Recognizing Construction Contract Revenue - An Accounting Rule Change is Heading Your Way
By John Troyer, Ciuni & Panichi, Inc.
Recently the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) announced significant new rules concerning how and when companies should recognize revenue. The new rules will apply to all companies, regardless of the industry you are in or where in the world you are located. The standard will be principle-based, thus requiring significant judgment to interpret customer contracts. It is a significant conceptual change from current practice.
For simple point-of-sale retail transactions, revenue is realized when goods or services are delivered to the customer. The process gets more complicated for long-duration, multi-element construction contracts, sales that include incentives for project owners with poor credit, and contracts with built-in discounts or performance bonuses.
To apply the revenue recognition standard, an entity should take the following steps:
- Identify the contract(s) with a project owner.
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the separate performance obligations.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
Revenue should only be recognized to the extent that it is “probable” the entity will not have to make a significant reversal in the future. Therefore, variable consideration such as rebates, discounts, bonuses, and right of return should be factored into the transaction price. If project owner payments are expected to be received over a period greater than one year, calculating the time value of money must be considered.
Most contractors are accustomed to the percentage-of-completion method which recognizes revenue as cost is incurred in relation to total estimated cost. This method will still be permitted if the company determines that a cost-to-cost method most appropriately measures progress towards satisfaction of the performance obligation. However, the completed contract method is not permitted by the new rules. Please note that these new rules affect generally accepted accounting principles requirements (GAAP) and not revenue recognition policies used for tax purposes.
Many contractors own real estate companies. The new approach will create a major change for how real estate companies recognize revenue for the sale of property.
While the above concepts may seem straight forward, significant judgments may be required. It is likely that more than just the accounting department will need to be involved. Sales and contracting processes may need to be reconsidered. Operational management and legal counsel may have to assist the accounting department in determining when performance obligations are met. Also, the information technology department may need to modify systems to capture and record information in compliance with the new standards.
The standards also require substantial new disclosures to be made by the reporting entity. These additional disclosures likely will include disaggregation of revenue, contract balances, performance obligations, remaining performance obligations, significant judgments and estimates, and policy decisions.
The new rules are effective for U.S. public companies for annual reporting periods beginning after December 15, 2016, including interim periods. Nonpublic entities are required to adopt for annual periods beginning after December 15, 2017. Retrospective treatment is required, so it will be important to prepare for the new rules well in advance of these effective dates.
Prudent companies will begin thinking about these changes immediately. The FASB and IASB have formed a Joint Transition Resource Group for Revenue Recognition to identify implementation issues. The American Institute of CPAs has established 16 separate industry task forces which are developing new accounting guides to assist management and accountants. Companies should appoint their own company staff to take the lead on understanding and implementing the new revenue recognition standard as this measurable is so critical to the financial reporting process.
Among the 16 separate industry task forces, is the Construction Contractors Revenue Recognition Task Force. They have already identified 12 concerns with the new guidance. These concerns include, among others, the complexity of the new disclosure requirements, accounting for contract modifications, training and transition costs, and the need to modify existing policies and systems.
FASB and the IASB are optimistic that the new rules will create an effective and universal way to recognize revenue, regardless of industry and/or jurisdiction. They believe investors and other financial statement users will benefit from the increased disclosure of financial information. While these are lofty goals, it may be a challenge to implement them. This will be especially true for private companies with limited accounting personnel. This article may be the first you are hearing of this new accounting rule. However, it will not be the last as these new guidelines are expected to have far-reaching effects.
For more information on this topic or any accounting and auditing issue, please contact John Troyer at 216-831-7171 or [email protected].