Revenue Recognition: A Comprehensive Look at the New Standard for the Construction & Real Estate Industries

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1 Revenue Recognition: A Comprehensive Look at the New Standard for the Construction & Real Estate Industries

2 Table of Contents BACKGROUND & SUMMARY... 3 SCOPE... 4 THE REVENUE RECOGNITION MODEL... 5 STEP 1 IDENTIFY THE CONTRACT WITH A CUSTOMER... 5 Collectibility... 6 Combining Contracts... 6 Contract Modifications... 7 STEP 2 IDENTIFY PERFORMANCE OBLIGATIONS... 9 Segmenting Contracts Warranties STEP 3 DETERMINE THE TRANSACTION PRICE Variable Consideration & Revenue Constraint Significant Financing Component Noncash Consideration Consideration Payable to a Customer STEP 4 ALLOCATE THE TRANSACTION PRICE TO THE SEPARATE PERFORMANCE OBLIGATIONS Changes in Transaction Price & Variable Consideration STEP 5 RECOGNIZE REVENUE WHEN (OR AS) PERFORMANCE OBLIGATIONS ARE SATISFIED Performance Obligations Satisfied Over Time Control Transferred at Point in Time OTHER ITEMS CONTRACT COSTS Incremental Costs of Obtaining a Contract Costs to Fulfill a Contract Amortization & Impairment ONEROUS PERFORMANCE OBLIGATIONS REPURCHASE ARRANGEMENTS Sale Leasebacks TRANSFERS OF ASSETS THAT ARE NOT AN OUTPUT OF AN ENTITY S ORDINARY ACTIVITIES PRESENTATION & DISCLOSURE PRESENTATION DISCLOSURES SEC REQUIREMENTS EFFECTIVE DATE & TRANSITION EFFECTIVE DATE TRANSITION CONTRIBUTORS

3 Background & Summary The model for revenue recognition is changing with the May 2014 release of ASU , Revenue from Contracts with Customers (Topic 606). Since 2008, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working jointly on developing a single model for recognizing revenue. The boards issued exposure drafts in June 2010 and November Feedback from the construction industry was intense and proved to be effective as FASB made several changes in the final standard to address industry concerns. One of the goals of the new model is for entities to recognize revenue more consistently for economically similar transactions regardless of industry. Substantially all existing revenue recognition guidance, including construction and real estate-specific industry guidance, will be replaced by the new standard. This paper focuses on how the new revenue model will affect entities in the construction and real estate industry. The new model becomes effective in 2017 and 2018 for public and nonpublic entities, respectively. The new model requires management to use greater judgment in recognizing revenue and related costs and significantly increases revenue disclosures. To aid transition to the new standard, the boards established the Joint Transition Resource Group for Revenue Recognition (TRG). The TRG will solicit, analyze and discuss stakeholder issues arising from implementation of the new revenue recognition guidance and share this information with the boards. The boards will consider information from the TRG and determine what action, if any, will be taken on each issue. Entities should begin assessing how they will be affected by the new standard in order to develop an appropriate implementation plan to ensure a smooth transition. This includes evaluating existing revenue contracts and revenue recognition accounting policies in order to identify potential changes that will result from adopting the new standard. Management will need to update data systems, processes and controls to support implementation of the new standard. Changes in the timing or amount of revenue recognized may affect sales agreements, longterm compensation arrangements, compliance with debt covenants and key financial ratios. 3

4 What to Do Now Action Item Review in process and existing contracts Review technology, controls and processes Review and update estimation process Review the overall business effect Develop a transition plan Thought Process Identify features that may require additional judgment and analysis such as variable consideration. Be mindful of contracts that provide customers with more than one good or service, as these might indicate separate performance obligations. Determine if the current technology, controls and processes can gather the data necessary to comply with the standard tracking contracts, measurements towards completion and making necessary disclosures. The new principles-based standard requires much more judgment from management than in the past. This will require implementation of controls and processes to help document management s estimates and judgments. Determine the tax implications of accelerating or deferring revenue based on the contract terms. Revenue-related compensation will be affected if revenue recognition changes. Debt covenants may need to be restructured. Pricing strategies may change as contracts are bundled or set up as separate performance obligations. There are two options for implementing the new standard: Full retrospective approach that provides entities with certain practical expedients Modified retrospective approach under which the cumulative effect of adopting the new standard is recognized at the date of initial adoption Scope The new revenue standard applies to all contracts with customers, except for those within the scope of other standards, such as lease contracts, insurance contracts, financing arrangements, financial instruments, guarantees (other than product or service warranties) and certain nonmonetary exchanges between vendors. A contract may be partially in the scope of the new standard and partially in the scope of other accounting guidance. If the other accounting guidance specifies how to separate and/or initially measure one or more parts of a contract, an entity should apply those requirements first before applying this ASU. Leases of property that is not investment property, as well as the related rental income, would be covered by the new lease standard. 4

5 The Revenue Recognition Model The model s core principle is that an entity would recognize revenue in the amount that reflects the consideration to which it expects to be entitled in exchange for goods or services when (or as) it transfers control to the customer. To achieve that core principle, an entity would apply a five-step model: Identify the contract(s) with a customer Identify performance obligations Determine the transaction price Allocate the transaction price to performance obligations Recognize revenue when (or as) a performance obligation is satisfied Step 1 Identify contract with customer Step 2 Identify performance obligations Step 3 Determine transaction price Step 4 Allocate transaction price Step 5 Recognize revenue Step 1 Identify the Contract with a Customer A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations and meets all of the following criteria: Approved by all parties to the contract this approval can be written, verbal or implied by an entity s customary business practices. Both parties must be committed to satisfying their respective performance obligations Contains identifiable rights, obligations and payment terms for each party to the contract Has commercial substance, defined as the expectation that the entity s future cash flows will change as a result of the contract Collectibility is probable, i.e., it s probable the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer Commercial substance Collectibility Contract Approval & commitment Identifiable rights, obligations & payment terms 5

6 A contract would not exist if each party has the unilateral enforceable right to terminate a wholly unperformed contract without compensation. Revenue will not be recognized for a contract that fails to meet all the criteria above until either: The entity has no remaining obligations to transfer goods or services to the customer and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable The contract has been terminated and the consideration received from the customer is nonrefundable Real Estate Sales Currently, profit recognition on a real estate sale is not allowed if the seller finances the transaction or the buyer s initial investment does not meet specific quantitative thresholds. The new model requires the seller to evaluate whether the buyer is committed to perform. The objective of customer commitment is retained in the new model without establishing bright lines (specific percentages for initial and continuing involvement). Entities must use judgment in evaluating all the facts and circumstances concerning whether the parties intend to be bound by a contract. Unpriced Change Orders Frequently, contractors and customers agree to changes in the scope of work, though the amount of consideration is not determined for a period of time. FASB clarified in its Basis for Conclusions that lacking identification of payment terms in a contract would not preclude revenue recognition if the scope of work has been approved and the entity expects the price will be approved. In these situations, an entity should estimate the change to the contract price as variable consideration. See Step 3 Determine the Transaction Price for variable consideration. Collectibility Collectibility is an explicit threshold that must be assessed before applying the new revenue recognition model to a contract. An entity must evaluate customer credit risk and conclude it is probable that it will collect the amount of consideration due in exchange for the goods or services. The assessment is based on the customer s ability and intent to pay as amounts become due. An entity only will consider credit risk and no other uncertainties, such as performance or measurement, as these are accounted for separately when determining timing and measurement of revenue. Any subsequent negative adjustments related to customer credit risk will be recognized as an expense in the income statement and measured in accordance with the financial instrument standard. This will affect the recognition of sales of real estate when collectibility of the proceeds is in question. The evaluation will require significant judgment because the new standard lacks the prescriptive guidance found in ASC , Real Estate Sales. It will be important for an entity to document its collectibility evaluation at contract inception. In making this assessment, an entity should consider the buyer s ability to pay amounts when due and could include the buyer s available resources and importance of the property to the buyer s operations. Combining Contracts Under current industry guidance, combining contracts is permitted provided certain criteria are met. While the language in the new revenue standard is different, it should not result in a substantial change in the assessment of whether contracts should be combined. 6

7 Combining Contracts Current U.S. GAAP Contracts may be combined if they: Were negotiated together with an overall profit margin objective Constitute an agreement for a single project Require closely interrelated construction activities with substantial common costs that cannot be separately identified with or reasonably allocated to the elements, phases or unit of output Are performed concurrently or in a continuous sequence under the same project management at the same location or at different locations in the same general vicinity Constitute an agreement with a single customer Combining contracts is permitted but not required if the underlying economics of the transaction are fairly reflected. New Model Contracts entered into at or near the same time with the same customer (or related parties) should be combined if one or more of the following criteria are met: Contracts are negotiated together with a single commercial objective Pricing interdependencies exist between contracts Goods or services in the contracts represent a single performance obligation (see Step 2 Identify Performance Obligations ) Contract Modifications A contract modification occurs when the parties to a contract approve a change in the scope or price of a contract that creates new enforceable rights and obligations or changes existing ones. Previous revenue recognition guidance did not include a framework for accounting for contract modifications, except for construction and production-type contracts. Under the new standard, a contract modification can be written, oral or implied by customary business practices. Contract claims, e.g., additional consideration for customer-caused delays, changes or errors in specifications, would be accounted for like contract modifications. Unsettled claims and unpriced change orders would be accounted for similar to modifications only if the scope of the work has been approved and the entity can estimate the change in transaction price. Entities should estimate the change in transaction price in accordance with the guidance on estimating variable consideration and constraint on revenue recognition (see Step 3 Determine the Transaction Price ). When an entity anticipates a claim being settled through adjudication or arbitration, the degree of uncertainty of the amount of consideration is likely to increase, causing delay in revenue recognition until the uncertainty is resolved due to the variable consideration constraint. Accounting for contract modifications will depend on the type of modification. A contract modification would be recognized as a separate contract only if distinct goods or services are added for additional consideration that reflects their standalone selling prices. If these two criteria are not met, the modification would be accounted for on a combined basis with the original contract, either prospectively or on a cumulative catch-up basis depending on whether the remaining goods or services are distinct from the goods or services transferred before the modification. If distinct, the modification is accounted for prospectively with the unrecognized consideration allocated to the remaining performance obligations and revenue recognized when (or as) the remaining performance obligations are satisfied. If the remaining goods or services are not distinct, the modification is accounted for as if it were part of the existing contract, forming part of a single partially satisfied performance obligation at the date of the modification. The modification s effect on the transaction price and on progress 7

8 toward satisfaction of the performance obligation is recognized as an adjustment to revenue on a cumulative catch-up basis. Since almost every construction contract is unique, change orders will have to be evaluated to determine whether they are part of an existing performance obligation or if they represent a new performance obligation. If a contract modification is treated as a new contract, the revenue recognition pattern likely will be different than if combined with the original contract. Current U.S. GAAP Contract revenue and costs are adjusted for approved scope and price modifications. Included in revenue if recovery is probable and amount can be reasonably estimated. Recorded when probable and estimable up to the extent of costs incurred. Profits are not recognized until realized. Modifications Unpriced Change Orders Claims Revenue New Model Depending on the type of modification, either considered a new contract or part of original contract. If change in scope has been approved, the change in transaction price should be estimated in accordance with guidance on variable consideration. Variable consideration should only be included in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur as a result of a change in estimate of the consideration. Included in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty is resolved. 8

9 Example An entity enters into a contract to construct a strip center for a customer, which is considered a single performance obligation (the services are highly integrated and are significantly customized to fulfill the contract). At inception, the entity expects the following: Transaction price $10,000,000 Expected costs (8,000,000) Expected profit $ 2,000,000 By the end of the first year, the entity has satisfied 50 percent of its performance obligation on the basis of costs incurred ($4 million) relative to the total expected costs ($8 million). Cumulative revenue and costs recognized for the first year are: Revenue $ 5,000,000 Costs (4,000,000) Gross profit $ 1,000,000 At the beginning of the second year, the parties agree to change one of the floor plans to accommodate a grocer rather than a clothing store. As a result, the contract revenue and expected costs increase by $1 million and $750,000, respectively. Since the remaining goods and services (changed floor plan) are not distinct from the original contract (delivery of a strip mall), the contractor accounts for the modification as if it were part of the original contract. The entity updates its measure of performance and estimates it has satisfied 46 percent of its performance obligation ($4 million actual costs incurred/$8.75 million total expected costs). The entity would recognize additional revenue of $60,000 (46% complete x $11 million modified transaction price - $5 million recognized to date). Step 1 Identify contract with customer Step 2 Identify performance obligations Step 3 Determine transaction price Step 4 Allocate transaction price Step 5 Recognize revenue Step 2 Identify Performance Obligations Once an entity has identified a contract, it would identify separate performance obligations within that contract. A performance obligation is a promise to transfer a distinct good or service (or a series of distinct goods or services that are substantially the same and have the same pattern of transfer) to a customer. In order to be distinct, a promised good or service must be both: Capable of being distinct, i.e., the customer can benefit from the good or service on its own or with other resources that are readily available to the customer Distinct within the context of the contract, i.e., the good or service is separately identifiable from other promises in the contract; the following indicators would be used to evaluate if a good or service is distinct within the context of the contract: 9

10 Significant integration services are not provided The customer was able to purchase, or not purchase, the good or service without significantly affecting the other promised goods or services in the contract The good or service does not significantly modify or customize another good or service promised in the contract The promise can be explicitly identified in a contract or implied by customary business practices, published policies or specific statements. The notion of a performance obligation is similar to the notions of deliverables, components or elements of a contract in previous revenue guidance. This is a critical step, as the performance obligation not the contract is the unit of account for recognizing revenue under the new model. Some goods and services may continue to be accounted for at the contract level, but in certain situations management may need to start to separately account for multiple obligations within a contract. Contract or segment Current U.S. GAAP A profit center is the unit of account for the measurement of revenues and costs. The profit center is usually a single contract, but under certain circumstances it may be a combination of two or more contracts, a segment of a contract or a group of combined contracts. Unit of Account Performance obligation New Model This is the promise to transfer distinct goods or services to a customer that can be explicitly identified in a contract or implied by customary business practices, published policies or specific statements. This step has generated the most questions from contractors, since many interpreted the first discussion paper to mean an entity would need to account for every good or service transferred as a separate performance obligation, e.g., every brick, every nail, every board. As a result of industry feedback, the final standard provides clearer and more practical guidance on the identification of performance obligations. For a building contractor, the materials used in a project, e.g., bricks, nails and boards, can be distinct; however, they are not distinct within the context of the contract and would not be accounted for as separate performance obligations, as doing so would not result in a faithful depiction of contract performance. Entities will need to exercise judgment and document their conclusions in evaluating separate performance obligations. For example, lease agreements have evolved from strictly payment for the rental of space, with separate charges for items like common area maintenance, to leases where the rent payment includes the reimbursement for embedded services, e.g., common area maintenance, security or landscaping. If a lessor provides other services to tenants, it would consider whether the rent and other services should be accounted for separately. The lessor would use the guidance in the leases standard to make this assessment and allocate consideration between the lease and the service elements. The lessor then would use the guidance in the revenue standard to account for the other services that have been separately identified. Another area for careful management evaluation would be a development contract that includes infrastructure and amenities. Because most construction contracts are highly integrated and customized, as highlighted in the example below, most construction contracts likely would be a single performance obligation. 10

11 Example An entity enters into a contract to design and build a hospital. The entity is responsible for the overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, construction of the structure, piping, wiring, installation of equipment and finishing. The entity would account for the bundle of goods and services as a single performance obligation because the goods or services in the bundle are highly interrelated and require the builder to provide significant integration, modification and customization in delivery of the hospital. Revenue from the performance obligation would be recognized over time by selecting an appropriate measure of progress toward complete satisfaction of the performance obligation. Segmenting Contracts The current industry guidance that permits segmenting contracts under certain circumstances was eliminated by the new standard. However, construction companies that segment contracts under current guidance might not be significantly affected due to the requirement to identify separate performance obligations. Current U.S. GAAP If all the following criteria are properly documented a contract can be segmented: Separate project components have bids distinct from the entire project Customer could accept the proposals on either basis Aggregate amounts of the separate proposals equaled the amount of the entire project proposal Once the criteria are met, then each individual proposal becomes the unit of account for accumulating costs and recognizing revenue. The profit margin on each proposal may be different than the combined contract. Warranties Segmenting Contracts New Model The following criteria must be met to separately account for performance obligations in a contract. The goods or services must be both: Capable of being distinct because the customer can benefit from the good or service on its own or with other resources that are readily available to the customer Distinct within the context of the contract the good or service to the customer is separately identifiable from other promises in the contract Entities must distinguish between warranties representing assurance of a product s performance and those representing a separate performance obligation. If a customer has the option to separately purchase a warranty, the entity has promised to provide a service to the customer and would account for that warranty as a separate performance obligation. The transaction price would be allocated on a relative standalone selling-price basis. If no separate purchase option exists, the entity would apply the cost-accrual guidance in ASC 460, Guarantees. If an entity promises both assurance and service-type warranties but cannot reasonably account for them separately, then it would account for both together as a single performance obligation. 11

12 Warranties Current U.S. GAAP Standard warranty liability is accrued when the warranty costs are probable and reasonably estimable Separately priced extended warranty contractually stated price is deferred and recognized over the warranty period New Model Entities must distinguish warranties that represent assurance of a product s performance from those that provide the customer with a service in addition to assurance; depending on the type of warranty, it may represent a separate performance obligation Separately priced extended warranty relative standalone selling price is deferred and recognized over the warranty period Step 1 Identify contract with customer Step 2 Identify performance obligations Step 3 Determine transaction price Step 4 Allocate transaction price Step 5 Recognize revenue Step 3 Determine the Transaction Price The transaction price is 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. The promised consideration may include fixed amounts, variable amounts or both. In order to determine the transaction price, an entity should analyze the terms of the contract and its customary business practices and consider the effects of the following: Variable consideration Constraining estimates of variable consideration The existence of a significant financing component in the contract Noncash consideration Consideration payable to a customer Judgment will be required when applying these principles to the construction and real estate industries, especially when the contract price is variable. Revenue related to awards or incentive payments may be recognized earlier under the new standard in some situations. Variable Consideration & Revenue Constraint Variable consideration is anything that causes the amount of consideration to vary and may result from volume discounts, rebates, price concessions, refunds, performance bonuses, contingencies, royalties, penalties or other items. An entity should include in the transaction price an estimate of the amount of variable consideration to which it expects to be entitled but only to the extent it is probable a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. The level of confidence needs to be relatively high to recognize revenue for variable consideration. This is a qualitative assessment and not a quantitative threshold. This constraint also would apply to a fixed-price contract if an entity s entitlement is contingent on the occurrence or nonoccurrence of a future event, for example, performance bonuses or sales with a right of return. Management s estimate of the transaction price 12

13 will be reassessed each reporting period; the transaction price should be updated for any changes in circumstances throughout the period. Significant judgment often will be needed to determine if the amount of cumulative revenue recognized is subject to a significant reversal. Entities should consider the following factors, which increase the likelihood or the magnitude of a revenue reversal: The amount of consideration is highly susceptible to factors outside the influence of the entity Resolution of the uncertainty about the amount of consideration is not expected for a long period of time The entity has limited experience with similar types of contracts The entity has a practice of offering a broad range of price concessions or changing the payment terms and conditions in similar circumstances for similar contracts The contract has a large number and broad range of possible consideration amounts Entities are required to estimate the transaction price using either the expected value or the most likely amount approach, depending on which one is expected to most accurately predict the consideration to which the entity will be entitled: Expected value used a probability-weighted estimate for a large number of contracts with similar characteristics Most likely amount used when a contract has only two possible outcomes An entity would use the same method throughout the life of the contract to update the estimated transaction price at each reporting date. Currently, for performance bonuses an entity would not include any amount until it is earned. Under the new model, an entity would estimate and include in the transaction price the most predictive amount of a performance bonus that would not be subject to risk of significant reversal. Some entities might recognize revenue earlier than current practice, if they have predictive experience. If an entity does not have predictive experience relative to the entire transaction price but does have predictive experience up to a certain amount or floor, the floor amount would be used in determining the transaction price. Sales of vacant commercial real estate commonly include rental guarantees wherein the seller will guarantee a minimum rental income for the buyer for a period of time. The seller retains risk exposure and continuing involvement through the guarantee period. Under previous guidance, if the guarantee was so significant that the risk and rewards of ownership had not passed to the buyer, no sale would be recognized. Under the new model, a rental guarantee would not preclude sale treatment; the rental guarantee would be considered a form of variable consideration. Asset management fees of REITs would be subject to the new model. Asset management fees based on performance, e.g., incentive fees based on a percentage of the property s net operating income, or the fair value of assets managed would be variable consideration. An entity now would be able to recognize some or all of such consideration if a significant revenue reversal is not likely. 13

14 Variable Consideration Current U.S. GAAP The seller s price must be fixed or determinable for revenue to be recognized (one of four recognition principles). Variable amounts are not included in the transaction price until the variability is resolved (except for percentage of completion method); the sales price in cancellable arrangements generally is not fixed or determinable until cancellation privileges lapse. New Model Variable consideration is included in the transaction price to the extent it is probable that a significant reversal of cumulative revenue will not occur. Estimates can be used if an entity has predictive experience. Significant Financing Component The construction industry typically has long-term contracts with various payment terms. Under the new standard, entities will need to assess the timing of customer payments in relation to the transfer of goods or services. A difference in timing could indicate a significant financing component for either the customer or the entity for which the transaction price would need to be adjusted to reflect a selling price as though the customer had paid cash at the time of transfer. To determine if a contract contains a significant financing component, an entity would consider all of the following: Whether the consideration would differ substantially if the customer paid cash promptly under the typical credit terms Expected length of time between delivery of goods or services and receipt of payment The interest rate in the contract and prevailing market interest rates As a practical expedient, an entity would not reflect the time value of money if the period between customer payment and the transfer of goods or services is one year or less; this also would apply to contracts greater than one year. An entity must disclose if this practical expedient is elected. The adjustment to the transaction price for the time value of money would use the discount rate implied in a separate financing transaction between the entity and the customer at contract inception, reflecting the borrower s (customer s) credit risk and any collateral or security provided. The rate may be calculated by discounting the nominal amount of the promised consideration to the cash selling price of the good or service. The rate cannot be adjusted for changes in circumstances or interest rates after contract inception. The effects of financing would be presented separately from revenue as interest expense or interest income in the statement of comprehensive income. An entity would not be precluded from presenting interest income recognized from contracts with a significant financing component as revenue, if it generates interest income in the normal course of business similar to a financial services entity. Retainage Many construction contracts include a provision allowing one party to withhold a percentage of the contractual payment until a project is substantially complete; the amount withheld is commonly referred to as a retainage. Retainages are intended to address concerns a contractor will not finish a project if full payment already has been made. The new model makes an exception for certain differences between the promised consideration and the cash selling price of the goods or services. A contract would not be considered to have a significant financial component, if the difference stems from a reason other than financing to either the customer or the contractor, and the difference is proportional to the reason for the difference. 14

15 An entity paying in advance for goods or services would not reflect the time value of money if the transfer of goods or services to a customer is at the discretion of the customer. As a result, a prepayment to secure supplies would not be considered a significant financing component. An entity enters into a construction contract that includes scheduled milestone payments for performance by the entity throughout the three-year contract. The performance obligation will be satisfied over time, and the milestone payments are scheduled to coincide with the expected performance. A percentage of each milestone payment is to be retained by the customer and paid only upon the building s completion. Since the milestone payments coincide with the entity s performance and the retainage amounts are related to performance, the entity concludes the contract does not include a significant financing component; retainages are intended to protect the customer from the contractor failing to complete its obligations under the contract. Entities may be required to recognize interest income or expenses, and total revenue could be more or less than the consideration received. Significant Financing Component Current U.S. GAAP Interest is imputed for receivables arising from the normal course of business that are due in more than one year. Interest is computed based on the stated rate in the contract or a market rate when discounting is required. New Model The transaction price is adjusted to reflect the time value of money if the contract has a significant financing component and the terms of the contract are greater than one year. If the transfer of goods or services is at the discretion of a customer, any cash advance payments would not be adjusted to reflect the time value of money. Noncash Consideration If a customer promises consideration in a form other than cash, an entity would measure the noncash consideration at fair value to determine the transaction price. If a reasonable estimate of fair value of the noncash consideration cannot be made, the estimated selling price of the promised goods or services would be used. This is similar to current accounting standards. Consideration Payable to a Customer Consideration payable to a customer includes amounts that an entity pays, or expects to pay, to a customer in the form of cash or noncash items, which the customer can apply against amounts owed to the entity. An entity would evaluate the consideration to determine whether the amount represents a reduction of the transaction price, a payment for distinct goods or services or a combination of the two. An entity would reduce the transaction price by the amount it owes to the customer, unless the consideration owed is in exchange for distinct goods or services transferred from the customer to the entity. If the consideration owed to the customer is payment for distinct goods or services from the customer to the entity, the entity would account for the purchase of these goods or services similarly to purchases from suppliers. If the amount of consideration owed to the customer exceeds the fair value of those goods or services, the entity would reduce the transaction price by the amount of the excess. If the entity cannot estimate the fair value of the goods or services it receives from the customer, it would reduce the transaction price by the total consideration owed to the customer. 15

16 An entity would recognize the reduction in revenue associated with adjusting the transaction price for consideration payable to a customer at the later of the following dates: When the entity recognizes revenue for the transfer of goods or services to the customer When the entity pays or promises to pay the consideration to the customer (this could be implied by customary business practices) Step 1 Identify contract with customer Step 2 Identify performance obligations Step 3 Determine transaction price Step 4 Allocate transaction price Step 5 Recognize revenue Step 4 Allocate the Transaction Price to the Separate Performance Obligations An entity would allocate the transaction price to performance obligations based on the relative standalone selling price of separate performance obligations. The best evidence of standalone selling price would be the observable price for which the entity sells goods or services separately. In the absence of separately observable sales, the standalone selling price would be estimated by maximizing the use of observable inputs and considering all information reasonably available to the entity. The objective would be to allocate the transaction price to each performance obligation in an amount that represents the consideration the entity expects to receive for their goods or services. Several approaches might be used: Adjusted market-assessment: An entity would evaluate the market and estimate the price customers would pay; competitors price information might be used and adjusted for an entity s particular cost and margins Cost plus margin: An entity would forecast its expected cost to provide goods or services and add an appropriate margin to the estimated selling price Residual value: An entity would subtract the sum of observable standalone selling prices for other goods and services promised under the contract from the total transaction price to obtain an estimated selling price for a performance obligation; this approach would be appropriate only if selling price is highly variable or uncertain, e.g., intellectual property where there is little or no incremental cost or a new product where price has not been set or the product has not been previously sold The use of the residual value approach is more limited within the ASU than under current accounting guidelines. The residual method becomes an estimation technique rather than an allocation methodology. Where more than one good or service has a highly variable price or is uncertain, an entity could use a combination of techniques to estimate their standalone selling price. An entity would first apply the residual approach to estimate the aggregate price for all the goods and services with highly variable or uncertain standalone prices and use another technique to allocate the aggregated estimated selling prices to the remaining good or services. 16

17 A group of doctors approached a contractor about building a medical office and installing a nurse calling system. The office and call system are separate performance obligations and have a combined contract consideration of $20 million. The relative standalone selling price of the office is $25 million and the call center $1 million (see below). Product Price Method Standalone Selling Price Medical Office Relative value 25 Calling System Relative value 1 Total 26 Allocation Medical Office 25/26 x Calling System 1/26 x Total 20 Changes in Transaction Price & Variable Consideration If the transaction price changes after contract inception, an entity would allocate the change to separate performance obligations in the same manner it allocates the transaction price at contract inception. Any change in the transaction price allocated to a satisfied performance obligation would be recognized as revenue or as a reduction in revenue in the period the change occurs. An entity would allocate a change in transaction price to a single distinct good or service, or group of goods or services using the same criteria applied to variable consideration noted below. Variable consideration may be attributable to the entire contract or to specific part of a contract. Variable consideration (and any subsequent changes) would be allocated entirely to a distinct good or service only if the variable payment relates specifically to either of the following: The entity s efforts to transfer that distinct good or service A specific outcome of transferring that distinct good or service Allocating the variable consideration entirely to the performance obligation or the distinct good or service is consistent with the general allocation principle that the transaction price should be allocated to each separate performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each separate performance obligation, considering all of the performance obligations and payment terms in the contract Current U.S. GAAP Except for allocation guidance related to contract segmentation, there is no explicit guidance on allocating contract revenue to multiple deliverables in a construction contract. Allocating the Transaction Price New Model An entity would allocate the transaction price to all separate performance obligations based on relative standalone selling price of separate performance obligations. 17

18 Step 1 Identify contract with customer Step 2 Identify performance obligations Step 3 Determine transaction price Step 4 Allocate transaction price Step 5 Recognize revenue Step 5 Recognize Revenue When (or as) Performance Obligations are Satisfied An entity would recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. An asset is transferred when the customer obtains control of the asset. For some industries, such as real estate, this is a significant departure from the current risk and rewards criteria. Change in control would occur when the customer has the ability to direct the use of and receive the benefits from the transferred good or service. Control also includes the customer s ability to prevent other entities from directing the use of and obtaining the benefit from the good or service. Revenue can be recognized over time or at a point in time. For real estate and construction companies, assessing whether a transaction meets the criteria to recognize revenue over time will be a key accounting judgment. This assessment is made at the performance obligation level rather than the contract level. Performance Obligations Satisfied Over Time An entity transfers control over time if any of the following criteria is met: The customer receives and consumes the benefits of the entity s performance as the entity performs, e.g., a cleaning service The customer controls the asset as it is created or enhanced by the entity s performance this could be tangible or intangible The entity s performance does not create an asset with an alternative use to the entity and the customer does not have control over the asset created, but the entity has an enforceable right to payment for performance completed to date and expects to fulfill the contract as promised To determine if an asset has an alternative use, the entity considers at contract inception the effects of contractual and practical limitations on its ability to readily direct the asset to another customer. An asset would not have an alternative use if an entity is prohibited from transferring the asset to another customer or would incur significant costs to redirect. An entity has an enforceable right to payment for performance to date if an entity is allowed to recover cost plus margin on goods and services transferred to date. The right to payment should be enforceable and management should consider the contractual terms as well as any legislation or legal precedent that could override those contractual terms. The right to payment for performance completed to date need not be for a fixed amount. Determination of transfer of control is straightforward for manufactured goods. For construction services, it can be difficult to assess whether a customer has the ability to direct the use of and obtain all the remaining benefits from a partially completed asset. For a contractor building on a customer s land, the customer generally controls any work in progress arising from the contractor s performance. 18

19 Revenue Recognized Over Time Current U.S. GAAP There are several methods for recognizing revenue depending on details of the contract: Construction Percentage of completion method Completed contract method Real Estate Sales Installment method Deposit method Cost recovery method Reduced profit method New Model An entity transfers control over time if any of the below criteria are met: The customer controls the asset as it is created or enhanced The customer receives and consumes the benefits as the entity performs The asset has no alternative use and the customer does not control the asset created, the entity has a right to payment for performance to date and the entity expects to fulfill the contract as promised Measuring Progress Toward Complete Satisfaction of Performance Obligation An entity would recognize revenue for a performance obligation satisfied over time only if it can reasonably measure its progress toward completion. In some cases, e.g., the early stages of a contract, an entity would be permitted to recognize revenue to the extent costs are incurred until the entity can reasonably measure its progress towards completion. An entity can measure its progress toward completion using either output or input methods; it would be required to apply that method consistently to similar performance obligations in similar circumstances. Within each performance obligation, the contractor may continue reporting revenue in a manner consistent with the current percentage of completion method. Output Methods Under an output method, an entity would recognize revenue by directly measuring the value of the goods and services transferred to date to the customer (milestones reached or units produced). The output selected should faithfully depict the entity s progress toward satisfaction of a performance obligation. For example, units produced or delivered could only be used if the value of any work in progress and units produced but not delivered to the customer at the end of the reporting period is immaterial. As a practical expedient, an entity could recognize revenue in the amount it is entitled to invoice, if it corresponds directly with the value of the goods or services transferred to date. It is common practice in the construction industry to periodically bill an owner of a project for progress completed and materials delivered to the job site. An entity would recognize revenue in the amount it is entitled to invoice if it corresponds directly with the value of the goods or services transferred to date. An entity may not be entitled to payment for work performed until specified performance milestones are met. If an entity receives payment for work performed only when achieving certain milestones, the continuous transfer method still may be appropriate for recognizing revenue of works performed before reaching a specific milestone (prior to achieving a present right to payment). 19

20 Input Methods Input measures use an entity s inputs, e.g., costs incurred, machine hours used or time lapsed, relative to the total expected inputs to satisfy a performance obligation. If inputs are incurred evenly over time, revenue would be recognized on a straight-line basis. An entity must adjust if the inclusion of certain costs would distort the contract s performance, e.g., wasted materials, labor or other resources needed to fulfill the contract that were not reflected in the contract price. The new model focuses on recognition of revenue rather than margin. Measuring Progress Current U.S. GAAP Input methods, output methods or passage of time can be used to measure progress toward completion. Gross profit method of calculating revenue, costs and gross profits based on the percentage complete is permitted. New Model Input methods or output methods can be used to measure progress toward completion. Gross profit method of calculating revenue, costs and gross profits based on the percentage complete no longer is allowed. For entities using the percentage complete on the cost-to-cost method, removal of cost that would distort the contract s performance, such as wasted materials, from the percentage of completion calculation will defer recognition of revenue on projects and reduce profits on early stages of projects. Example An entity enters into a contract with a customer to build a single family home for $3 million. A portion of the drywall purchased was defective (no scrap value) and a different product had to be ordered. Including the cost of the defective drywall in the percentage completion calculation distorts the contract s performance. Current U.S. GAAP Cost to date 400, ,000 Less wasted materials Subtotal 400, ,000 Total estimated project costs 2,400,000 2,400,000 Percent complete 17% 8% Total contract amount 3,000,000 3,000,000 Revenue to be recognized 510, ,000 Job costs capitalized (400,000) (200,000) Costs directly expensed 0 (200,000) Gross profit (loss) to be recognized 110,000 40,000 New Model (excluding wasted materials cost) (200,000) (wasted drywall expensed) Uninstalled Materials If an entity acting as a principal procures goods from another vendor and does not design or manufacture those goods, and the cost of the goods is significant relative to the total cost to satisfy the performance obligation, and control of the goods is transferred to the customer significantly in advance of delivery or services related to those goods, an entity may recognize revenue in an amount equal to the cost of the goods, i.e., zero-margin revenue on those specific goods. 20