Revenue recognition: Key considerations for the construction industry

Transcription

1 Revenue recognition: Key considerations for the construction industry November 9, 2017

2 Your instructors Brandon Maves Partner, National Construction Industry Leader Minneapolis, Minnesota

3 Your instructors Brandon Jones Partner, National Construction Industry Tax Leader Minneapolis, Minnesota

4 Agenda Topic Introduction Core principle and key steps Loss contracts Contract costs Presentation and disclosure Effective date and transition Income tax implications

5 Objectives By the end of this webcast, you will be able to: Describe the overall approach in the new revenue recognition guidance to the construction industry Determine how your revenue recognition accounting policies, processes and controls may be affected by the new guidance

6 Core principle and key steps

7 Core principle 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

8 Key steps

9 Core principle and key steps > Step 1: Identify the contract with a customer

10 1. Identify the contract with a customer Does a customer contract exist? Defined as an agreement between two or more parties that creates enforceable rights and obligations Whether rights and obligations are enforceable is a matter of law Can be written, oral or implied based on the entity s usual business practices Does the customer contract provide the unilateral, enforceable right to each party to terminate the contract with no compensation to the other party if the contract is wholly unperformed? If so, no accounting consequences related to the contract Example - Service and maintenance contracts (Working Draft of AICPA Engineering & Construction Contractors Revenue Recognition Implementation Issue #4-5)

11 1. Identify the contract with a customer The following contract existence criteria must be met to account for a contract using ASC 606 s revenue model: Commercial substance exists Approvals have been obtained and a commitment to perform exists on the part of both parties Rights of both parties are identifiable Payment terms are identifiable Collection of the amount to which the entity will be entitled is probable (i.e., likely to occur) Once these criteria are met, reassessment is only required if there is a significant change in circumstances

12 Oral Contracts When assessing whether an oral agreement meets the definition of a contract under ASC 606, an entity must determine whether the agreement is legally enforceable A company s policy to obtain signed written agreements from customers does not preclude an oral agreement from meeting the definition of a contract under ASC 606 as long as the oral agreement is legally enforceable. Key construction considerations: Who has the authority to bind the customer? What are normal customer policies for oral contracts?

13 Oral Contracts Oral contracts should be evaluated to ensure they meet all of the contract existence criteria before moving on to the next step of the model. Due to the inherent nature of oral contracts (i.e., not written), oral contracts could be an area with a heightened risk of fraud and errors. Management should pay particular attention to oral agreements to ensure that they meet all of the criteria for proper revenue recognition. If there is significant uncertainty of enforceability, then a written contract and/or legal interpretation by a qualified legal counsel may be required to support conclusions that the parties to the contract have agreed and that there are enforceable rights and obligations.

14 Assessing collectibility Focus is on whether it is probable that the customer has the ability and intention to pay substantially all of the consideration to which the entity will be entitled in exchange for the promised goods or services that will be transferred to the customer Use of substantially all instead of all Promised goods or services that will be transferred may not be all of the promised goods or services in the contract

15 Example: Collectibility General contractor (GC) enters into a contract for construction of an office building for a Developer on the Developer s land The contract price is $25M (which is also the consideration to which the entity will be entitled for purposes of this example) GC will submit billings monthly for work performed, which will include 5 percent retention held back from each billing, and amounts paid by the Developer are nonrefundable GC does not intend to offer Developer a price concession and Developer does not have a valid expectation of receiving a price concession based on GC s customary business practices, published policies or specific statements

16 Example: Collectibility Developer is a new customer that met the standards required by GC s credit policies GC s credit and collection policies and procedures are designed to ensure that it is probable that its customers will pay the amounts owed GC can support that its credit and collection policies and procedures are functioning as intended GC experiences a 96% collection rate with new customers similar to Developer

17 Example: Collectibility Is it probable that Developer has the ability and intention to pay substantially all of the consideration to which GC will be entitled in exchange for the construction of the building? Yes, because: Developer meets the standards required by GC s credit policies, which together with GC s collection policies, are designed to ensure collection is probable GC can support that its credit and collection policies and procedures are functioning as intended As a result, GC expects that it will complete the entire construction of the building for the Customer As a result, the amount GC expects to be entitled to is the contract price of $25M, including any amounts held in retention Because Developer meets the standards required by GC s credit policies, there is a 96% collection rate related to the $25M 96% meets the threshold of substantially all

18 Combining contracts Contracts entered into at or near the same time with the same customer (or related parties of the customer) should be combined if any of the following criteria are met: The contracts were negotiated as a package and share the same commercial objective The consideration to be paid under one contract is tied to the other contract s price or performance The contracts include goods and (or) services that represent a single performance obligation Practical expedient: ASC 606 may be applied to a portfolio of contracts if doing so is not reasonably expected to result in a materially different outcome

19 Combining contracts Contracts entered into between different divisions of the same entity at or near the same time should also be evaluated for possible combination (e.g., a demolition division, design and construction divisions) Contracts entered into at or near the same time with multiple customers that are not related parties cannot be combined even if they were negotiated as a package to achieve a single commercial objective Definition of at or near the same time is based on specific facts and circumstances Related parties under the same holding company in which there are multiple contracts signed at or near the same time will need to be combined

20 Legacy GAAP vs ASC 606, Combining contracts Under legacy GAAP, the ability to combine contracts existed provided certain conditions were met but it was generally optional Under ASC 606, the evaluation of whether to combine contracts signed at or near the same time is required

21 Contract modifications Accounting depends on a variety of factors, such as: Were the scope and (or) price changes properly approved? What is the pricing of the modification? Are any new products or services added by the modification distinct? Are any of the remaining goods or services part of a partially satisfied single performance obligation? Depending on the facts and circumstances, the modification will be accounted for as one of the following: A separate contract The termination of one contract and execution of a new contract (results in prospective treatment) Part of the original contract (which would result in recognition of a cumulative catch-up adjustment)

22 Change orders Accounting depends on a variety of factors, such as: Were the scope and (or) price changes properly approved? Who has the authority to approve? Does this create a binding change order? What is the pricing of the modification? Fixed or variable? Are any new products or services added by the modification distinct? See distinct guidance under identifying performance obligations (later slides) If distinct, may result in a new contract (prospective) vs part of the original contract (cumulative) Are any of the remaining goods or services part of a partially satisfied single performance obligation? Does the contract create something new or additional or is this a change for time/weather delays?

23 Change orders Some of the factors to consider when evaluating change orders include (AICPA Guide ): The customer s written approval of the scope of the change order; Current contract language that indicates clear and enforceable entitlement relating to the change order; Separate documentation for the change order costs that are identifiable and reasonable; or The entity s favorable experience in negotiating change orders, especially as it relates to the specific type of contract and change order being evaluated

24 Example: Contract modifications Contractor is building a facility on Customer s land Assume the contract contains only one performance obligation Due to excessive rainfall, construction is delayed 30 days and the Contractor has incurred various cost overruns Customer has agreed to compensate the Contractor for the unforeseen delays

25 Example: Contract modifications General contractor (GC) enters into a contract for construction of an office building for a Developer on the Developer s land The land is within the central business district of a metropolitan city The contract is modified mid-construction for a change in scope, adding a parking garage that will be adjacent to the building but not attached The parking garage is a separate performance obligation The price for the change has been agreed to and is commensurate with the standalone selling price of the parking garage

26 Construction industry concerns Customer financial stability Owners Developers General contractors Governmental bodies Paid when paid contract provisions Unapproved change orders Oral contracts Contractors need to be aware of the financial viability of a project including the viability of the payment chain

27 Core principle and key steps > Step 2: Identify the performance obligations in the contract

28 2. Identify the performance obligations in the contract Identify all of the promised goods or services Determine if the promised goods or services represent performance obligations Performance obligations (i.e., units of account) Construction Industry Resource: AICPA Revenue Recognition Guide, Chapter 11.2

29 Differences from legacy GAAP Current guidance typically results in revenue recognition based on the contract as a whole, with segmentation or combination only in certain circumstances Legacy GAAP on segmenting contracts is replaced with guidance on identifying performance obligations to determine the unit of account in a contract

30 Identifying promised goods or services Consider both explicit and implicit promises Implicit based on the entity s customary business practices, published policy or specific statement Not all activities performed by the entity in conjunction with the customer contract provide or transfer goods or services to the customer Common example is set-up activities such as mobilization

31 Determining if promised goods or services are performance obligations Is the promised good or service distinct? If so, account for separately as a performance obligation (i.e., unit of account) Series exception: When the promised good or service is part of a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer, the series of distinct goods or services is the performance obligation If not, combine with other promised goods or services until there is a group that is distinct A promised good or service is distinct if it is both: Capable of being distinct Separately identifiable from other promises in the contract (e.g., distinct within the context of the contract)

32 Capable of being distinct A promised good or service is capable of being distinct when a customer can benefit from the promised good or service on its own or together with other readily available resources Examples of situations in which a promised good or service is considered capable of being distinct: The entity regularly sells the good or service separately The customer can sell the good or service on a standalone basis for other than scrap value The customer can use the good or service together with a good or service that has already been transferred to it by the entity (e.g., installation service can be used with the equipment that has already been transferred to the customer) The customer can use the good or service together with a good or service that is readily available in the marketplace

33 Separately identifiable from other promises in the contract Is the nature of the entity s promise within the context of the contract to: Transfer the promised good or service individually? If so, the promised good or service is separately identifiable from the other promises in the contract Transfer a combined item or items to which the promised good or service is an input? If so, the promised good or service is not separately identifiable from the other promises in the contract Additional factors provided to help with this determination

34 Separately identifiable from other promises in the contract Indicators that the promised good or service is not separately identifiable from other promises in the contract The entity provides a significant service of integrating the various promised goods or services included in the contract into one or more combined outputs that were contracted for by the customer The various promised goods or services are inputs to the combined output AICPA Revenue Recognition Guide, Chapter notes that a promised good or service is not distinct when the contract is for the construction of a single, combined output (ASC (a)) Is there a difference between the risk of integrating promised goods and services and the risk of transferring other promised goods and services?

35 Separately identifiable from other promises in the contract Indicators that the promised good or service is not separately identifiable from other promises in the contract One or more of the promised goods or services significantly modify or customize one or more of the other promised goods or services in the contract Neither the promised modification/customization service nor the promised good or service to be modified/customized is separately identifiable

36 Separately identifiable from other promises in the contract Indicators that the promised good or service is not separately identifiable from other promises in the contract The promised goods or services are highly interdependent or highly interrelated with each other, such that each of the promised goods or services in the contract is significantly affected by one or more other promised goods or services in the contract This indicator isn t expected to be as important to contractors (AICPA Revenue Recognition Guide, Chapter )

37 Performance obligations example Example 1: Construction of an apartment building Contract stipulates the following: Project management Excavation Soft costs Direct building costs (foundation, structural, mechanical, electrical) Parking Landscaping

38 Performance obligations example Example 2: Contractor enters into a contract to design and build an apartment building Contractor s analysis: The Contractor has designed and built similar buildings in the past for this customer Once the design of the building is completed and approved, the Contractor thinks it is unlikely that major changes or revisions will be made

39 Warranties Does the customer have the option to purchase the warranty separately? No Does the warranty (or part of the warranty) provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications? Yes Yes No The warranty is a performance obligation Depending on the facts and circumstances, the service-type warranty or the warranty as a whole is a performance obligation The warranty is not a performance obligation

40 Core principle and key steps > Step 3: Determine the transaction price

41 3. Determine the transaction price The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes) An entity should assume the contract will be fulfilled in accordance with its terms (i.e., no assumption of cancellation, renewal, or modification of the contract)

42 3. Determine the transaction price Entitled notion is what results in no consideration being given to the customer s credit risk Estimate is reassessed each reporting period until all performance obligations have been satisfied Accounting policy election: An entity may elect to exclude sales and similar taxes collected from customers from the transaction price If an entity does not make this election, it must apply ASC 606 s principal vs. agent guidance to determine whether such taxes should be included in the transaction price

43 Determine the transaction price Transaction price may include: Variable consideration (more to come ) Fixed cash consideration Includes upfront nonrefundable fees Significant financing component (more to come ) Noncash consideration (more to come ) Consideration payable to the customer Reduces the transaction price unless the entity receives something in return that is distinct and has a reasonably estimable fair value that equals or exceeds the consideration payable 43

44 Variable consideration Examples of variable consideration in the construction industry Performance bonuses Back charges Liquidated damages Cost-target incentives Penalties Discounts Claims Implied price concessions

45 Variable consideration Overall accounting model Estimate the amount of consideration the entity expects to be entitled to using whichever one of the following two methods better predicts that amount (not an election and must be applied consistently for life of contract): Expected value method probability-weighted estimate used when there are several outcomes (e.g., cost-target incentives, liquidated damages) Most likely amount method used when there are few outcomes (e.g., performance bonus of a fixed amount so either earn the bonus amount or don t) Include the estimate in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur Referred to as the variable consideration constraint Estimate should be updated throughout the life of the contract

46 Variable consideration Differences from legacy GAAP Unpriced change orders may be estimated as variable consideration if both parties to the contract have approved the scope of the change order Legacy GAAP allows for recognition of an unpriced change order when it is probable that it will be approved and can be reliably measured

47 Variable consideration example 1 Re-paving of a 20 mile stretch of highway State engineer authorizes the tear up and re-paving of an additional 10 miles while on site Should variable consideration be estimated and included in the transaction price for this unpriced change order?

48 Variable consideration example 1 Should variable consideration be estimated and included in the transaction price for this unpriced change order? Likely yes, based on these limited facts as: Scope of work is agreed upon additional 10 miles Historically the agreed upon price per feet/yard/mile in the existing contract will continue forward (most likely amount method for estimation)

49 Variable consideration example 2 Contractor is missing agreed upon deadlines and delaying subcontractor work Owner/customer files claim against contractor for expected failure to meet deadline and contractor doesn t expect to meet deadline Should variable consideration be estimated and included as a reduction to the transaction price for this penalty?

50 Variable consideration example 2 Should variable consideration be estimated and included as a reduction to the transaction price for this penalty? Yes based on these limited facts as: Failure is expected by both the owner/customer and the contractor and the contractor is liable for a reduction in contract price if they fail based on the number of days delayed Penalty amount would be estimated based on number of days expect to be delayed (expected value method for estimation)

51 Significant financing component Can occur with both advance and deferred payment terms Deferred payments decrease the transaction price and result in the recognition of interest income over a period of time Advance payments increase the transaction price and result in the recognition of interest expense over a period of time Whether a significant financing component exists depends on the facts and circumstances What is the difference between: (a) the amount the customer would have had to pay upon transfer of the goods (i.e., cash selling price) and (b) the amount the customer pays under the contract? How much time will pass between the transfer of the goods and services and payment for those goods or services and what are the prevailing interest rates in the relevant market?

52 Significant financing component Exceptions to reflecting a significant financing component in the transaction price include: The customer makes an advance payment, but the timing of transferring the goods or services is at the customer s discretion Payment of substantial variable consideration is contingent on an uncertainty that the entity does not control Reasons other than the provision of financing justify the difference in cash selling prices and promised consideration Progress payments therefore do not necessarily qualify as a significant financing component Because retainage is intended to be a security measure for performance of the contract, it typically would meet this exception and not be considered a significant financing component Practical expedient: Not necessary to apply if difference between transfer of goods/services and customer payment is expected to be one year or less at contract inception

53 Core principle and key steps > Step 4: Allocate the transaction price

54 4. Allocate the transaction price Overall approach is to allocate transaction price using a relative standalone selling price model Steps in allocating the transaction price Estimate the standalone selling prices of each performance obligation Determine whether any discounts or variable consideration should be allocated to one or more, but less than all, performance obligations Allocate the transaction price

55 Standalone selling prices A standalone selling price is the amount the entity charges (or would charge) when the goods or services are sold on their own to a customer Determined only at contract inception Best evidence is the directly observable price charged by the entity when they sell the goods or services separately in similar circumstances to similar customers If it exists, it must be used If a directly observable price does not exist, must estimate a standalone selling price Maximize observable inputs Consider all reasonably available and relevant information

56 Estimating a standalone selling price Three approaches discussed in ASC 606 Adjusted market assessment approach Expected cost plus a margin approach Residual approach; however, may only be used when: One or more, but not all, of the performance obligations have underlying goods or services for which the standalone selling price(s) is highly variable or uncertain due to specific factors The standalone selling prices for the goods or services in the other performance obligations are observable Not limited to these approaches and a combination of approaches may be appropriate Practical alternative provided to estimate the standalone selling price of certain options (e.g., contract renewals)

57 Allocate discounts and variable consideration In general, proportionately allocate discounts and variable consideration in a customer contract by using the relative standalone selling price model However, if certain criteria are met, a discount or variable consideration must be allocated to one or more, but not all, performance obligations Separate criteria to evaluate for discounts vs. variable consideration

58 Core principle and key steps > Step 5: Recognize revenue

59 5. Recognize revenue Recognize the transaction price allocated to a performance obligation when (or as) it is satisfied Performance obligation is satisfied when (or as) control of the underlying distinct good or service (or distinct bundle of goods or services) transfers to the customer Control has transferred when the customer has the ability to direct the use of the good or service and receive substantially all of the related remaining benefits

60 Over time or at a point in time? KEY QUESTION: Is a performance obligation satisfied (and control of the underlying good or service transferred) over time or at a point in time?

61 Performance obligations satisfied over time A performance obligation is considered satisfied over time if any one of these criteria are met: The customer simultaneously receives and consumes benefits as the entity performs Could another entity step in and fulfill the remaining performance obligation without having to substantially reperform the work already performed by the entity? The entity s performance creates or enhances an asset that the customer controls as it is created or enhanced The entity s performance does not create an asset with an alternative use to the entity and there is an enforceable right to payment for performance completed to date (including a representative profit margin)

62 Performance obligations satisfied over time Identify a single method by which to measure progress toward complete satisfaction of the performance obligation, which should be: A reasonable and reliable method If one cannot be identified, recognize revenue to the extent of costs incurred only if the costs are expected to be recovered and only until a reasonable and reliable method can be identified Consistent with how control of the underlying goods or services are transferred to the customer

63 Performance obligations satisfied over time An input method or output method may be appropriate depending on the facts and circumstances Practical expedient: If the entity has a right to consideration from the customer in an amount that corresponds directly with the value to the customer of the entity s performance completed to date, the entity may recognize revenue in the amount to which it has a right to invoice For example, a service contract in which the entity bills a fixed amount for each hour of service provided

64 Performance obligations satisfied at a point in time If a performance obligation is not satisfied over time, it is satisfied at a point in time Recognize revenue when the customer obtains control over the underlying good or service Indicators that control has transferred include: The entity has a present right to payment for the distinct good or service One or more of the following have transferred/passed to the customer Legal title to the distinct good or service Physical possession of the distinct good or service Significant risks and rewards of ownership The customer has accepted the distinct good or service

65 Performance obligations satisfied over time Measuring progress toward completion Output methods or input methods permitted depending on facts and circumstances (whichever best measures progress toward complete satisfaction of the performance obligation) Examples of input methods: Costs, labor, time Examples of output methods: Units (careful) Use of Alternative B (ASC ) where revenue equals costs incurred plus margin is no longer allowed

66 Performance obligations satisfied over time Measuring progress toward completion If input method used, must exclude inputs that do not contribute to progress toward complete satisfaction of the performance obligation Zero profit margin may be appropriate in limited circumstances in which an entity can t reasonably measure the progress toward completion but expects to recover costs incurred in satisfying the performance obligation

67 Performance obligations satisfied over time example Contract to build a new Formula 1 track for $1B transaction price, 3 year project, on the customer s land. Estimated contract cost is $950M (5% margin). Payments will be made throughout project based on costs incurred (American Institute of Architect (AIA) pay apps) Contractor determined that there is one performance obligation that is satisfied over time as: The entity s performance creates or enhances an asset that the customer controls as it is created or enhanced Building a race track on the customer s land

68 Performance obligations satisfied over time example Contractor concludes that an input measure based on costs incurred is the best measure of progress toward complete satisfaction of the performance obligation Costs incurred in year 1 of $300M and estimated contract costs remain at $950M at the end of year 1

69 Performance obligations satisfied over time example How much revenue should be recognized in the first year? Costs incurred in the first year $300M Total estimated costs at year-end $950M Progress cost-to-cost 31.6% Total transaction price $1B Revenue recognized $316M Gross margin (5%) $16M

70 Performance obligations satisfied over time example Year 2 Contract changes result in issuance of a $100M ($50M in costs) change order No costs associated with change order have been incurred What do we need to know? Nature of the change distinct or not? Additional costs relate to an adjustment to the paddock, but rest of the track remains the same The paddock can t be used for purposes other than enhancing the track Not distinct within the context of the contract Contractor has concluded that the modification does not add distinct goods and therefore a cumulative catch-up approach must be used

71 Performance obligations satisfied over time example Year 2 Costs incurred in year 2 of $400M ($700M total) Estimated contract costs increased to $1B at the end of year 2 Transaction price increased to $1.1B at the end of year 2

72 Performance obligations satisfied over time example How much revenue should be recognized in the second year? Costs incurred during the first two years ($300M year 1, $400M year 2) $700M Total estimated costs at year-end $1B Progress cost-to-cost 70% Total transaction price $1.1B Revenue recognized during first 2 years $770M Revenue recognized in year 2 ($770M less $316M recognized in year 1) $454M Gross margin through end of year 2 (6%) $70M

73 Construction industry concerns Owner purchased materials Uninstalled materials Mobilization

74 Construction industry concerns Uninstalled materials Potential shortcoming in input methods when there s no direct relationship between inputs and transfer of control of goods or services In these cases, any inputs that don t depict transfer of control of goods or services to the customer should be excluded from an input method when measuring progress to completion This may occur with: Owner purchased materials Uninstalled materials Unexpected wasted labor and materials

75 Construction industry concerns Uninstalled materials This can happen when: Cost incurred does not contribute to an entity s progress in satisfying the performance obligation (cost of inefficiencies such as unexpected amounts of wasted materials or labor) Consider delays outside of contractor s control (weather, subcontractors, owner). Cost incurred is not proportionate to the entity s progress in satisfying the performance obligation May need to adjust the input method to recognize revenue only to the extent of costs incurred if all of the following conditions are met: Good is not distinct Customer controls goods significantly before will receive service related to those goods Cost of transferred good is significant relative to the total costs to completely satisfy the performance obligation Entity procures good from third party and is not significantly involved in designing and manufacturing the good

76 Loss contracts

77 Loss contracts Contractors with contracts in the scope of ASC must accrue the full loss when a loss is anticipated by management and becomes evident due to the total consideration expected to be received being less than the total estimated costs Need to evaluate the impact of all future variable consideration Policy election can be made to identify and recognize losses at the performance obligation level or the contract level.

78 Contract costs

79 Contract costs Applicability Costs to fulfill a contract Costs to obtain a contract Guidance only applies when the contract is within the scope of ASC 606 and if the costs are not within the scope of other ASC Topics Example Setup costs / Mobilization Commission Capitalization criteria Capitalize costs if all of the following criteria are met: Directly relate to the contract or an anticipated contract Generate or enhance resources that will be used to satisfy performance obligations in the future Expected to be recovered Capitalize incremental costs if they are expected to be recovered Capitalize costs that are not incremental only if they are explicitly chargeable to the customer regardless of whether the contract is obtained

80 Contract costs Practical expedient Amortization Impairment Costs to fulfill a contract None Costs to obtain a contract Expense if amortization period would otherwise have been one year or less ( ) Method should be consistent with how the related goods or services are transferred to the customer Depending on the facts and circumstances, it may be appropriate to use an amortization period longer than the initial contract period Compare the carrying amount to an amount that considers the revenue and costs that remain to be recognized under the contract, including expected contract renewals and extensions with the same customer

81 Costs to obtain a contract Examples of costs that are not incremental to obtaining a contract: Costs that are incurred regardless of whether the contract is obtained, such as costs incurred in negotiating or drafting a contract; Costs that depend on further performance such as continued employment Payments based on operating metrics like EBITDA or operating income that are not solely linked to obtaining one or more contracts.

82 Costs to obtain a contract Guidance for the treatment of these costs is within ASC (new Codification section) Some significant changes: Contractors will not be able to elect to expense all commissions Costs that will be incurred regardless of whether the contract is obtained, such as costs incurred to trying to obtain a contract, are expensed (unless they meet the criteria to be capitalized as fulfillment costs)

83 Construction industry concerns - Costs to obtain a contract Currently, some contractors defer some employee compensation related to obtaining a contract based on an analogy to legacy GAAP addressing loan origination fees This is no longer allowed as these are not incremental costs of obtaining a contract as salary would be paid regardless of whether or not they were successful in obtaining the contract Could result in a change in practice for contractors that currently either capitalize bid costs or that expense sales commission costs Need to identify those costs that are incremental to obtaining the contract and exclude non-reimbursable bid costs that would be incurred regardless of whether the contract is obtained

84 Costs of fulfilling a contract Examples of direct costs that are eligible for capitalization: Direct labor, such as employee wages Direct materials, such as supplies Allocation of costs that relate directly to a contract, such as depreciation and amortization Costs explicitly chargeable to a customer under the contract Other costs incurred only because the entity entered into the contract, such as subcontractor costs

85 Costs of fulfilling a contract Examples of costs required to be expensed as incurred: General and administrative costs (unless explicitly chargeable under the contract) Costs related to satisfied performance obligations Costs of wasted materials, labor or other contract costs Costs that do not clearly relate to unsatisfied or partially satisfied performance obligations

86 Presentation and disclosure

87 Balance sheet presentation Entity recognizes a contract asset or contract liability by comparing its performance under the contract (i.e., transferring control of performance obligations) to Customer s performance under the contract (i.e., making payments) Contract asset Entity s performance > Customer s performance Contract liability Entity s performance < Customer s performance Receivables are only recognized for the unconditional right to receive consideration Recognized separate from other assets

88 Disclosures Objective is to help financial statement users understand the nature, amount, timing and uncertainty of the related revenue and cash flows Annual and interim disclosures required of public entities Less on an interim basis, but mostly quantitative in nature More disclosures required of public business entities (PBEs) and certain nonprofit entities and employee benefit plans However, disclosures for all others are still significant

89 Disclosures Detailed quantitative and qualitative information about the following must be disclosed: Disaggregated revenue by location, product type Contract assets, contract liabilities and receivables Performance obligations in general and the transaction price allocated to the remaining performance obligations at the end of the reporting period Significant judgments related to when performance obligations are satisfied and used to estimate and allocate the transaction price Capitalized customer contract costs

90 Effective date and transition

91 Effective date Calendar year end entities June 30 year end Effective date of ASC 606 entities Public entities*, quarter and year January 1, 2018 July 1, 2018 beginning Other entities, year ending December 31, 2019 June 30, 2020 Early adoption of ASC 606 Allowed for both public entities and other entities As early as January 1, 2017 * Public entities include PBEs, nonprofit entities that have issued, or are conduit bond obligors for, securities that are traded, listed or quoted on an exchange or an over-the-counter market and (c) employee benefit plans that file or furnish financial statements to the SEC. However, the SEC staff recently announced that they would not object to those entities that are PBEs solely because their financial statements or financial information is included in a filing with the SEC pursuant to SEC rules and regulations choosing to adopt the new guidance in accordance with the effective date provided for private companies. As early as July 1, 2017

92 Transition methods Entities may choose to apply one of the following transition methods: Full retrospective application of ASC 606 to all periods presented, with multiple practical expedients available Modified retrospective application as of the date of initial application of ASC 606, with one practical expedient available

93 Income tax implications

94 Income tax implications IRS Notice IRS requested and received several comments on the effect of Topic 606 to taxpayers Recognizes that some industries may be more impacted than others Construction Software Entertainment Manufacturing

95 Income tax implications IRS Notice Requested comments on a proposed revenue procedure for taxpayers who for federal income tax purposes request consent to change a method of accounting for recognizing income in order to comply with the new financial accounting standards The proposed guidance is limited to taxpayers requesting consent within the same year in which they adopt the new standards defined as a qualifying same-year method change to change to a method of accounting that complies with section 451 Proposed guidance does not include section 460, which has been requested in comment letters

96 Income tax implications Notice (cont.) Draft automatic consent procedures only qualifying same-year method change Form 3115 There is however a proposal for small taxpayers (defined as a separate and distinct trade or business with total assets of less than $10 million or average annual gross receipts of $10 million or less for the three preceding tax years) to implement the changes under a cut-off approach (no section 481(a) adjustment)

97 Income tax implications We are hoping for substantive guidance: Relating to specific issues (e.g., full book/tax conformity, safe harbors, percentage-of-completion method issues, etc.) Relating to the determination on section 481(a) adjustment period. Generally, unfavorable adjustment is a 4-year spread. Release date not yet provided by IRS representatives

98 Income tax implications What we know: The IRS realizes that GAAP income may change For taxpayers using Section 460 (Percentage of Completion), the code and regulations were similar to legacy GAAP Change in GAAP method does not equal a change in tax method. The IRS MAY provide taxpayers a mechanism to change their method to for tax purposes to follow ASC 606 The IRS believes in Percentage of Completion The great equalizer Look-Back Calculation Hopefully an opportunity to implement other Section 460 method changes at the same time as adopting ASC 606

99 Revenue Recognition Resource Center

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