ACCOUNTING AND COMPLIANCE
JOINT FASB AND IFRS REVENUE
RECOGNITION STANDARDS
EDWARD OPALL, CPA
Back in college in the 1980s, it was understood
that change was inevitable and the best course was
to embrace it. The watchword was always: “Learn,
adapt, and evolve or be left behind.” There is no
question that the world has only gotten more
complicated since then, and the proliferation of
new accounting pronouncements is a prime example. Though frequently frustrating, most people have become comfortable with adapting to
more complexity and constantly changing methods of doing work.
One thing that has remained constant
throughout this period has been the accounting standards on revenue recognition for the
construction industry. These accounting standards have been in place since 1981 and had
been widely used in practice long before that
time. They logically captured the nuances of
the financial arrangements and the inherent
business issues in the industry. But that is soon
to change.
As a result of increased globalization in
business, the governing boards responsible
for Generally Accepted Accounting Standards (GAAP) in the United States and International Financial Reporting Standards
(IFRS) have been working to create unified
international accounting standards. Their
project began in 2002. Revenue recognition is
one of many topics covered in this joint project. The proposed revenue recognition standard would provide one generic standard for
all industries, eliminating GAAP’s industryspecific standards. This new standard will replace the current standard, ASC 605-35,
“Revenue Recognition for Construction Type
Contracts.” The coming change is not necessarily designed to correct inherent flaws in
EDWARD OPALL is a director in the Construction and Real Estate
practice group in the Philadelphia office of EisnerAmper, LLP.
the current method, but rather to react to
changes in the world at large.
Background
When the Financial Accounting Standard Board
(FASB) issued its first exposure draft, “Revenue
Recognition (Topic 605): Contracts with Customers” in 2010, there were significant and fundamental changes in store for the construction industry. Fortunately, over a thousand comment letters
from industry leaders, the accounting profession,
and other industry stakeholders convinced FASB to
revisit the topic. In November 2011, FASB re-issued
its exposure draft and improved the proposed standards by aligning the goal of standard revenue
recognition across industries with a principlesbased approach, while retaining much of the current construction industry practices. Since the proposed standard is applicable for all industries
utilizing “contracts” with customers, the challenge
has been to be sure that changes to accommodate
the construction industry fit within the principles
promulgated for all industries.
At a meeting on 11/6/13, the FASB Board
concluded its review of the 2011 exposure
draft, with the minor revisions agreed to since
that time, and directed its staff to draft the final
standards. The final standards are expected to
be issued in the first quarter of 2014, and will
become effective for periods beginning after
2016 for public entities and after 2017 for private entities. Upon adoption of the proposed
standards, contractors will be required to modify any prior periods presented in comparative
statements in order to present full/or modified
retrospectively presented financial statements.
The current standard mandates percentage of
completion accounting for revenue recognition
for long-term contracts, and presumes that contractors are able to make reasonable estimates of
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Over a thousand
comment letters
convinced FASB to
revisit the first
exposure draft.
84
project costs.1 That mandate will remain under
the proposed standards. Contractors will encounter certain changes in accounting practices
for contracts using the cost to cost method, as
well as major changes to their disclosure requirements. Fundamentally however, the manner in
which the industry accounts for contract revenue will remain intact. Before focusing on the
ultimate changes in store, it is important to review the situation until now.
The June 2010 exposure draft introduced
the following core principles,2 which remain
the foundation of the proposed standards:
• Identify the contract with the customer.
• Identify the separate performance obligations
in the contract.
• Determine the transaction price.
• Allocate the transaction price to the separate
performance obligations.
• Recognize revenue when performance obligations are satisfied.
Major problems from the 2010 exposure
draft (hereinafter the “original proposal”) were
identified through the public comment
process:
1. Depending on the level of granularity, all contracts in the construction industry contain
multiple performance obligations. One could
conceivably view each building, phase, section,
or subcontract as a separate performance obligation. The original proposal implied that
companies would be required to disaggregate
each contract element/obligation for accounting purposes.
2. It was unclear whether companies could use
the percentage of completion method using a
cost to cost approach as a means of recognizing
revenue over the course of a project because
the proposed standard recommended the output method (units produced).3
3. Accounting for variable contract prices (unapproved or unpriced change orders, incentive
payments, and claims) would have been less
conservative than current practice. The original proposal required contractors to estimate
the value of unresolved contract issues recognized using a probability-weighted approach.
4. The original proposal added significant disclosure requirements: tabular reconciliation of beginning and ending contract assets and liabilities each year, the expectation of when ending
performance obligations will be satisfied, the
opening and closing liabilities for onerous performance obligations, and a summary of significant judgments and changes in judgments
REAL ESTATE TAXATION
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used in determining the satisfaction of performance obligations. Since contractors are
continually updating their project estimates,
these disclosures show the impact of changing
estimates on reported revenue.
5. The original proposal deemed warranties as
separate performance obligations, so one must
defer recognition of a portion of total contract
revenue.
Without abandoning the core principles
previously established, the 2011 exposure draft
(the “revised proposal”) produced clarifications
and revisions to the proposed standards. The
changes are major improvements for the construction industry:
1. The revised proposal allows bundled performance obligations.4 This is the ability to bundle
performance obligations when multiple goods
or services are highly interrelated and a business provides a significant service of integrating multiple goods and services into the combined item. This change allows for the most
construction contractors to presume that the
unified contract would remain the only performance obligation for revenue recognition.
2. “Input” is also important.5 The revised proposed standards eliminate the presumption
that the output method (units completed,
progress toward completion) is preferable to
the input method (cost to cost, labor hours) for
measuring progress toward satisfying performance obligations. Percentage of completion
using cost to cost (input method) would be allowed with certain exceptions noted below.
3. Conservative reporting is encouraged.6 FASB
revised the proposed standards for estimating
the value of unapproved change orders, potential incentive payments, and claims in the total
contract value to encourage conservative reporting of uncertain elements of the contract
amount. The proposed standards provide that
these estimates would be determined using either a probability-weighted approach or the
“most-likely” estimate. The “most likely” estimate method is appropriate in the construction industry, where the outcome choices are
likely to be binary rather than one of a range of
outcomes. In addition, the revised proposal
states that entities use judgment to determine
when variable consideration is “reasonably assured.” This revision brings the proposed standard more in line with the current standard.
4. Disclosure requirements have been scaled
back. The revised proposal will still require robust revenue recognition disclosures for public
ACCOUNTING AND COMPLIANCE
EXHIBIT 1
Revenue and profit with $100 of costs ‘not depicting the transfer of goods or services.’
Costs to date
Total estimated project costs
Percent complete
Total contract amount
Revenue to be recognized
Job costs recognized
Less costs directly expensed
or capitalized
Gross profit (loss) to be recognized
Current standard (all
project costs excluded)
$ 200
$ 1,200
17%
$ 1,500
$ 250
(200)
$
and non-public companies. However, FASB
eliminated the requirement of tabular reconciliations of beginning and ending contract information for private companies.7 During its 2013
deliberations, FASB eliminated entirely the requirement for tabular reconciliations of liabilities for onerous performance obligations.8
5. Warranties would be handled differently. The
revised proposal provided for warranties to be
accounted for in a manner similar to the current
standard. If the customer has the option to purchase the warranty separately, it would be a separate performance obligation to be accounted
for separately. If the warranty was merely an assurance that the entity’s past performance would
be as specified in the contract, it does not constitute a separate performance obligation.9
Significant changes
As a result of the revised exposure draft of 2011,
subsequent additional public comments, and further deliberations of the board during 2012 and
2013, there are fewer fundamental changes from
the original proposal for construction contractors.
However, the following issues will constitute
major changes from the current standards.
Contract costs. Contractors that calculate revenue using the percentage of completion on the
cost to cost approach will face a fundamental
change. The proposed standard will remove certain categories of costs (see below) so they will not
be in the numerator and denominator to calculate
the percentage completed. The change in calculation will defer recognition of revenue on projects
and make revenue reporting more conservative.
The result will be lower revenue recognized during the early stages of a project.
ACCOUNTING AND COMPLIANCE
–
50
Proposed standard (certain
project costs excluded)
$ 100
$ 1,100
9%
$ 1,500
$ 136
(100)
$
(100)
(64)
The current standard provides a self-correcting mechanism in accounting for diminished profit due to unrecovered costs under the
percentage of completion method. Once identified, the diminished profit would already have
been in the cost incurred to date (numerator)
and the total estimated project costs (denominator). The percentage presumably would be
higher due to the higher numerator.
Thus, when applied to the contract price,
revenue is recognized earlier than would be
permissible under the proposed standards. For
a sample calculation using the current and proposed standards at an early point in the project,
with $100 of costs described as “not depicting
the transfer of goods or services,” see Exhibit 1,
above.
The proposed standard would exclude three
categories of costs from the calculation.10
1. Costs that do not accurately depict the transfer
of control of goods or services (such as costs of
1
2
3
4
5
6
7
8
9
10
The five steps
remain the
foundation of the
proposed standards.
ASC 605-35-25-60.
FASB Exposure Draft, “Revenue Recognition (Topic 605),”
6/24/10, paragraph 2.
The cost to cost formula for finding the percentage of completion it the total of all costs recorded to date on a project
or job, divided by the total estimated amount of costs that
will be incurred for that project or job.
Revised FASB Exposure Draft, “Revenue Recognition (Topic
605),” 11/14/11, paragraph 29.
Id., paragraphs 44-46.
Id., paragraphs 55, 81-84.
Id., paragraph 130.
“Project Update: Revenue Recognition: Summary of Decisions Reached to Date (as of October 30, 2013),” available
at www.fasb.org/cs/ContentServer?site=FASB&c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=1175801890084#summary.
Revised FASB Exposure Draft, supra note 4, paragraph
IG12.
Id., paragraphs 93-96.
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wasted materials, labor, or other resources).
The proposed standard would require idle time
charged to projects expensed to an allocated
labor account.
2. Costs to obtain a contract will be expensed as
incurred. The proposed standard would require that costs to bid a project be expensed
rather than included in job costs.
3. Direct costs of fulfilling a contract (such as
commissions or mobilization costs) are capitalized and amortized if they related directly to a
contract, relate to future performance, and are
expected to be recovered. The proposed standard would require companies to accumulate
these early costs, remove them from job cost,
and record these costs as a prepaid expense
that will be written off over the life of the project. Presumably, this will result in a minimal
difference to net earnings.
Applying these changes in practice will be
difficult, since most companies’ contract reporting and job cost reporting systems are not
set up to account for the proposed changes
without manual journal entries. For management purposes, companies would not want to
lose track of these costs and their association
with particular projects due to external reporting requirements.
Changes to disclosures. The proposed standards would require significant changes to the
footnote disclosures. Their objective would be to
enable users of financial statements to understand
the nature of a company’s contracts with customers, significant judgments used for applying
the standards, and assets recognized and amortized from the costs to fulfill contracts.
11
12
13
86
Id., paragraphs 114-116.
Id., paragraph 117.
Id., paragraphs 118-119.
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Contracts. Contractors would be required to
disclose their various types of contracts, durations
of contracts, and timing of transfers of work in
process.11 Public companies would be required to
provide tables and non-public companies would
need to disclose qualitatively.
Public companies would be required to disclose tables that distinguish between revenue
from work performed during the year and revenue recognized due to cumulative changes in
estimates from work performed in prior years.12
Contractors would be required to disclose
descriptions of how performance obligations are
satisfied, significant payment terms, and types of
warranties and related obligations.13 Companies
would be required to disclose the aggregate
amount of backlog, which would be distinguished between approved contract balances
and the amount of unapproved change orders.
Conclusion
For those who have followed the deliberations on
this new standard for the last several years, it has
been interesting to see how the process evolved.
FASB and IASB developed a very theoretical
model containing the principles needed to accomplish their mission. The first effort in 2010 had
many deficiencies that made it impractical to use.
Because of the strong pushback, a more workable
exposure draft was issued. The end result is a standard that appears to be acceptable. Implementation of these changes by each company will be
challenging as accounting policy decisions would
need to be made, followed by changes to internal
processes and controls, and accounting software
will need to be revised to efficiently capture the
needed information. At least the industry will
have several years to digest the final standards and
prepare for the necessary changes. n
ACCOUNTING AND COMPLIANCE