By Anthony J. Campolo, CPA, Partner CohnReznick
For construction contractors, revenue is one of the most important measures used to assess a company’s performance.
Recognizing the need for improving how companies measure and report revenue, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) spent many years working together on a converged standard to replace the accounting guidance for revenue recognition. In May 2014, the two standard setters issued converging guidance on revenue in contracts with customers. In the U.S., the FASB issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). The IASB’s standard was issued as IFRS 15.
Superseding virtually all existing revenue recognition guidance in U.S. GAAP, the new revenue recognition standard establishes an underlying core principle under which an entity recognizes 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. The standard establishes a five-step framework that entities will be required to apply in order to achieve the core principle described above.
Each of the steps in the five-step framework can impact the amount and the timing of revenue recognized. The potential impacts can vary significantly among entities.
In a poll conducted during the annual Construction Financial Management Association (CFMA) conference in June 2017, 94% of respondents indicated they are not prepared to meet the new revenue recognition standards. With the deadline to adopt the new standard on the horizon, there is an opportunity for contractors to craft and execute a thoughtful and strategic adoption plan. Accordingly, the time is now for contractors to capitalize on that opportunity to ensure they are fully prepared for implementation of the new standard, as well as the related implications its adoption may have on their businesses.
Which areas of the new revenue recognition standard will most impact contractors?
Conversion to the new standard will present challenges to construction contractors that are unique from other industries. The new standard has broad implications which impact many areas of a contractor’s business, including financial reporting, contract revenue recognition, and integration with operations. This means that contractors must take steps now to identify and arrange the right resources to address the necessary changes under the new standard.
Since the original release of the standard in 2014, many updates have been made to the guidance, making compliance much more manageable for contractors. Below are key areas that will impact contractors and clarity around each:
|Key Areas of New Revenue Recognition Standard
|What You Need to Know
|Contract performance obligations
|Many (not all) construction contracts may have a single performance obligation satisfied over time. Contractors will still need to evaluate each contract for separate performance obligations, document their conclusions, and determine the appropriate recognition method for each.
|Percentage of completion accounting
|Cost to cost can still be used to determine revenue recognition on contracts in progress.While the thought process and terminology will be different, revenue recognized under the new standard may be similar to the percentage of completion method used today. The new standard allows for the use of input or output methods to determine revenue to be recognized. This is based on the assumption that most contracts will be treated as having a single performance obligation satisfied over time.
|FASB included specific language, whereby, in certain circumstances (but not all), contractors may be allowed to recognize revenue equal to the cost of the uninstalled materials if the customer obtains control of the goods. If control has not been transferred, “inventory” type treatment would be more appropriate. Generally, no profit margin can be recognized until materials are installed.
|Change orders now called Contract Modifications; more than just a name change
|Change orders will be recognized differently. There is an enormous amount of judgment in terms of what will and will not be recognized. A modification that is agreed to in terms of scope but not price shall have its value estimated based on the rules associated with variable consideration.
|Variable Consideration – Claims, unapproved or unpriced change orders, liquidated damages, performance bonuses, etc.
|The recognition of these items will be estimated by the contractor based on the most predictable method – either the expected value or the most likely amount. Further, constraints may have to be applied to those estimates. This is where significant judgment must be employed.
|Expensing of wasted materials or labor
|Contractors will be expected to treat inefficiencies differently. For instance, if 500 hours of labor are overrun on a project, those 500 hours will have to be expensed outside of the contract. Never before has the contractor been tasked with treating inefficiencies as a specific period cost.
|Contractors will add significantly more footnotes to the financial statements, as well as more name changes
|While new disclosures will be required, there will be some relief for nonpublic entities. Some of the new disclosures include: disaggregated data by type of contract, geography, type of customer, etc.; changes in contact receivables, contract assets (formerly Cost In Excess) and contract liabilities (formerly Billings In Excess); the timing of cash flow in relation to the satisfaction of performance obligations; when and how performance obligations are satisfied, and significant payment terms, warranty obligations and significant judgments affecting the recognition of revenue.
Assuming a calendar year end, a public company reporting under U.S. GAAP would be required to adopt on January 1, 2018. A non-public company would be required to adopt on January 1, 2019. In the year of adoption, contractors can select from the following two transition methods of reporting:
Full Retrospective Method: Under this transition method, the new standard would be applied retrospectively to each prior reporting period presented with the cumulative effect of the change recorded in retained earnings as of the first day of the earliest period presented.
Modified Retrospective Method: The new standard is applied under this transition method to all existing contracts as of the effective date or the adoption date and to all future contracts. The cumulative effect of initially applying the new standard is recognized in opening retained earnings in the year of adoption. Under this transition method, companies only need to consider the effects of applying the new standard to contracts that are not completed as of the new standard’s effective date. Further, revenue for periods prior to the date the new standard is adopted will be presented under legacy U.S. GAAP.
What Does CohnReznick Think?
While implementation of the new revenue recognition standard has been delayed in the past, CohnReznick believes the current effective dates will stand firm and that contractors should assemble the resources they need now to ensure smooth implementation by the effective dates. Implementation teams need to be developed quickly to gain an understanding of the impact on financial reporting and operations. The CFMA poll indicates that the construction industry is behind the curve on this issue and needs to take action. Since publicly traded companies will begin implementing the standard starting with the first quarter of 2018, CohnReznick will be tracking how those companies report and disclose in their filings. We will keep our clients and contacts informed and develop best practices.
Despite the requirement for private companies to implement starting in 2019, they should be creating the technology to gather the data to monitor such things as uninstalled materials, contract modifications and wasted materials or labor. This is such that they are able to determine the financial impact on contracts in progress as of the end of 2018. CohnReznick will have more offerings on these critical issues as they develop.
Visit CohnReznick’s The Countdown to Revenue Recognition video series and thought leadership articles for further understanding on how your business can prepare for compliance. Stay tuned for our live webinar in November focused on revenue recognition compliance for contractors.
To discuss preparation for the new standard and how it may impact your business, please contact:
Anthony J. Campolo, CPA
Partner, CohnReznick’s Construction Industry Practice
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.