The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) recently published a joint Exposure Draft on revenue recognition, which will have significant implications on contract accounting in the building and construction (B&C) sector if implemented in its current form. The Exposure Draft, Revenue from Contracts with Customers (the ED), is part of the Boards’ ongoing project to develop a new, converged accounting standard on revenue recognition. Currently, construction contractors generally follow guidance contained in ASC 605-35, formerly known as SOP 81-1 (i.e. percentage of completion accounting). If adopted, the new guidance would repeal ASC 605-35.
New Requirements
The ED introduces a five step model approach to accounting for revenue:
- Identify the contract(s) with a customer.
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the separate performance obligations.
- Recognize revenue when the entity satisfies each performance obligation.
Steps 2 and 5 are perhaps the most critical to the B&C sector.
Whereas the current economic measure is the entire contract under ASC 605-35 (SOP 81-1), which dictates the contract is not further subdivided for the purpose of revenue recognition, the ED contains potentially significant revisions to this approach by requiring entities to identify separate “performance obligations” (PO’s) within contracts, to the extent that the PO’s are distinct. A PO is defined in the ED as an “enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to that customer.” A PO is considered to be distinct if the entity or another entity sells an identical or similar good or service separately; or because the entity could sell the good or service separately because it has a distinct function and a distinct profit margin.
Revenue is then recognized as the requirements of the PO’s are satisfied. The PO is deemed to be satisfied when the customer obtains control of the promised good or service.
The key issue that arises from this concept in the B&C sector is determining when PO’s should be accounted for separately. Under the ED, a single contract may have various PO’s with varying profit margins. Change orders, which under ASC 605-35 are treated as changes to the original contract, will now have to be evaluated to determine whether they constitute separate PO’s altogether.
Furthermore, since contract revenue will be recognized as PO’s are satisfied, instead of measured by actual contract costs incurred, a decoupling of contract costs from contract revenues occurs. Therefore, in many cases, the recognition of contract revenues may not be tied to actual costs incurred (cost-to-cost method of percentage completion accounting).
To help offset this separation of costs from revenues, the ED establishes new capitalization rules related to precontract costs. The ED specifies that the costs of fulfilling a contract can be recognized as an asset if the costs relate directly to a contract (or a specific contract under negotiation); and the costs relate to future PO’s and are expected to be recovered. Without these rules, many contractors might experience negative profit margins during the early stages of a contract. Costs associated with the procurement of the contract are not eligible to be capitalized and will continue to be expensed as incurred.
Disclosure Requirements
Recognizing that these prescribed changes will potentially be significant, the ED introduces a number of additional disclosure requirements to assist third party users of the statements. Many of these requirements are narrative (qualitative) in nature. The more significant additional disclosure proposals include the following:
- For contracts with an original expected duration of more than one year, the entity discloses the amount of the transaction price allocated to the performance obligator remaining at the end of the reporting period and the scheduling of related revenue recognition.
- An entity discloses information about its contracts with customers to help users understand the amount, timing and uncertainty of revenue and cash flows from contracts. This includes details of how revenue has been disaggregated and a reconciliation of opening and closing contract balances with revenue recognized and cash received during the period. It would also need to include a description of PO’s.
This exposure draft will substantially impact how contractors approach revenue recognition and will require a much more detailed level of analysis to be performed, on a contract-by-contract basis. This would likely require changes to underlying business processes to address:
- The identification of separate PO’s;
- An analysis of the timing of transfer of control to the customer and whether continuous transfer is appropriate;
- The allocation of appropriate profit margins to identified PO’s;
- The monitoring of forecast revenue and costs for each PO; and
- The additional disclosure requirements.
While the anticipated effective date for these proposed requirements is uncertain at this time, retrospective application of the standard is proposed, which would provide a significant challenge to contractors to assess each of their existing contracts in accordance with the accounting standards. Such an exercise would need much cooperation from non-accounting operational personnel to assist in the assessment, identification and measurement processes necessary to implement the proposals.
Greg Wilson, CPA
Assurance Principal
