JUNE 2012: 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 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.
The revised exposure draft retained the same core principles, but included many clarifications and revisions. 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.
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.
Example of calculation of revenue and profit where $100 of costs have been identified as "not depicting the transfer of goods or services" at early point in project
(all project Costs)
Proposed Standard(certain project costs excluded)
|Costs to date||$ 200||$ 100|
|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||-||(100)|
|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 shall be expensed as incurred. Under this standard, costs to bid a project would need to be expensed.
- 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|
|Less Provision for Doubtful Accounts||$ (200)|
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.