How the New Revenue Recognition
Standards will Impact Construction Entities
Presented by:
John Armour
June 19, 2014
Disclaimer
The information in this presentation
is a brief summary of new standards that may
change existing practice in the construction
Industry and may not include all
the details relevant to your situation.
Please contact your service provider to further
discuss the impact on your business.
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FASB’S NEW REVENUE
RECOGNITION STANDARD
BACKGROUND
Reasons for the New Guidance
The FASB and the IASB initiated a joint project to clarify the principles for
recognizing revenue and to develop a common revenue standard for U.S.
GAAP and IFRS that would:
1.
Remove inconsistencies and weaknesses in existing revenue
recognition standards and practices. U.S. GAAP has multitude of
Industry and transaction specific standards. IFRS has two standards
on Revenue Recognition IAS 11 and IAS 18.
2.
Provide a more robust framework for addressing revenue recognition
issues. Weaknesses exist in both set of standards.
3.
Improve comparability of revenue recognition practices across
entities, industries, jurisdictions and capital markets.
4.
Simplify the preparation of financial statements by reducing the
number of requirements to which entities must refer.
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Reasons for the New Guidance - continued
The new guidance utilizes a contract-based approach that places the focus
on the assets and liabilities that are created when an entity enters into and
performs under a contract.
While some of the concepts in the new guidance are similar to existing
guidance, other may change existing practice leading to changes in the
amount and timing of revenue recognized.
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REVENUE RECOGNITION
CURRENT PRACTICE
Revenue Recognition Basics
`
The current revenue recognition model followed under U.S. Generally
Accepted Accounting Principles is focused on the “earning process”
(CON-5).
` Generally, it is appropriate to recognize revenue upon the culmination
of the earnings process.
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`
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This means the seller must determine when the earnings process is completed
(when the seller has substantially completed what it agreed to do). This
determination is not always readily apparent for a variety of reasons.
The determination of “earned” focuses on measurement and
recognition thresholds (e.g., the four basic revenue recognition criteria)
Industry guidance originally published as SOP 81-1 plays a significant
role in revenue recognition.
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Percentage of completion
Input/Output measurement
Profit Center typically the entire contract as modified.
Guidance on contingent income, change orders, claims, etc.
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Basic Revenue Recognition Criteria
Revenue is generally realized, or realizable, and earned
when all of the following criteria are met:
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`
`
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Persuasive evidence of arrangement
Price is fixed or determinable
Delivery has occurred or service has been rendered
Collectability is reasonably assured
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CHANGES TO REVENUE
RECOGNITION UNDER THE NEW
GUIDANCE
Revenue Recognition – The Future has Arrived
FASB Accounting Standard Update No. 2014-09
Revenue from Contracts with Customers (Topic 606)
`
Standard applies to all transactions which relate to and
include –
`
`
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Contract, and
Customer
Terminology has changed – first step is to gain
understanding of the new language of revenue
recognition
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Taking your crutch away
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`
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Industry guidance from SOP 81-1 will no longer be
relevant
Decisions relative to Revenue and, to some degree,
Costs will be guided by the principles of ASU 2014-09.
FASB expects industry practice guidance to be
developed but it will not be under the authority of the
FASB
`
AICPA has formed multiple industry groups to address and
modify current audit and accounting guides – these will not
be GAAP unless designated by FASB
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Engineering and Construction Task Force
Aerospace and Defense Task Force
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Core Principle and Five-Step Process
Core principle:
The core principle of the guidance 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.
Five steps to apply the core principle:
1.
2.
3.
4.
5.
Identify the contract(s) with a customer.
Identify the performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations in the
contract.
Recognize revenue when (or as) the entity satisfied a performance
obligation.
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Core Principle and Five-Step Process
`
Basic Observations
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`
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On the surface the five step process does not seem overly complex
and arguably, it appears to include much of what is currently done to
determine revenue recognition.
However, each of the five steps will require significant judgments by
management and auditor in applying the underlying principles
included in the new guidance.
The transfer of “control” to the customer becomes the driving issue
in evaluating the appropriateness of revenue recognition under the
new guidance.
Currently, the evaluation of “risk and reward” often drives the
determination of revenue recognition. While it remains an
important consideration, it is no longer determinant under the new
guidance.
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Identify the Contract with the Customer
Issue 1. Contracts can include implied or verbal agreements.
` Existing GAAP does not require written agreements although
many entities follow conservative processes of not recognizing
revenue on verbal agreements
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`
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How does an auditor verify a verbal or implied agreement?
What criteria will be applied to determine if enforceable rights and
obligations have been created in the absence of a written
agreement?
What will be the timing of recognition?
`
`
Transaction price is driven by expected receipt for the goods or service
The new constraint provision will impact recognition
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Identify the Contract with the Customer
Issue 2. Change Orders (including unpriced change orders)
` Under current guidance change orders are accounted for as a
modification of the original contract but large variance in practice
exists for timing of measurement and recognition.
` Under current guidance change orders with agreement on scope
but no agreement on price are accounted for under claim
guidance
` New standard guidance is “Contract Modification”
`
Determination of whether the change order is a new contract, a new
performance obligation that is distinct, or a change in the original
agreement.
`
`
The conclusion of regarding the above will change timing of recognition,
presentation, and possibly disclosures
May require evaluation under new “Variable Consideration” standard
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Contract Modification
`
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. there are two paths to
consider when evaluating the accounting related to the
modification.
An entity shall account for a contract modification as a separate
contract if both of the following conditions are present:
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The scope of the contract increases because it results in the addition of
promised goods or services that are distinct.
The price of the contract increases by an amount of consideration that reflects
the entity’s standalone selling prices of the additional promised goods and
services and any appropriate adjustment to that price to reflect the
circumstances of the particular contract.
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Contract Modification
`
If a contract modification is not accounted for as a
separate contract, an entity shall account for the
promised goods or services not yet transferred at the
date of contract modification in whichever of the
following ways is applicable:
An entity shall account for the contract modification as if it were a
termination of the existing contract and the creation of a new
contract, if the remaining goods or services are distinct from the
goods or services transferred on or before the date of the contract
modification.
An entity shall account for the contract modification as if it were
part of the existing contract if the remaining goods or services are
not distinct, and, therefore, form part of a single performance
obligation that is partially satisfied at the date of the contract
modification.
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Contract Modifications
`
If the remaining goods or services are a
combination of the items above, then the entity
shall account for the effects of the modification
on unsatisfied (including partially unsatisfied)
performance obligations in modified contract in a
manner that is consistent with the objectives of
the relevant paragraph.
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Identify the Contract with the Customer
Issue 3. Claims
`
`
`
Four conditions precedent to recognize claim revenue under
current standards are not carried into the new standard
Pre-resolution revenue recognition limited to costs incurred
under current standards
New standard guidance is “Contract Modification”
`
Determination of whether the claim is a new contract, a new
performance obligation that is distinct, or a change in the original
agreement.
`
`
`
`
The conclusion of regarding the above will change timing of recognition,
presentation, and possibly disclosures
May require evaluation under new “Variable Consideration” standard
May require evaluation under new “Financing” standard
Margin can be recognized if estimated recovery exceeds costs.
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Identify the Contract with the Customer
Issue 4. Combining Contracts
`
`
Current standards allow combining contracts but rules
based criteria are very difficult to satisfy
New standard guidance may create more opportunity to
measure multiple contracts in a single step
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`
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Goes against surety separate risk on single projects but this third
party risk is not part of the criteria for combining
Will require evaluation including considering proper treatment when
multiple contracts with a single customer exist.
Note that the decision to combine contracts occurs before the
evaluation of performance obligations
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Contract Combination
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An entity shall combine two or more contracts entered into at
or near the same time with the same customer (or related
parties of the customer), and account for the contracts as a
single contract if one or more of the following criteria are
met:
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`
`
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The contracts are negotiated as a package 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 (or some goods or
services promised in each of the contracts) are a single performance
obligation.
Note that these standards are similar but not identical for tax
qualifications for combining contracts
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Identifying Performance Obligations
`
`
Current practice evaluates “profit centers” which typically are
the entire contract.
A performance obligation is a promise in a contract with a
customer to transfer to the customer:
`
`
A good or service (or bundle of goods or services) that is distinct.
A series of distinct goods or services that are substantially the same
and that have the same pattern of transfer to the customer.
This is the standard that permits multiple performance obligations to be
bundled and reported on a total contract basis.
Generally explicit but may also include promises that are implied by an
entity’s customary business practices, published policies or specific
statements, if at the time of entering into the contract those promises
create a valid expectation of the customer that the entity will transfer a
good or service to the customer.
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Distinct
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A promised good or service is considered distinct if
both of the following conditions are met:
`
`
The customer can benefit from the good or service either
on its own or together with other resources that are
readily available to the customer (that is, the good or
service is capable of being distinct).
The entity’s promise to transfer the good or service to
the customer is separately identifiable from other
promises in the contract (that is, the good or service is
distinct within the context of the contract)
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Distinct
`
A customer can benefit from a good or service, if
the good or service could be used, consumed, sold
for an amount greater than scrap value, or
otherwise held in a way that generates economic
benefit.
`
Various factors may provide evidence that the customer
can benefit from the good or service either on its own or
in conjunction with other readily available resources. For
example, the fact that an entity regularly sells a good or
service separately would indicate that a customer can
benefit from the good or service on its own or with other
readily available resources.
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Distinct
`
Determining whether the good or service is “distinct within
the context of the contract” is a critical aspect of identifying
the performance obligations. Factors that indicate that an
entity’s promise to transfer a good or service to a customer
is separately identifiable include but are not limited to:
`
The entity does not provide a significant service of integrating the
goods or services into the bundle of goods or services that the
customer has contracted for.
`
The good or service does not significantly modify or customize
another good or service promised in the contract.
`
Most construction contracts will include a bundle of services
Most construction contracts will include modification or customizing
The good or service is not highly dependent on, or highly
interrelated with, other goods or services promised in the contract.
Most construction contracts will be dependent and interrelated with other
goods or services.
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Distinct
`
If a promised good or service is not distinct, an
entity shall combine that good or service with other
promised goods or services until it identifies a
bundle of goods or services that is distinct.
`
In some cases, that would result in the entity accounting
for all the goods or services promised in a contract as a
single performance obligation.
The construction industry will likely adopt a practice that the presumption
is that the goods or services are not distinct and are therefore combined
and the contract is reported as a single performance obligation - unless
there is evidence to the contrary.
This will require each contract to be evaluated.
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Possible contracts with multiple PO
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Contracts that provide both services and product
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Design/Build contract
EPC contracts
IDIQ contracts
Contracts with separate deliverables
Add-on change orders
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Determining the Transaction Price
`
The transaction price is the amount of consideration
that an entity expects to be entitled to in exchange
for transferring promised goods or services to a
customer. Issues that impact the determination of
the transaction price include the following:
`
`
`
`
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Variable consideration
Constraining estimates of variable consideration
The existence of a significant financing component in the
contract
Non cash consideration
Consideration payable to a customer.
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Variable Consideration
`
Often, part of the contractual consideration related to a
good or service is variable in nature or contingent on
future events.
(not an all inclusive list):
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`
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`
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Discounts
Rebates
Refunds
Credits
Incentives
Performance bonuses - early completion, savings sharing, etc.
Royalty
Unit pricing
Economic price adjustments
Latent defects
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Variable Consideration
`
An entity shall estimate an amount of variable consideration
by using either of the following methods, depending on
which method the entity expects to better predict the amount
of consideration to which it will be entitled:
`
`
The expected value – the expected value is the sum of probability
weighted amounts in a range of possible consideration amounts. An
expected value may be an appropriate estimate of the amount of
variable consideration if an entity has a large number of contracts
with similar characteristics.
The most likely amount – the most likely amount is the single most
likely amount in a range of possible consideration amounts (that is,
the single most likely outcome of the contract). The most likely
amount may be an appropriate estimate of an amount of variable
consideration if the contract has only two possible outcomes.
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Constraint on Transaction Price
`
An entity shall include in the transaction price some or
all of an amount of variable consideration only to the
extent that it is probable that a significant reversal in
the amount of cumulative revenue recognized will not
occur when the uncertainty associated with the
variable consideration is subsequently resolved.
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Constraint on Transaction Price
`
Factors that could increase the likelihood or the
magnitude of a revenue reversal include, but are not
limited to any of the following:
`
`
`
`
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The amount of consideration is highly susceptible to factors outside
the entity’s influence.
The uncertainty about the amount of consideration is not expected
to be resolved for a long period of time.
The entity’s experience (or other evidence) with similar types of
contracts is limited, or that experience (or other evidence) has
limited predictive value.
The entity has a practice of either offering a broad range of price
concessions or changing payment terms and conditions of similar
contracts in similar circumstances.
The contract has a large number and broad range of possible
consideration amounts.
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Significant Financing Component
`
`
`
In determining the transaction price, a contract must be adjusted
for the effects of the “time value of money” when the contract
contains a financing component.
A practical expedient is provided that allows an entity to ignore the
time value of money when the time between the transfer of the
goods/services and payment is less than one year. This is
allowable even when the contract itself exceeds one year.
The following factors should be considered when determining
whether a significant financing component is present in the
contract.
`
`
`
The length of time between when the transfer of goods or services to
the customer occurs and when payment is made.
Whether the amount of consideration in the contract would
substantially differ if the customer paid cash when the transfer of the
goods or services occur.
The interest rate in the contract and the prevailing interest rate in the
relevant market.
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Significant Financing Component - Retention
`
Example 27 – Withheld payments on long-term contract
concludes that retention will normally not be a financing
because the withholding is intended to protect the
customer from the contractor failing to adequately
complete its obligations under the contract!!!!!!
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Reassessment
`
At the end of each reporting period, an entity shall
update the estimated transaction price (including
updating its assessment of whether an estimated
variable consideration is constrained) to represent
faithfully the circumstances present at the end of the
reporting period and the changes in circumstances
during the reporting period.
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Allocate the Transaction Price
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The objective when allocating the transaction price is for an
entity to allocate the transaction price to each performance
obligation (or distinct good or service) in an amount that
depicts the amount of consideration which the entity expects
to be entitled in exchange for transferring the promised
goods or services to the customer.
`
To meet the allocation objective, an entity shall allocate the
transaction price to each performance obligation in the contract on
a relative stand-alone selling price basis.
`
`
Relative selling price is best evidenced by the observable price of a
good or service when sold separately in similar circumstances and to
similar customers.
If a stand-alone selling price is not directly observable, an entity shall
estimate the standalone selling price.
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Allocate the Transaction Price
4.
Allocate the Transaction Price
`
When estimating the relative stand-alone selling price,
management should maximize the use of observable
inputs. The following are some possible estimation
methods (not all inclusive):
` Adjusted market assessment approach
` Expected cost plus a margin approach
` Residual approach (in certain circumstances).
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Five-Step Process becomes Three-Step
`
If the performance obligation qualifies to be
reported at the contract level the revenue model
becomes:
1.
2.
3.
Identify the contract(s) with a customer.
Determine the transaction price.
Recognize revenue when (or as) the entity satisfied a
performance obligation.
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Recognize Revenue as Performance Obligation is
Satisfied
`
An entity shall recognize revenue when (or as) the entity
satisfies a performance obligation by transferring a promised
good or service (that is, an asset) to a customer. An asset is
transferred when (or as) the customer obtains control of that
asset.
`
Control of an asset refers to the customer’s ability to
direct the use of and obtain substantially all of the
remaining benefits from the asset. Indicators that a
customer has obtained control are as follows:
`
`
`
`
`
The entity has a right to payment for the asset.
The entity transferred legal title to the asset.
The entity transferred physical possession of the asset.
The customer has the significant risk and reward of ownership.
The customer has accepted the asset.
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Performance Obligation Satisfied Over Time
`
An entity transfers control of a good or service over time
and, therefore, satisfies a performance obligation and
recognizes revenue over time if one of the following
criteria are met:
`
`
`
The customer simultaneously receives and consumes the
benefits provided by the entity’s performance as the entity
performs.
The entity’s performance creates or enhances an asset (WIP)
that the customer controls as the asset is created or
enhanced.
The entity’s performance does not create an asset with an
alternative use to the entity and the entity has a right to
payment for performance completed to date.
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Measurement of PO Satisfied Over Time
`
Similar to current practice
`
Output measurement
`
`
Units of delivery or production
Milestones
`
Input measurement
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`
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Cost to cost
Labor based
Measurement should be reflective of transfer of control of the asset to the
customer.
Zero margin in early stages of completion is acceptable
Uninstalled materials
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`
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Generally create audit challenges
Excluded from cost to cost PCM measurement
Revenue recognized equal to costs incurred (no margin)
Exclude costs that do not contribute to performance if cost to cost
`
Wasted materials, inefficiencies, owner provided materials
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Performance Obligation Satisfied at a Point in Time
`
If a performance obligation is not satisfied over time, an
entity satisfies the performance obligation at a point in
time. The specific point in time is dependent on when
the customer obtains control of the promised asset and
the entity satisfies the performance obligation.
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Costs to Obtain a Contract
`
An entity should recognize as an asset the incremental
costs of obtaining a contract that the entity expects to
recover.
`
`
Incremental costs are those costs that the entity would not
have incurred if the contract had not been obtained
Practical expedient – expense costs if amortization period is
1 year or less
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Costs to Fulfill a Contract
`
Follow existing guidance under other standards, if
applicable.
`
Otherwise, recognize as an asset if those costs meet all of the
following criteria:
`
`
`
`
Relate directly to a contract (or a specific anticipated contract)
Generate or enhance resources of the entity that will be used in
satisfying performance obligations in the future
Are expected to be recovered
Examples
`
`
Pre-construction costs
Mobilization
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Disclosures
`
Disclosures
`
The objective of the disclosure requirements (Topic 606) is for
an entity to disclose sufficient information to enable users of
financial statements to understand the nature, amount,
timing, and uncertainty of revenue and cash flows arising
from contracts with customers.
`
The disclosure requirements found in the new revenue recognition
guidance are significantly in excess of what is currently required
under U.S. GAAP.
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Disclosures
`
Disclosures
`
An entity shall disclose qualitative and quantitative
information about all of the following:
`
`
`
Its contracts with customers
The significant judgments, and changes in the judgments made in
applying the guidance in Topic 606 to those contracts
Any assets recognized from the costs to obtain or fulfill a contract
with a customer.
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Disclosures
`
Disclosures
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Contracts with customers
Disaggregation of Revenue
Contract balances
Performance obligations
Transaction price allocated to the remaining performance
obligations
Significant judgments in the application of the guidance in
Topic 606
Determining the transaction price and the amounts allocated
to performance obligations
Practical expedients
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PREPARING FOR THE CHANGE
NEXT STEPS
Next Steps
`
Effective Date of Adoption (Public Entity)
` For a public entity, the amendments in Topic 606 are
effective for annual reporting periods beginning after
December 15, 2016, including interim periods within that
reporting period. Early application is not permitted.
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Next Steps
`
Effective Date of Adoption (Nonpublic entities)
` For all other entities (nonpublic entities) the amendments
in Topic 606 are effective for annual reporting periods
beginning after December 15, 2017, and interim periods
within annual periods beginning after December 15, 2018.
`
A non public entity may elect to apply the guidance in Topic 606
earlier, however, only as of the following:
An annual reporting period beginning after December 15, 2016,
including interim periods within that reporting period (public company
effective date)
An annual reporting period beginning after December 15, 2016 and
interim periods with annual periods beginning after December 15,
2017
An annual reporting period beginning after December 15, 2017,
including interim periods within that reporting period.
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Next Steps
`
It is hard to imagine a more significant event to financial
reporting than the significant overhaul of historical revenue
recognition guidance. History tells us that many entities will
misjudge the amount of time, effort and expertise that is
required when extensive changes are made to significant
accounting guidance.
` The adoption of fair value and consolidation accounting
guidance is a relatively recent example for us to consider.
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Next Steps
`
The impact from the adoption of the new revenue
recognition standard will likely be complex and farreaching and involve many different functions within an
organization.
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`
`
`
`
`
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Information systems may require adjustment.
Standard “sales” contracts and other sales agreements
should be evaluated in light of the changes.
Sales incentives/commissions should be considered.
Internal control processes may need updating.
Executive compensation arrangements
Debt covenants
Tax Implications
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Next Steps
`
Changing Business Models?
` Existing sales strategies and legal documents used in the
selling process may require change or no longer be
required under the new guidance.
` Over the years many selling strategies have developed to
deal with the “bright-line” accounting rules. Upon adoption
of the new revenue recognition guidance there is a unique
opportunity to rethink the way business is done.
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Next Steps
`
Those entities that are currently subject to significant
industry guidance are likely to experience the most
significant impact.
`
`
`
`
`
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Telecommunication
Software
Construction/Aerospace and Defense
Real Estate
Entertainment and Media
Multiple Deliverable Contracts
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Next Steps
Transition
` The FASB has allowed two methods for transition:
Retrospectively to each prior reporting period
presented.
Practical expedients provided
Retrospectively with the cumulative effect of initially
applying the guidance recognized at the date of initial
adoption. Certain disclosures are required:
The amount by which each financial statement line
item is affected in the current reporting period by the
application of Topic 606 as compared to the
guidance that was in effect before the change.
An explanation of the reasons for significant
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`
Next Steps
`
Transition and Implementation
`
`
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Challenges for entities with contracts that span multiple
years.
What do investors expect?
What are your peers likely to do?
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Next Steps
`
Transition and Implementation
` The implementation of the new revenue recognition
standard should be a team effort across many different
corporate functions.
` The level of effort and amount of time necessary will be
contingent on a number of variables including the size,
complexity and previous reliance on industry related
revenue recognition guidance.
` Start early. With the long “on-ramp” that FASB has
allowed for, it is easy for entities to get lulled into a false
sense of security. Large public companies with three
year P&L presentations face the most time pressure.
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Next Steps
`
Transition and Implementation
` Consider the use of an implementation team approach.
Existing pricing committees might be a good way to
govern the implementation process.
` Talk with your auditor and/or professional advisors.
` Watch for further education opportunities from the FASB
Revenue Recognition Implementation Group.
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Questions?
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