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 been already 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, revenue would be recognized earlier than will be permissible under the proposed standards.
|Example of calculation of revenue and profit where $100 of costs have been identified as "not depicting the transfer of goods or services" at early point in project|
(all project costs)
(certain project costs
|Costs to date||$200
|Total estimated project costs||$1,200||$1,100|
|Total contract amount||$1,500||$1,500|
|Revenue to be recognized||$250||$136|
|Job costs recognized||(200)||(100)|
|Less costs directly expensed||-
|Gross profit (loss) to be recognized||$50||$(64)|
The proposed standard notes three categories of costs that need to be excluded from the calculation:
- 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.
- Costs to obtain a contract will be expensed as incurred. Under this standard, costs to bid a project would need to be expensed rather than included in job costs.
- Direct costs of fulfilling a contract (such as commissions or mobilization costs) are capitalized and amortized if they related 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 2011 exposure draft 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 is onerous. 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. At the March meeting, the board tentatively decided to retain the current standard.
Time Value of Money
The proposed standard includes a provision that 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. The Board tentatively decided to retain this provision, but provided practical exceptions for contracts whose durations are greater than one year, but the time period between performance and payment is less than one year. As a result, most contractors would not be required to adjust revenue for the time value of money.
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” is reported as revenue. Provisions for bad debts based on the impairment of receivables would be presented as a separate line item as an expense on the statement of income. Bad debts expense would no longer be combined with other general & administrative expenses within the statement of income.
Like the storm-chasers in the movie “Twister,” many in the industry have been following the developments closely over the years and got involved to comment on the proposed standards. It is gratifying that this effort has affected positive change. With the results of the March 2013 FASB Board meeting, the final standards are expected to be very 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 – but not expected to be effective before January 1, 2017 at the earliest.