Guidance on Revenue Recognition and impact on construction
On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) (collectively the Boards) issued new standards on revenue recognition. The construction industry provided significant feedback to the Boards that was taken into account in Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts with Customers, and the IASB's standard was issued as IFRS 15. While the new standard will replace virtually all existing guidance for revenue recognition and supersedes construction specific industry standards under existing US GAAP and IFRS, the majority of contractors will not have to completely overhaul how they account for contract revenue. There will, however, be significantly greater disclosures providing information about construction contracts with customers and the judgments made in accounting for those contracts.
In current US GAAP there are frequent inconsistencies in the revenue recognition requirements for specific transactions. Over the years the Boards have issued industry specific guidance which has resulted in different accounting for economically similar transactions to respond to these inconsistencies. The primary objective of the Boards' joint revenue project was to clarify the principles for recognizing revenue and to develop converged standards under US GAAP and IFRS.
The Boards believe the new standards will "improve financial reporting by creating common revenue recognition guidance for U.S. GAAP and IFRS that clarifies the principles for recognizing revenue and that can be applied consistently across various transactions, industries, and capital markets."
The Main Provisions
The new guidance will impact all entities that enter into contracts with customers to transfer goods or services or nonfinancial assets unless those contracts are within the scope of other non superseded existing US GAAP (for example, insurance contracts or lease contracts).
The core principle of the ASU 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.
Entities applying the new ASU to contracts will follow five steps:
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
When entities apply the primary steps above, the ASU may involve even more significant amounts of judgment and estimates than were not previously required under current guidance.
Application to the Construction Industry
Under current accounting for construction contracts, revenue recognition is accounted for using two basic methods: (1) the percentage-of-completion method where revenue, costs, and profits are recognized each accounting period as the contract progresses to completion (using the input or output methods such as cost-to-cost to measure performance), or (2) under the completed-contract method where revenues, costs, and profits are deferred until the project is substantially complete. In addition, accounting standards developed over time to address industry specific aspects of long-term construction contracts can include guidance for change orders and other contract modifications, combining or segmenting construction contracts, and guidance for identifying the contract price and any variable consideration.
The new ASU on revenue recognition will supersede and replace the existing accounting guidance for construction contracts including commonly applied methods such as the percentage-of-completion method.
What Does CohnReznick Think?
Current accounting guidance for long-term construction contracts is prescriptive and includes specific terminology and guidance for the construction industry. Contrast that with the new revenue standard which is a single standard – written to create consistent revenue recognition across multiple industries and transactions (more of a principle based standard). While much of the construction industry specific guidance and terminology will be replaced and we have some concerns about the new standard's impact, we believe the fundamental accounting for long-term construction contracts will remain fairly consistent with current practice. The way contractors assess and evaluate contracts under the new standard will change as well as how construction companies can recognize variable consideration (see below) related to claim income and unapproved change orders. Significant additional financial statement disclosures will be required. But the final standard, unlike the earlier drafts, is a standard the construction industry can work with.
Below we highlight certain key aspects of the new revenue standard related to construction contracts including combining contracts, the pattern of revenue recognition, contract modifications and change orders including variable consideration, and the recognition of contract assets and liabilities. The new revenue standard also contains guidance on many other revenue related issues that occur in construction contracts that will need to be evaluated as part of the implementation of the new standard, including, but not limited to, accounting for pre-contract costs and costs to fulfill a contract, accounting for loss-making contracts, customer furnished materials, claims, time value of money, and the accounting for warranties.
The new revenue standard will require entities to combine two or more contracts with the same customer into a single contract if the contracts are entered into at or near the same time and if they meet one or more of the following requirements:
- The contracts are negotiated with a single commercial objective
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract
- The goods or services promised in the contracts are a single performance obligation
The requirement to combine contracts is generally consistent with the underlying principles in current accounting guidance. As a result, the assessment of combining contracts is not expected to change significantly. It is important to note that the new standard is silent regarding segmenting. However, while the new standard may not have specific guidance on segmenting contracts, entities segmenting contracts under current guidance may not be impacted due to the new standard's requirement to account for separate performance obligations. As a result, entities may reach similar conclusions about segmenting contracts as they do under today's guidance.
Current revenue recognition for the construction industry is generally based on the activities and performance of the contractor, assuming reasonable estimates are available. Under the new standard, revenue is recognized when the contractor satisfies performance obligations which occurs when the control of either goods or services are transferred to the customer. Entities will either select an input or output method (such as cost-to-cost) to measure the progress toward satisfaction of the performance obligation. In addition, transfer of control to a customer can occur either over a period of time or at a single point in time. For the construction industry transfer of control generally occurs over a period of time and therefore applying the new standard to construction contracts may result in a similar revenue recognition pattern as under existing GAAP. However, construction contractors should be mindful of the specific criteria required by the new standard to recognize revenue over time. Those criteria are the existence of one of following: 1) "The customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs." 2) "The entity's performance creates or enhances an asset... that the customer controls as the asset is created or enhanced.", or 3) "The entity's performance does not create an asset with an alternative use to the entity... and the entity has an enforceable right to payment for performance completed to date." One or more of these three criteria must be met in order to recognize revenue over time, if not then recognition at a point in time will be required.
The following example is from the new revenue standard and provides an overview in applying the ASU to construction contracts:
Example 8 — Modification Resulting in a Cumulative Catch-Up Adjustment to Revenue1
An entity, a construction company, enters into a contract to construct a commercial building for a customer on customer-owned land for promised consideration of $1 million and a bonus of $200,000 if the building is completed within 24 months. The entity accounts for the promised bundle of goods and services as a single performance obligation satisfied over time in accordance with paragraph 606-10-25-27(b) because the customer controls the building during construction. At the inception of the contract, the entity expects the following:
Transaction price $ 1,000,000
Expected costs $ 700,000
Expected profit (30%) $ 300,000
At contract inception, the entity excludes the $200,000 bonus from the transaction price because it cannot conclude that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Completion of the building is highly susceptible to factors outside the entity's influence, including weather and regulatory approvals. In addition, the entity has limited experience with similar types of contracts.
The entity determines that the input measure, on the basis of costs incurred, provides an appropriate measure of progress toward complete satisfaction of the performance obligation. By the end of the first year, the entity has satisfied 60 percent of its performance obligation on the basis of costs incurred to date ($420,000) relative to total expected costs ($700,000). The entity reassesses the variable consideration and concludes that the amount is still constrained in accordance with paragraphs 606-10-32-11 through 32-13. Consequently, the cumulative revenue and costs recognized for the first year are as follows:
Revenue $ 600,000
Costs $ 420,000
Gross profit $ 180,000
In the first quarter of the second year, the parties to the contract agree to modify the contract by changing the floor plan of the building. As a result, the fixed consideration and expected costs increase by $150,000 and $120,000, respectively. Total potential consideration after the modification is $1,350,000 ($1,150,000 fixed consideration + $200,000 completion bonus). In addition, the allowable time for achieving the $200,000 bonus is extended by 6 months to 30 months from the original contract inception date. At the date of the modification, on the basis of its experience and the remaining work to be performed, which is primarily inside the building and not subject to weather conditions, the entity concludes that it is probable that including the bonus in the transaction price will not result in a significant reversal in the amount of cumulative revenue recognized in accordance with paragraph 606-10-32-11 and includes the $200,000 in the transaction price. In assessing the contract modification, the entity evaluates paragraph 606-10-25-19(b) and concludes (on the basis of the factors in paragraph 606-10-25-21) that the remaining goods and services to be provided using the modified contract are not distinct from the goods and services transferred on or before the date of contract modification; that is, the contract remains a single performance obligation.
Consequently, the entity accounts for the contract modification as if it were part of the original contract (in accordance with paragraph 606-10-25-13(b)). The entity updates its measure of progress and estimates that it has satisfied 51.2 percent of its performance obligation ($420,000 actual costs incurred ÷ $820,000 total expected costs). The entity recognizes additional revenue of $91,200 [(51.2 percent complete × $1,350,000 modified transaction price) — $600,000 revenue recognized to date] at the date of the modification as a cumulative catch-up adjustment.
Contract Modifications and Change Orders
The ASU contains specific guidance around contract modifications, including unapproved modifications. The parties to construction contracts frequently agree to modify the scope or price of a contract. Section 606-10-25-12 through 13 of the new standard contains guidance around contract modifications, which is generally consistent with the current guidance for contract modification under ASC 605-35.
Under the new ASU, if a construction contract is modified the contractor must determine whether the modification creates a new contract or whether it should be accounted for as part of the existing contract. As discussed above, the conclusions around combining contracts under the new standard are not expected to significantly impact current practice for the construction industry as most construction contracts are viewed as a single performance obligation (the contract and modifications are negotiated with a single commercial objective – e.g. to build a building).
The new guidance defines a contract modification as "a change in the scope or price (or both) of a contract that is approved by the parties to the contract. In some industries and jurisdictions, a contract modification may be described as a change order, a variation, or an amendment. A contract modification exists when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract." The new standard also states "a contract modification could be approved in writing, by oral agreement, or implied by customary business practices."
A construction contractor will account for a contract modification if the parties to the contract approve a change in the scope and/or price of a contract. If the contract modification is a change in the scope but the corresponding change in price has not yet been determined (e.g. an unpriced change order), then the contractor should estimate the change to the contract price as variable consideration.
Unpriced Change Order Example
A general contractor enters into a construction contract to build a sports stadium, which is considered to be a single performance obligation (building the stadium). The contractor has a history of executing unpriced change orders. It is not uncommon for the contractor to begin work related to change orders after the contractor and customer agree to the scope of the change, but prior to the price being agreed to. Based on the background information, when could the contractor include the unpriced change orders in contract revenue?
In this example the contractor determines that the change order is not a separate contract because the remaining goods or services, including the change order, are not distinct and are part of a single performance obligation that has already been partially satisfied.
Also, since the contractor has a history of executing unpriced change orders, the contractor might conclude that it expects the price of the change order to be approved. As such, once the scope of the change order is approved the unpriced change order would be accounted for as variable consideration and the contractor should update the transaction price to include the change order and record a cumulative catch-up adjustment based on the measurement of progress towards completion of the contract (see Example 8 — Modification Resulting in a Cumulative Catch-Up Adjustment to Revenue above).
This example of an unpriced change order is relatively simple, but one element in the example above that will require significant judgment and analysis will be determining the amount of variable consideration to include in the transaction price. In accounting for variable consideration, the contractor would "determine the amount to include in the transaction price by estimating either the expected value (that is, probability-weighted amount) or the most likely amount, depending on which method the entity expects to better predict the amount of consideration to which the entity will be entitled."
After estimating the amount of variable consideration within the transaction price, the entity then must apply the constraint on variable consideration concept. That is, the estimate of the change order price would only be included in the transaction price "to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur" when the price of the change order is approved.
When determining the estimated amount of variable consideration to include in the transaction price, entities will be required to perform this qualitative assessment that takes into account both the likelihood and the magnitude of a potential revenue reversal. The new standard provides factors that could indicate that an estimate of variable consideration is subject to significant reversal. Some of the factors include the amount of consideration that is susceptible to factors outside the entity's influence, if there is a long period of time before the uncertainty is resolved, the entity's experience with similar types of contracts, the entity's practices of providing concessions or changing terms, or if the contract has a broad range of possible consideration amounts.
Contract assets and liabilities
The new revenue standard requires that entities present either a contract asset or a contract liability. A contract asset is created when an entity satisfies a performance obligation by delivering the promised good or service and has earned a right to consideration from the customer. Alternatively, when the customer performs by prepaying its promised consideration the entity has a contract liability.
The requirements of the new standard to record contract assets and liabilities are similar to the existing construction contract guidance requiring a contractor to record cost in excess of billings and billings in excess of cost on the balance sheet. We don't expect significant change in the accounting or presentation when applying the ASU to contract assets and liabilities.
The ASU includes new comprehensive disclosure requirements that are expected to provide users of financial statements with detailed information on an entity's contracts with customers. The enhanced disclosure requirements will provide more information that enables "users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers."
What Does CohnReznick Think?
Contractors should expect significantly expanded financial statement disclosures intended to provide both qualitative and quantitative information about contracts with customers and significant judgments in accounting for those contracts and assets recognized from costs to obtain or fulfill a contract. CohnReznick will look to provide examples of the newly required disclosures in the future, but we expect, much like was the case with the multiemployer defined benefit plans, significant additional financial statement footnote disclosures will be needed. A key area of judgment will be on disclosures related to incomplete performance obligations, including the required actions, timing, and expenses necessary to satisfy the performance obligation.
Effective Date and Transition
For public entities, the ASU is effective for annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. Early application is not permitted for public entities.
For nonpublic entities, the ASU is effective for annual reporting periods beginning after December 15, 2017, and interim and annual reporting periods after those reporting periods. A nonpublic entity may early adopt the ASU, however the early adoption date must not be earlier than the effective date for public entities.
The ASU outlines two methods of transition upon adoption – full retrospective or a modified retrospective approach.
Using the full retrospective approach an entity would apply the ASU to all periods presented with certain practical expedients. Using the modified retrospective approach, an entity would record a cumulative effect of initially applying the ASU at the date of initial adoption. Under the modified retrospective approach the ASU would only be applied to the current period presented in the financial statements as of the ASU's effective date, meaning that the ASU would only apply to existing contracts with remaining performance obligations as of the date of adoption and any new contracts entered into after the date of adoption. The modified retrospective approach would not change the accounting for contracts already completed (contracts with no remaining performance obligation) prior to the ASU's effective date.
The Boards have announced the formation of the Joint Transition Resource Group for Revenue Recognition. This Group will consist of preparers and users of financial statements along with auditors, representing numerous industries in both public and private companies and organizations.
The Group will not issue any guidance, but will inform the Boards about potential implementation issues that could arise when companies begin applying the ASU. The Group will meet periodically over the next couple of years with the first meeting scheduled in July 2014.
The AICPA has created sixteen industry task forces to help develop a new AICPA Accounting Guide on Revenue Recognition that will provide illustrative examples and insight on how to apply the new ASU.
What Does CohnReznick Think?
What can companies do now? Although the effective date of this new standard is a few years away, the FASB and IASB provided this time so companies can properly prepare. CohnReznick recommends that contractors don't let this time go to waste. Read and understand the new standard; establish a management plan for the adoption process; identify typical and recurring contracts with customers; evaluate new contracts within the context of the new recognition model and identify potential implementation issues. Companies should identify where the data needed to implement the ASU exists within the organization. Special attention should be focused on how this new standard will impact current bank covenants, surety requirements, and employee performance incentive/bonus plans that are tied to revenue or net income. Companies should also get involved with industry or peer groups to seek thoughts and opinions on the application of the ASU to similar transactions by other companies. Starting now allows proper time to make required modifications to agreements and to modify internal processes, policies and procedures to address this new standard well in advance of the effective dates.
CohnReznick will issue more detailed publications on the new revenue standard in the coming months including but not limited to:
- Claim recognition
- Loss contracts
- Contract costs
- Implementation considerations
If you have specific questions regarding the new guidance for revenue recognition, please contact your CohnReznick partner for assistance or Michael Beck, National Director of Audit and Accounting, at 404-847-7728.
1 Financial Accounting Standards Board, Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), May 2014
This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.