REVENUE RECOGNITION AND IMPLEMENTATION FOR THE CONSTRUCTION INDUSTRY
In May 2014, the Financial Accounting Standards Board (FASB) issued a new standard on revenue recognition after years of drafts, comments, delays and adjustments. The new standard, Accounting Standards Update (ASU) NO. 2014-09, Revenue from Contracts with Customers (ASU 606) will replace the current transaction and industry-based revenue recognition guidance with a principles-based approach that creates comparability across industries and geographies. The standard is effective for periods beginning after December 15, 2017 for public companies and periods beginning after December 15, 2018 for nonpublic companies.
The construction industry, like all industries, will be impacted by the new standard and this impact will extend beyond finance and accounting. Every construction company that reports their financial statements under Generally Accepted Accounting Principles (GAAP) will need to implement the new standard within the accounting function affecting their internal controls, systems and processes. It significantly impacts a construction company as new terminology and concepts could affect the way contracts are structured, jobs are estimated, costs are tracked, and revenue is calculated. While the percentage of completion method of recognizing revenue on long-term contracts has been maintained under the new standard, many nuances of ASU 606 will require evaluation.
Public companies are already complying with the new standard, but most nonpublic calendar year end companies will be required to reflect the changes in their December 31, 2019 financial statements. While that may seem like a long way off, those companies that have not yet begun to address their implementation may have fallen behind. As long-term contracts by definition run from one year to the next, nonpublic construction companies will need to implement and track the impact of the new standard on their December 31, 2018 contracts in progress for when they prepare their December 31, 2019 financial statement. Therefore, it is important to have an implementation plan in place now to evaluate the impact on your company.
ACCOUNTING STANDARDS UPDATE NO. 606 – REVENUE FROM CONTRACTS WITH CUSTOMERS
The new standard requires companies to recognize revenue when promised goods or services are transferred to customers, in the amount of consideration to which the company expects to be entitled. The FASB has outlined a 5-step process that companies should follow to comply with the standard.
Step 1 – Identify the contract with a customer
In order to be identified as a contract, an agreement must contain the approval and commitment of the involved parties, identify the rights of the parties, identify the payment terms, have commercial substance, and collection must be probable. The construction industry dictates that contractors be very familiar with contracts. The new revenue recognition standard will require management to make additional judgements on each contract.
Step 2 – Identify performance obligations in the contract
After identifying the contract, a company needs to evaluate the contract terms to determine whether the goods or services to be provided represent single or separate and distinct performance obligations. Making this determination requires a degree of judgement. The guidance provides that goods or services are distinct if they are capable of being distinct in that the customer can benefit from that good or service and are distinct in the context of the contract in that they are separately identifiable.
Step 3 – Determine the transaction price
Determining the transaction price can be easy in most industries, but not construction. Variable considerations that are inherent in most construction contracts add to the complexity of determining a transaction price. The challenge is how much of the variable consideration to include in the transaction price. The guidance provides for two methods to estimate variable consideration with the goal being to avoid a significant reversal in the future.
Step 4 – Allocate the transaction price to the performance obligations
The total transaction price is then allocated to each distinct performance obligation on a relative standalone selling price basis. This will require the use of observable market data and one of three allowable estimation methods. Most contractors will likely utilize the “expected cost plus margin” approach as it mirrors the estimation and bid process.
Step 5 – Recognize revenue
Revenue is to be recognized when or as the company satisfies a performance obligation which can be at a single point in time or over time. A contractor recognizing revenue over time will utilize input or output methods for measurement of progress towards satisfaction, which are reasonably consistent with current GAAP.
ISSUES IMPACTING THE CONSTRUCTION INDUSTRY
While this 5-step process may seem straight forward, the nature of the construction industry provides for many nuances in the application of ASU 606. As revenue is usually the single largest line item in every contractor’s financial statement, the impact could be significant. Some of the key issues that construction companies need to be aware of and whose impact can be evaluated are variable consideration, combining contracts, uninstalled materials, inefficiencies and waste, and fulfillment costs. While there are many other issues, these are the areas that will be the focus of this article.
Variable consideration is inherent in most construction contracts and include items such as performance bonuses/penalties, liquidating damages, unapproved/unpriced change orders, claims, shared savings and non-cash considerations. Contractors will need to estimate the amount of variable consideration to include in the contract amount utilizing a method that best predicts the amount of variable consideration that will be realized. The guidance provides for two methods to estimate variable consideration: the expected value method and the most likely amount method.
The expected value method is a probability weighted amount that results from considering a range of possible outcomes. It is most appropriate when each point in the range has the potential to be the result. The most likely amount method is the single most likely amount in a range of possible outcomes. It is most appropriate when only two possible outcomes exist. Estimating the amount of variable consideration to include in the transaction price represents a change from the relatively straightforward guidance from the past and will require more effort, coordination and documentation within the company.
The combining of contracts is another nuanced change under ASU 606. Under the new standard, the combining of contracts is required if certain conditions are met rather than being optional under the existing standards. Two or more contracts will be required to be combined if the contracts are entered into at or near the same time with the same customer and one or more of the following conditions are met: 1) The contracts are negotiated as a package with a single commercial objective; 2) the amount of consideration to be paid in one contract depends on the price or performance of the other contract; 3) the goods or services promised in the contracts are a single performance obligation. The fact of negotiating multiple contracts at the same time does not necessarily demonstrate that the contracts represent a case requiring combination. A typical scenario for combining would occur when a contractor prices a second contract based on efficiencies or savings earned from a first contract.
ASU 606 also provides guidance on the treatment of uninstalled materials when a contractor utilizes the input method to determine progress in satisfying a performance obligation (ie: cost-to-cost method of percentage of completion). The guidance provides that an adjustment to the percentage of completion calculation may be required when a cost incurred is not proportionate to the contractor’s progress in satisfying the performance obligation. When materials are delivered to the job site but have not yet been installed, a cost is incurred but progress in satisfying the performance obligation has not. This could lead to revenue being recognized prematurely. The adjustment under the new standard would be that revenue would only be recognized to the extent of the cost of the uninstalled material, that is, no profit on the materials would be recognized until installed.
Another area that should be reviewed for items not contributing towards progress of satisfying the performance obligation is inefficiencies and waste, as the standard also states that an adjustment to measure progress may also be required when a cost incurred does not contribute to the contractor’s progress in satisfying the performance obligation. Labor inefficiencies, delay costs, defective materials, and rework costs are all legitimate costs that a contractor may incur on a job but not contribute towards the progress. These costs incurred would be required to be expensed but excluded from the percentage of completion calculation under the cost-to-cost input method. The impact would be a lower percent complete and less revenue and gross profit recognized.
These items present challenges in that they will need to be factored out of the percentage of completion calculation and therefore will need to be tracked separately. They will also require judgement in determining what does and does not contribute to progress in satisfying the performance obligation.
Incremental and fulfillment costs also represent a change from current accounting practices as the new standard dictates that the incremental costs of obtaining a contract or costs incurred in fulfilling a contract will need to be capitalized when incurred and amortized over the life of the contract. Costs such as design costs, mobilization costs, bond premiums and set-up costs will no longer be expensed as incurred and factored into the percentage of completion calculation for progress. Instead, the costs will need to be capitalized on the balance sheet and amortized to the job over the life of the contract. Such costs may be expensed as incurred if the amortization period is one year or less.
All of these items and more represent potentially significant changes in the way contractors calculate and recognize their revenue. Considering this and all the areas of a construction company’s operations that will be impacted, it is important to put an implementation plan in place to fully evaluate and assess the impact on your company.
Any implementation plan should start with identifying the key stakeholders that use and rely on a company’s financial statements or will be impacted by the changes in the new standard. These stakeholders could include owners, CFOs/controllers, project managers, estimators, sureties, bankers, lenders or agencies. Think about how the changes in the timing and amount of revenue recognized will impact debt covenants, bonding capacity, and compensation arrangements. It is essential that communication with these key stakeholders be early and consistent to ensure they are aware of the coming changes to the financial statements. Proactive communication can help ensure a successful transition.
Communication with internal staff is also essential as ASU 606 will require changes in processes and controls that the staff will need to implement. These internal changes within the company’s internal controls will take time and effort to implement and effective communication and planning will help to successfully carry out the changes necessary to adopt the new standard.
It is best to start by putting together a cross-functional team to brainstorm, develop and implement a plan. The team should be assigned a leader and should include representatives from throughout the organization and not just accounting (ie: finance, accounting, IT, legal, estimating, project management, executive management). Many areas of a company will be affected and having individuals to voice those different perspectives will help assess the full impact of implementation.
The team should start in gaining an understanding of the scope of the changes and the effect on the company by understanding the new standard. They should then identify the company’s main types of contracts and revenue streams. Each type of contract/revenue stream should be evaluated for the impact of the changes and the effect it will have on operations. Existing procedures and controls should be assessed to determine what changes are needed and a new process should be developed based on the 5-step process for each contract type/revenue stream to ensure they adhere to the new standard.
As mentioned above, the standard is effective for periods beginning after December 15, 2017 for public companies and periods beginning after December 15, 2018 for nonpublic companies. Early implementation is permitted (although there is no advantage to doing so), which many public companies have done. Most nonpublic calendar year end construction companies will implement the new standard on their December 31, 2019 financial statements.
FULL RETROSPECTIVE METHOD VS. MODIFIED RETROSPECTIVE METHOD
ASU 606 requires retrospective application and allows for two options to apply: the full retrospective method or the modified retrospective method. Both choices can be time consuming and each has its trade-offs.
The full retrospective method requires companies to apply the standard to all contracts presented in the financial statements as if the standard has been in effect since the inception of the contracts and would include contracts completed in that year end. When presenting calendar year 2019 and 2018 in comparative financial statements, 2018 would need to be restated using the new standard. The modified retrospective method requires companies to apply the standard to the most current period presented in the financial statements, with an adjustment to beginning retained earnings as of the date of initial application to recognize the cumulative effect of the new standard. When presenting calendar year 2019 and 2018 in comparative financial statements, the opening 2019 retained earnings would include a catch-up adjustment and 2018 would not be restated.
Regardless of the transition method, the standard must be applied to prior years job activity reflected in the initial statement under the new standard.
Yes, there are going to be changes in the way your construction company recognizes revenue. The impact could be more significant to some segments of the industry than others, but you will not know until you put an implementation plan in place and fully assess that impact. At the very least, there will be additional disclosure requirements in your financial statements that will require disaggregation of revenues and qualitative information about performance obligations. For years the industry has been saying that change is coming. Change is here, start your implementation now.
For any questions on the new revenue recognition standards and what they mean to your construction business, feel free to reach out to a Sax advisor at (973) 472-6250 or visit www.saxllp.com.
W. Michael Curry, CPA, CCIFP is Partner-in-Charge of Sax’s New York City office and a vital member to the firm’s Construction Practice. Michael has decades of experience with general contractors including civil, interior, heavy-highway and site work contractors, subcontracting and specialty trades, construction equipment, and leasing companies. Michael can be reached at [email protected]