Revenue Recognition Standard: Implementation Considerations for the Construction Industry

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1 February 2017 Revenue Recognition Standard: Implementation Considerations for the Construction Industry Brett Ralls, Senior Manager DHG Construction In May 2014, the Financial Accounting Standards Board (FASB) issued a new revenue recognition standard Accounting Standards Codification Update , Revenue from Contracts with Customers with the intent of unifying all previous industry driven revenue recognition guidance into one standard method, which would allow for consistency and comparability across industries. Due to a one-year deferral, the effective date for application of the new revenue recognition standard will be for annual reporting periods beginning after December 15, 2017, for public business entities and for annual reporting periods beginning after December 15, 2018, for non-public business entities. 1 Early adoption is permitted for both public and non-public entities for annual periods beginning after December 15, The world is not coming to an end. When the International Accounting Standards Board (IASB) and FASB started the revenue recognition project, the participants in the construction industry expressed concern that two of the bedrock fundamentals of revenue recognition in the construction industry were going to be forever changed. First, there was concern that the construction process was going to be disaggregated into individual trades, and companies would be required to track the process of each trade separately and recognize revenue accordingly. Second, there was concern that participants in the industry would be required to wait until control of a project was turned over to the customer before revenue could be recognized. Had these concerns not been alleviated, the result of adopting this standard would have been an excessive administrative burden and inconsistent revenue recognition for participants in the industry. The final version of this standard does not change the following fundamentals: the primary unit of measure is still a contract or specific obligation within a contract and not by trade; and the percentage-ofcompletion revenue recognition methodology is still intact.

2 However, this does not mean that this standard does not come without some impact. What did result from the implementation of this standard is a five-step process that will, to varying degrees, impact all participants in the construction industry. Whether it will add to comparability between participants in the construction industry and participants in other industries remains to be seen. In the following paragraphs, we will highlight the impact that the new standard will place on the construction industry by process step and explore the transition plans that should be taken by your company in order to prepare for implementation. Step 1: Identify the Contract This step is easier for the construction industry than many other industries because we have historically used the signed contract as the basis for our revenue recognition. In order to determine if you have a contract the following questions need to be answered: Does the agreement have commercial substance? (Will cash flows change?) Does the agreement have approval and commitment of both parties? Can both parties enforceable rights be identified? Are the terms and manner of payment identifiable? Is collectability probable? If the answer to all of these questions is yes, then you have a contract. The guidance in certain circumstances allows for contract combination and contract segmentation, the details of which we will not explore in this article. Consult with your accountant for guidance on combining and segmenting contracts. Step 2: Identify the Performance Obligations A performance obligation (PO) is defined as a promise in a contract. Under the new standard, the performance obligation, rather than the contract, is the new basis of measurement for revenue recognition. Distinct POs require separate revenue recognition, which results in separate tracking within the accounting system. A PO is distinct if it can be used on its own, is separately identified from other promises in the contract and has a different pattern of revenue recognition from other promises. Evidence that a PO is not distinct would be if it is interdependent with other promises within the contract, if the contractor provides the service of integrating it with other promises and if the good or service promised significantly modifies other promised goods or services. If you have trouble determining whether or not a PO is distinct, think with a customer s perspective. Do they see this good or service as having standalone value? Generally a contract will be one performance obligation, as it involves interrelated goods and services that are integrated by the contractor. Step 3: Determine the Transaction Price For some contractors this step has the potential for requiring the biggest change from previous revenue recognition methodology. In determining the transaction price, the new standard requires the contractor to assess the original contract price plus adjustments for variable consideration. The contract price is typically stated in the contract as a fixed price or as a calculated value from agreed upon time and materials billing rates, plus fully executed change orders. Variable consideration (VC) as defined in ASU is a new term but not a new concept. It represents award fees, early completion bonuses, liquidated damages, etc., or the various carrots and sticks that are written into contracts. When including variable consideration in a transaction price calculation, the new guidance stipulates that the contractor should use either the estimated value approach or the most likely amount approach depending on the type of consideration. If the variable consideration could result in multiple possible outcomes, then the contractor should assess the probability of each outcome and calculate a weighted average VC impact accordingly. If the outcome of the variable consideration is binary, meaning that there are only two possible results, then the contractor should use the most likely amount of VC based on their history with the variables in question (type of consideration, type of work, customer, etc.). In regards to variable consideration, the guidance has a constraining estimate requirement. All variable consideration should only be included in the transaction price to the extent of its probability that it will not be reversed. 2

3 Step 4: Allocate the Transaction Price As noted in Step 2, most contracts will result in one performance obligation. In these instances, this step is very easy. The entire transaction price determined in Step 3 is assigned to the lone performance obligation identified in Step 2. If there are multiple performance obligations, then the contractor must allocate the transaction price between the POs. The transaction price should be allocated by one of the following methods (in order of priority): Standalone selling prices of the various POs An adjusted market assessment of the various POs Extended cost plus margin of the various POs A residual approach If there is variable consideration included in the contract, and you can determine that it relates specifically to one PO, then it should be allocated specifically to that PO. Step 5: Recognize Revenue In an earlier paragraph, we stated that the percentage-ofcompletion revenue recognition methodology is still alive and in use. Contractors previously using this methodology will still use it in recognizing revenue on their various performance obligations. The new guidance refers to this as recognizing revenue as the PO is satisfied over time, in contrast to recognizing revenue as a PO is satisfied at a point in time. The recognition process can still be measured by input or output methods similar to how it has been recognized under legacy GAAP guidance. Contract Modifications, Claims and Change Orders Claims and change orders are being identified separately because they impact multiple steps in the revenue recognition process above. As adjustment to the contract (Step 1), the scope of a claim or change order may impact the identification of the performance obligations (Step 2) and the price of the change order may impact the determination of the transaction price (Step 3). If a change order is agreed upon in scope and price, the contractor should assess whether it creates a distinct good or service separate from the POs identified in the original contract. If it does create a distinct PO and the price of the change order reflects the pricing of a stand-alone agreement, then the change order should be accounted for as a separate contract and revenue would be recognized accordingly. If the goods/services are distinct, but the pricing is not reflective of a stand-alone sales price, the contractor should treat the transaction as if the original contract is terminated and a new contract is in place. The contractor should determine the revenue remaining from the original scope of work and add it to the revenue from the change order, then allocate accordingly between the remaining performance obligations using the appropriate allocation method identified in Step 4 above. If goods/services are not distinct, the contractor should use a cumulative catch-up method similar to the way in which they account for change orders under the legacy GAAP guidance. The contract amount and total estimated costs would be increased for the impact of the change order, and any additional profit would be recognized to the extent that performance obligations had been previously satisfied. Previous guidance dictated that the amount of revenue capable of being recognized on claims and unapproved change orders was limited to the extent of costs incurred on those claims and unapproved change orders. The new revenue recognition guidance allows for claims to be accounted as variable consideration as described in Step 3, which could allow for the earlier recognition of profit compared to previous guidance. Disclosures Regardless of how impacted a contractor may be by the changes noted above, the new guidance stipulates that there will be more extensive disclosures related to revenue. Examples of additional disclosures stipulated include but are not limited to the following: Disaggregation of revenue by classification that would be most useful to the users of the financial statements (geography, type of good/service, type of contract, etc.) 3

4 Opening and closing balances of receivables, contract assets and contract liabilities Revenue recognized in the period that was previously a contract liability Revenues recognized from POs satisfied in previous periods from change orders executed in the reporting period A description of the timing of the satisfaction of POs relative to the timing of payment and the impact of the differences in timing on contract assets and liabilities Quantitative and/or qualitative information about assets recognized from the costs to obtain or fulfill a contract with a customer Relief is provided for non-public companies that allows them to elect not to disclose certain items noted above. Please contact your accountant for additional guidance related to required disclosures. Create a Transition Plan While 2018 and 2019 may seem distant, it is prudent to start a transition plan as soon as possible by implementing the following: Build a transition team: To determine the implementation effects of the new standard for a specific contractor, it is important to determine how it may affect the entity as a whole, so the process should not solely involve accounting department personnel. The project team should also include individuals from pre-construction, estimating, operations, project management and IT to benefit from additional perspectives that can most likely identify the impact across the entire organization. Management should include its auditors in various stages of implementation to avoid surprises. The transition team should consider appropriate milestones, including key decision points, communications to the board of directors, audit committee and other key stakeholders. Inventory Types of Contracts: While the Company s typical contracts may not be impacted by the changes in the guidance noted above, the Company should assess all contracts for nonstandard options: multiple performance obligations, extended/ accelerated payment terms, variable consideration, materials, heavy jobs and non-cash consideration. Define Communication Systems: Enhanced revenue tracking systems will be required for contracts with multiple performance obligations. An in-depth analysis of contract terms will be required in order to appropriately determine transaction prices. Contract terms will change throughout projects via change orders. This will require constant communication between all facets of the organization to appropriately track, classify and record revenue. Formal communication systems should be put in place now to accommodate the increased communication requirements. Budgets, Forecasts and Communication with Stakeholders: The changes in the revenue recognition guidance may change the timing of revenue recognized by the entity. Your company will need to evaluate the impact that this change will have on budgets, forecasts, debt covenants and bonding ratios. Once potential impact is determined, it s imperative to communicate such impact to the key stakeholders of the company, i.e. the bank and the bonding company. Method of Implementation: There are two methods of implementation prescribed in the new revenue recognition guidance. The full retrospective method will involve recasting prior period financial statements. While this method likely would be preferred by the financial statement users because it will result in greater comparability of the periods presented, it will often increase the cost and complexity of adoption The modified retrospective method will recognize the cumulative effect of initially applying the standard as an adjustment to opening equity. Disclosures reflecting the results under legacy GAAP would be required for the initial year of adoption, which would effectively require dual recordkeeping for that year. 4

5 Regardless of the implementation method, the project team should realize and plan for the reality that the company generally will have to provide more disclosures in financial statements, including qualitative and quantitative information about contracts with customers, significant judgments made and contract assets recognized from costs to obtain or fulfill a contract. Consider operational changes: As it is with most significant changes in accounting policies and procedures, give appropriate consideration of the changes to internal controls throughout the company, including the adoption process, ongoing accounting and disclosure requirements and relevant technological changes. To avoid surprises, management should begin preparing for implementation of this revenue recognition standard as soon as possible. DHG advisors are available to answer questions and help you through such an analysis. About the Author Brett Ralls, Senior Manager, has more than 10 years of experience in public accounting focusing his efforts in the construction industry. He has significant experience in performing assurance services, serves as the chair of the programming committee for the Piedmont Triad chapter of the Construction Financial Management Association (CFMA), and is a member of the CAGC Young Leaders. In addition to performing internal trainings for the DHG Construction group, Brett has been a featured speaker for the CFMA Carolinas Construction Conference. Brett Ralls Senior Manager DHG Construction brett.ralls@dhgllp.com About DHG Construction Our dedicated Construction group consists of approximately 45 full-time professionals. The availability of extensive industry resources allows us to provide bestin-class service to our clients. 1. Companies should refer to the definitions within GAAP of public and nonpublic entities, as certain entities that are not SEC registrants are considered to be public business entities under GAAP. 5