As a new year begins, it means that we are one year closer to the implementation dates of the new standards on revenue recognition and lease accounting standards, ASU-2014-09 – Revenue from Contracts with Customers (“RFCWC”) and ASU 2016-02 – Lease Accounting (“Leases”), respectively.
Revenue from Contracts with Customers
These two updated standards will have a multitude of effects on many industries, and the construction and architectural and engineering industries are no exception. Although these standards aren’t effective for current year financial statements, it’s best to have an understanding of them now, to avoid any confusion when dealing with the future adoption of them.
Prior to the release of RFCWC, we became accustomed to using the percentage of completion method of revenue recognition for companies that have long-term construction or design contracts. This method gave those entities the ability to recognize revenue on an ongoing basis for as long as the contract was active. Using the cost-to-cost method, comparing the amount of actual expenses to estimated costs to complete gave then a reasonable estimate on how far along the contract was. Early interpretations of the new guidance scared many contractors and design professionals into believing that they would no longer be able to use the percentage of completion method. Upon further analysis of the new standard, it has been determined that it is not necessarily the case.
When RFCWC becomes effective, all existing revenue recognition and industry-specific guidance will be eliminated and replaced with a principles-based approach for determining revenue recognition. It will also increase the necessary disclosures required for financial statement footnotes. As overwhelming as this may seem, let’s first look at the core principle behind the new standard as well as the five-step model for accounting for revenue recognition to achieve the core principle of revenue recognition.
The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve this, an entity should apply the following steps:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
So what does this all-encompassing standard mean for the construction and architectural and engineering industries? For one, it means that the company’s management must review each contract on their work-in-process schedule in order to properly identify information that will help them satisfy these five steps. Although steps 1 and 3 may be easy to identify, step 2 is the crux of the revenue recognition standard.
Identifying the performance obligations of each contract will tell us how and when they should recognize revenue on long-term contracts. According to RFCWC, a performance obligation is a promise outlined in a contract with a customer to transfer a good or service to the customer. If an entity promises to transfer more than one good or service, then the entity should account for each promised good or service as a performance obligation as long as the good or service is distinct. It is this area where management will need to exercise significant judgment to distinguish each performance obligation within a contract along with how those obligations are satisfied.
So what does this mean for an entity that has a contract to construct a warehouse for a customer whereas the only performance obligation is the completion of that warehouse? This is where step 5 will bring us back, once again, to the percentage of completion method of accounting. Step 5 of the new standard explains that for each performance obligation, an entity should determine whether the entity satisfies the performance obligation (noted in step 2) over time by transferring control of a good or service over time. The standard goes further to explain that an entity transfers control of the goods or service over time provided that one of the following three criteria is met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- The entity’s performance creates or enhances an asset (work in process) that the customer controls as the asset is created or enhanced.
- The entity’s performance does not create an asset with the alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
As seen in the second criteria, enhancing an asset that is still under the customer’s control will allow the contractor building the warehouse to recognize the revenue of that job over time since they do not have control of the asset they are enhancing. They are then allowed to use either the input or output method to recognize their revenue. Under the output method, progress is based on the direct measurement of values transferred to the customer such as units produced. Under the input method, progress is measured by the company’s efforts to satisfy the performance obligation (i.e. the cost-to-cost method). The latter method is basically a mirror image of the percentage-of-completion. This should make transitioning to the new revenue rules much easier for some of our contractor clients.
AFC WC is effective for public entities for periods beginning after December 15, 2017 (Calendar years 2018). For all other entities, it is effective for periods beginning after December 15, 2018 (Calendar 2019). In the year of transition, the company can restate the prior years’ results, if comparative financial statements are presented, or they can report the cumulative effect of the adoption at the initial date of the adoption if one-year financial statements are presented. Using either of these methods, companies will need to begin to calculate revenue under RFCWC the year before they adopt the new accounting standards so that they have the prior year information under the new standard when it is adopted.
Leases
Unlike the new revenue recognition standards, leases will significantly change the way construction and architectural and engineering companies will account for them. It’s a topic that should be discussed by the management of these companies as soon as possible so that they can begin to prepare for a major change in the accounting for leases, both operating and financing. These changes will impact a company’s financial statements, including the footnote disclosures. In addition, management will need to evaluate the potential effect that the new accounting for leases may have on loan covenants and allowable costs used in the computation of overhead rates in certain contracts.
Under current accounting standards, leases may be accounted for in one of two ways which we are very familiar with. One is a capital lease which is recorded on the company’s balance sheet as both an asset to use and a liability. That lease will only be defined as a capital lease should it satisfy any of the following criteria:
- If the lease life exceeds 75% of the life of the asset.
- If there is a transfer of ownership to the lessee at the end of the lease term.
- If there is an option to purchase the asset at a “bargain price” at the end of the lease term.
- If the present value of the appropriately discounted rate exceeds 90% of the fair market value of the asset.
If the lease terms do not satisfy just one of those criteria, the lease will be deemed an operating lease and recorded through the company’s income statement.
The new lease standard takes effect for nonpublic entities whose fiscal years beginning after December 15, 2019 (Calendar 2020), and it will eliminate the existing accounting standards. The new standard states that any lease which carries a term of over 12 months must be classified on the entity’s balance sheet as a right to use the asset and with a corresponding liability for the obligation to pay. The new standard also defines how a company should determine the lease term of the underlying assets when the lessee calculates the value of the right-to-use asset and the corresponding liability. The right-to-use asset will also need to be discounted to its present value using either an interest rate implicit in the terms of the lease or the lessee’s incremental borrowing rate. Companies which also have leases with terms under 12 months will still be able to record those leases in the same way that operating leases are accounted for through rent expense payments on their statement of income.
This new standard will significantly change a company’s balance sheet by now including assets and corresponding liabilities for all leases with terms in excess of 12 months. More importantly, this will also significantly impact various financial covenants for companies with outstanding loans from financial institutions. It may also affect the allowable costs which a company may include when they compute their overhead rate for certain contracts. Although this standard will not be effective for a couple of years, company management should start discussing the impact of the lease standard on the company’s financial statements sooner rather than later.
Conclusion
Although the implementation dates of these new accounting standards are a couple of years away, management of construction companies, and architectural and engineering firms should start to do their homework, if they haven’t already started, relating to their adoption of the Revenue Recognition and Lease Accounting standards. Their homework assignment should include:
- A preliminary assessment of the impact of both standards.
- Review “contract” language and consider if modifications are necessary or desired.
- Review the terms of all of the existing leases, especially operating leases.
- Review your current accounting policies and software systems.
- Review debt covenants
- Review regulators’ financial requirements (including pre-qualification requirements).
- Remember that transitions to both of the new accounting standards will require retrospective adjustments to previously issued financial statements.
Michael Pahira, CPA | [email protected] | 731 842 3113
Paul Kuhl, CPA, CITP, CGMA | [email protected] | 609 520 1188
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