CFMA Alert on New Revenue Recognition Rules
Proposed Revenue Recognition Rules Would Significantly Affect Contractors & Users of Construction Financial Statements
On June 24, 2010, the Financial Accounting Standards Board (FASB) issued its highly anticipated Exposure Draft, Revenue from Contracts with Customers.
The issuance of this Exposure Draft follows approximately 18 months of evaluation and input received following the issuance of the similarly titled Discussion Paper, Preliminary Views on Revenue Recognition in Contracts with Customers. To read CFMA’s letter in response to the Discussion Paper, click here.
At present, construction contractors generally follow the guidance contained in ASC 605-35 (formerly known as SOP 81-1); however, if the provisions of this Exposure Draft are adopted, these changes could have a significant and undesirable impact on the financial statements of contractors.
For this reason, we are encouraging contractors, CPAs in practice, and in particular, users of financial statements (such as sureties and lenders) to learn about and understand the proposed changes; and then, to help us take action by responding to FASB with our thoughts on the proposed Exposure Draft.|
Key Changes Affecting Contractors
With very limited exceptions, the economic unit of measure in ASC 605-35 is the entire contract, which means the contract is not further subdivided for the purpose of determining how revenue should be recognized. In addition, change orders are treated as adjustments to the original contract as opposed to treating them as separate economic units. The Exposure Draft contains potentially significant revisions to this approach, as discussed below.
ASC 605-35 presumes ratable revenue recognition during the entire construction period. While the Exposure Draft permits ratable recognition of revenue, the contractor must demonstrate it meets specific criteria to qualify for ratable recognition of revenue. In practice, most contracts will continue to qualify for ratable revenue recognition, but some will not.
Another significant difference between ASC 605-35 and the Exposure Draft is the decoupling of contract costs from contract revenues. Under ASC 605-35, most contractors use “costs incurred” to measure revenue, hence the recognition of revenue is aligned with costs. By contrast, in the Exposure Draft, revenue is recognized as “performance obligations” are satisfied, which in some cases will not be tied to costs incurred; hence, the decoupling of contract costs and contract revenues.
To compensate for the decoupling of costs and revenues, the Exposure Draft prescribes new cost capitalization rules. In general, this will be important when contractors are incurring precontract costs, but have not yet satisfied a performance obligation.
Because the performance obligation becomes the economic unit of measure, if a contractor anticipates a loss in fulfilling a performance obligation, that estimated loss is accrued as soon as it is identified – even if there may be substantial estimated profit in the fulfillment of other performance obligations.
Finally, the Exposure Draft prescribes new disclosure requirements to assist financial statement users in understanding revenue recognition transactions (e.g., the reporting entity must provide a reconciliation of changes in net open contract positions from the last reporting date to the current reporting date).
Economic Unit of Measure
As previously noted, in most cases, the economic unit of measure in ASC 605-35 is the entire contract as adjusted from time to time for change orders. However, the Exposure Draft requires that contracts must be separated into various performance obligations; guidance is provided to help illustrate how this might work. For example, a design/build general contractor would generally separate the project’s design aspects and its building aspects into at least two separate performance obligations.
Once performance obligations in the contract are identified, the contract price is allocated among the various performance obligations based upon either a known or estimated standalone selling price for each service. Since almost every construction contract is unique, considerable judgment will be required in both identifying performance obligations in the contract and in allocating the contract price among various performance obligations. Likewise, change orders will have to be evaluated to determine whether a change order is a change to an existing performance obligation within the contract or if it constitutes a new performance obligation altogether.
While these changes may not sound alarming at first reading, company owners and construction financial professionals will have enhanced opportunities to break up their contracts into various performance obligations and place the revenue into those parts of the contract where they want to see the most profit – and, the highly subjective nature of the standard will make it difficult to challenge these judgments. This has the potential to lead to earnings management, and ultimately, to undermine the credibility in financial reporting that exists today.
We believe that this will result in sureties and lenders wanting to see contracts re-aggregated into a single economic unit of measure. This is why input is so important, particularly from the financial statement user community.
Qualifying for Ratable Revenue Recognition
The Exposure Draft contains a concept referred to as “continuous transfer of goods or services.” Several criteria are defined to help reporting entities determine whether the contract provides for a continuous transfer of goods or services—and hence, ratable revenue recognition.
When a customer initiates a project and directs the hiring of the contractor (even if through a representative, such as an architect), then there is a strong likelihood the contract will meet the continuous transfer criteria. Alternatively, if the contractor acts as the project developer (e.g., in the building of condominiums), then it is less likely the project will meet the continuous transfer criteria, and revenue recognition would be deferred until the customer has obtained ultimate control of the project.
In situations where a continuous transfer is deemed to exist, then the contractor will recognize revenue ratably for that performance obligation using either an input or output measure. Input measures can include items like labor hours or costs incurred. Accordingly, within each performance obligation, the contractor can continue to report revenue in a manner consistent with the current percentage-of-completion method.
Under the Exposure Draft, new cost capitalization rules have been incorporated at the behest of construction industry constituents since costs have been divorced from revenues. The importance of these rules can be most clearly seen in the early stages of a contract (e.g., when a contractor may be incurring mobilization costs, which by definition are not related to the fulfillment of a specific performance obligation). Absent the cost capitalization rules, contractors might experience a negative profit margin in the early stages of many contracts.
Costs incurred in procuring the contract are not eligible for capitalization, while costs incurred in fulfilling the contract are eligible for capitalization. Costs may be incurred during the procurement phase that also relate to fulfillment, such as certain design costs. So long as those costs are integral to the fulfillment of the contract, they may be capitalized, but only for contracts actually awarded to the contractor.
Once costs are capitalized, they should be derecognized in a rational manner as performance obligations are fulfilled—in this case, generally, revenues will be matched against costs.
Under ASC 605-35, anticipated losses on uncompleted contracts are accrued at the time they are identified. The Exposure Draft retains this guidance; however, anticipated losses will be accrued for each discrete performance obligation for which a loss is anticipated – even if a profit is anticipated for the overall contract. Decisions made after a contract has begun to incur additional costs in one phase, to save costs in a later phase, may inadvertently trigger the accrual of a loss even if the overall project becomes more profitable. Theoretically, this could occur; but, all relevant facts (including new cost capitalization rules) will need to be taken into account before presuming this will be the case.
FASB recognizes these changes will potentially be significant, particularly for the construction industry, so new disclosure guidance is included in the Exposure Draft to help enhance comparability and understanding by financial statement users. Reporting entities are required to disclose judgments used in determining the satisfaction of performance obligations, allocation of overall contract price to the specific performance obligations, methods used to recognize revenue when a continuous transfer is deemed to occur, how liabilities are measured when a loss is anticipated, and reconciliation of net open positions, as previously mentioned.
This Exposure Draft will substantially impact how contractors approach revenue recognition. FASB has not yet announced when these new rules will take effect; however, comments on the proposed rules are due by October 22, 2010.
CFMA will undertake outreach initiatives to educate members on the proposed rules, elicit feedback regarding the proposed rule, and organize a coordinated response from our membership group and other construction industry constituencies.
In the meantime, we encourage all General Members to begin considering how the new rules might impact their approach to revenue recognition and encourage Associate Members to evaluate how the new rules might impact their evaluation of revenue recognition, which is highly subjective.