IASB Chairman, Hans Hoogervorst, indicated that the two Boards have not only improved the revenue recognition requirements of both U.S. GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards), but managed to achieve one fully converged standard.
Previous revenue recognition guidance in U.S. GAAP was comprised of more than 100 broad revenue recognition concepts together with numerous revenue requirements for particular industries or transactions (including all existing construction specific revenue and cost guidance). This sometimes resulted in different accounting for economically similar traditions. IFRS on the other hand provided limited guidance and was difficult to apply in complex transactions. Accordingly, the two Boards initiated the joint project to clarify principles for revenue recognition and have now developed a common revenue standard for both U.S. GAAP and IFRS. This new standard applies to contracts with customers other than those within the scope of other standards, such as leases, insurance, financing arrangements, financial instruments, and guarantees (other than product or service warranties). Additionally this standard does not apply to other parties to a contract who are not customers.
To meet the objectives identified by the joint boards, the FASB amended FASB Accounting Standards Codification and created a new Topic 606, Revenue from Contracts with Customers. The IASB issued IFRS 15, Revenue from Contracts with Customers.
The challenge faced by users of this guidance will be achieving a successful understanding and transition to this new standard. For U.S. public companies, the standards will take effect for annual reporting periods ending after December 15, 2016, including interim periods within (2017 calendar year filers). For nonpublic companies in the U.S., the standard takes effect for annual reporting periods beginning after December 15, 2017 and interim periods within (2018 calendar year reporting companies). A nonpublic entity may elect to apply the guidance earlier than the effective dates, however, no earlier than the public company effective date.
For those companies using IFRS, the standard will be applied for reporting periods beginning on or after January 1, 2017. Early application is permitted for companies that use IFRS.
Under the new standard, companies will recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the payment to which a company expects to be entitled to in exchange for such goods or services (“transaction price.”) The new guidance utilizes a contract-based approach that places the focus on the assets and liabilities that are created when an entity enters into, and performs, under a contract. The standard will also require additional disclosures and provide more comprehensive guidance for transactions such as service revenue and contract modifications. Under the new standards, companies will be required to transition to the new standard by one of two approaches: 1) upon adoption, restate prior periods presented in comparative financial statements or 2) upon adoption, on the effective date apply to existing contracts in progress and new contracts going forward. Approach #2 will require a cumulative effect adjustment to opening retained earnings and certain transitional disclosures but prior periods would not have to be restated.
An entity should recognize revenue to depict the transfer of promised goods or services to customers in amounts that reflect the consideration to which the entity expects to be entitled, in exchange for those goods and services.
There are five steps to complying with this core principle:
On the surface, the five step process does not seem overly complex and appears to include much of what is currently done in practice to determine revenue recognition. One challenge to the process lies in the significant judgments that will be required by entities’ management and their auditors in applying the underlying principles included in the new guidance. Currently, the concept or evaluation of “risk and reward” often drives the determination of revenue recognition. This will remain an important consideration under the new guidance but it will no longer be the main determinant. Instead, the transfer of “control” to the customer will be the driving determinant in evaluating the appropriateness of revenue recognition.
The new guidance also specifies the accounting treatment for certain costs to obtain or fulfill a contract with a customer.
Now, how will this impact the construction & engineering industries? GAAP had carved out specific construction industry guidance in the 1955 AICPA Accounting Research Bulletin (ARB) No. 45, Long-Term Construction Type Contracts and the 1981 Statement of Financial Position (SOP) 81-1(now ASC Topic 605-35), Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The AICPA’s Accounting & Auditing Guide “Construction Contractors” is also a well-used publication. Under IFRS this guidance is included in International Accounting Standards 11, Construction Contracts. Well guess what? These references will be eliminated and replaced by the new standard. Don’t worry; the percentage of completion method for long-term construction contracts has survived, as has the cost-to-cost method for estimating percentage complete but the term “completed contract method” will no longer exist. Additionally the AICPA has established 16 industry task forces to develop new accounting guides including the Engineering & Construction Task Force and Aerospace & Defense Task Force. However, there are some new challenges that construction industry will have to address. Let’s address these as we discuss each of the above 5 steps in the new standard.
Assuming a contract is legally binding, the dollar amount does not have to yet be identified; however, it must ultimately be collectible. Matters such as commercial substance, approval by both parties, identifiable rights regarding assets to be transferred and identifiable payment terms are not new to the construction industry. Additionally, contracts can be combined for financial reporting purposes if they are negotiated with a single commercial objective such as a large development project with many moving parts and the consideration of one contract depends on the other contract in which the goods or services are considered a single performance obligation. See Step #2 below; however, be careful in that contract modifications may be considered a new contract for revenue recognition application if there are distinct services or goods that are valued at stand-alone selling price. If the goods/services are not distinct then the modifications are accounted for with the original contract similar to old standards. For instance, you have been hired to construct a school. During the performance of your contract, you are asked to build a pedestrian bridge over a creek on the school grounds. This modification would most likely be accounted for as a new contract under the new revenue standards and therefore have to be accounted for separately. As a result, more paperwork and organization will be required in the field. Oh yeah, be careful when you drive the backhoe from the school construction site to the bridge construction site and have to account for that properly between jobs.
However in building the school, is the site work, foundation, framing, etc. all accounted for as separate contracts for revenue recognition? What about a design/build contract consisting of engineering, soil sampling, procurement of materials, excavation, foundation and overall project management? Now are you scared? Well don’t be! This is because the promise to deliver a good or service (a performance obligation) is only separately accounted for if it is distinct in which the customer can benefit from the goods/service on its own (stand-alone basis) and the goods/service is separable from other goods/services in the contract. Well, there is your out! Most construction contracts will not be deemed to have more than one performance obligation since the goods/services are highly interdependent and interrelated, the entity provides significant integration services and the goods/services significantly modify or customize other goods/services in the contract. However, the following may be examples of contacts that could have more than one performance obligation:
We recommend that construction entities prepare a brief analysis of its contracts noting that combining contracts and separate performance obligations have been considered and documented for compliance with the new standard. Your CPA firm will love you for this!
Determining the transaction price, which is the amount of consideration to which an entity expects to be entitled to receive in exchange for transferring goods/services, is reassessed at the end of each reporting period. Areas of challenges under the old and new standards include variable consideration such as awards, incentive payments, customer furnished materials, liquidated damages, claims and un-priced change orders. In order to recognize variable revenue under the new standard you must be able to estimate the expected value by either using a probability-weighted method (such as in evaluating uncertain tax positions) or the most likely amount (“best estimate”). Additionally one qualitative constraint to recognition is that the additional revenue estimated must be probable that a significant reversal of it will not occur (“reasonably assured”) upon being resolved. Thus variable revenue consideration under the new standards may allow for contractors to recognize more income than under the old standards. For instance under old standards un-priced change orders could be recognized as revenues with a profit if the recovery was probable and reasonably estimable. Under the new standard amounts are recognized if the contractor expects the price will be approved and the significant reversal constraint is overcome. Claims and unapproved change orders under old standards were recognized when probable and estimable but only to the extent of costs incurred. Under the new standard you can recognize a profit on the claim by including it in the transaction price if you can document that the expectation is it will be received and you can overcome the significant reversal constraint.
Step 3 also requires the contractor to evaluate the time value of money and calculate discounts if there is a significant financing component (receivable or payable) and period between payment and performance is greater than a 1 year expectation at inception or contracts greater than 1 year long. Are you looking worried and wondering about retainages? Well don’t be. While retainages will depend on contract terms and normal practices, it is usually intended to protect the customer and is typically not a form of financing. The companies who are members of a Private – Public Partnership or extremely large projects may need to dig a little deeper into the time value of money concept.
In order to allocate the transaction price to the separate performance obligations in the contract the contract price would be allocable to the performance obligations pro-rata based on the stand-alone selling price of each. The best evidence of a stand-alone selling price is the observable price of a good/service when sold separately. For example using the school/field example above, the total contract price is $50M but the school portion alone is $45M value and the field is $10M value on its own, thus a packaged discount of $5M. The $50M contract would then be allocated as 81.8% school and 18.2% field. The job costing system would have to account for these jobs separately to make the tracking easiest. Same for billings. Software vendors may need to make it easier to prorate vendor costs and customer invoices between jobs during the inputting; and time records and equipment costs would need to be charged by performance obligation and not by contract. Ouch!
Revenue is recognized over a period of time when the customer receives a benefit a) as the services happen, b) that enhances an asset that the customer controls or c) that does not create an asset with alternative use but there is a payment right for services to date. Typical examples may be a) building maintenance contractor, b) GC building on land owned by customer and c) environmental consultant, engineer or architect. Similar to old standards, progress is measured towards completion based on input or output methods such as costs incurred, labor hours, machine hours, or units delivered and surveys. When using inputs contractors must exclude those that do not depict performance such as inefficiencies, customer provided materials and uninstalled materials.
Recognizing revenue at a point in time is done when control doesn’t transfer over time and the criteria above are not met. This method is not expected to be relevant to construction contracts because the contractor has rights to payments during construction, the customer routinely accepts work performed to date and that work is transferred to the customer via the contract, and the customer maintains significant risks, rewards and legal title to the assets over time. However, further evaluation is needed for homebuilders who build developments on land they own when a customer has been identified for the homes built or to be built.
Common in the construction industry is the delivery of materials (not specifically produced or fabricated for the project) to job sites that sit uninstalled and are therefore not reflective of contract progress or ownership transfer to the customer. As in the past these costs are not included as costs to date for measuring percentage complete but instead are recorded as revenue up to costs of the uninstalled materials. Under the new standard when control of the materials transfers upon delivery to the customer and not installation a contractor must inventory the equipment prior to the delivery and not reflect the costs as performance (job) costs. Example, a Company that specializes in building manufacturing facilities in which the contract includes specialized/customized equipment as part of building the facility in which equipment ownership is transferred to the customer upon delivery and not installation. Under this scenario revenue would be recognized only up to costs incurred when the equipment is delivered to the customer. Additionally the customized equipment may be deemed a separate performance obligation to be accounted for separately under the percentage of completion method as the equipment is installed.
Accruing a provision for losses when contract performance obligations are more than the transaction price is performed similar to old standards. However, given the differences in recognizing variable revenues described in Step 3, these accrued losses may be less under the new standard even if the claim revenue is not yet recognized. For example your construction company is suffering a substantial loss on a performance obligation due to customer imposed delays and you must accrue future estimated losses on uncompleted work. The Company has calculated a delay claim (variable revenue) but does not believe it can be recorded and recognized under the new recognition thresholds (Step #3). However, The Company increases the transaction price (original contract price) by the amount it “expects to be entitled to”. This may defer a portion or all of the loss based on the percentage of completion calculation because the contract price is being increased by some or all of the cost overruns. Your auditors may challenge you in this area so document accordingly and be up front during the audit planning.
Other matters impacting the construction and engineering industries by the new standard relate to incremental costs to obtain a contract and contract fulfillment costs. Incremental costs to obtain a contract are those costs the entity would not have incurred if the contract was not obtained, such as bidding and pre-engineering costs. Direct contract fulfillment costs such as mobilization and other preconstruction costs are those costs incurred once a contract is awarded (or specifically anticipated). Direct contract fulfillment costs would be capitalized and amortized to job costs over the life of the contract (as control transfers) based on percentage complete if the costs are expected to be recovered and used to satisfy performance obligations in the future. These costs are expensed if amortization period is less than one year or they don’t relate to a specific contract to provide future performance or they may not be recoverable such as when a contract has an estimated loss (asset impairment). As a result most incremental costs of obtaining a contract would be expensed as incurred unless those costs are anticipated to be reimbursed by the customer even if the contract is not obtained.
Well, hopefully this article does a good job at explaining the 5 steps outlined above and their applicability to the construction & engineering industries. Many may interpret the 150 page FASB update Topic 606 differently so guidance and industry practices will become important references. To wrap up, the below are some additional closing comments:
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