New Revenue Recognition Standards Will Change the Way You Think
Contractors are facing the most significant event in financial reporting in recent history as the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) present a new way to recognize revenue. You will be required to think differently.
FASB Accounting Standard Update No. 2014-09 affecting Revenue from Contracts with Customers (ASC 606) will apply to all your customer contracts and transactions. The good news is that in the effort to remove past inconsistencies, some of the changes will simplify the preparation of financial statements by reducing the number of requirements to which businesses must refer, making the statements easier to understand.
The new guidance utilizes a contract-based approach that places the focus on the assets and liabilities. Some of the changes will affect the reporting of the amount of revenue earned and the timing when it is recognized. Until now, revenue has been recognized upon the culmination of the earnings process – the price is fixed or determinable, delivery has occurred or service has been rendered, and collectability is reasonably assured. Collectability is one of the key differences in ASC 606, as it is a factor when determining whether a valid contract exists.
Under the new rules, contractors will apply a five-step model to determine when to recognize revenue and at what amount. They are as follows:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) a performance obligation is satisfied.
While on the surface the five-step process does not seem complex, the transfer of “control” to the customer becomes the driving issue in evaluating the appropriateness of revenue recognition under the new guidance. Significant judgments by management and an auditor in applying the underlying principles will be required. Several issues will need to be addressed.
Contracts will now be considered to include both implied and verbal agreements while in the past many contractors did not recognize the revenue based on verbal agreements. Your auditor will have to decide how to verify these agreements, criteria will be needed to determine enforceable rights and obligations in these instances, and the new constraint provision will impact revenue recognition.
A number of the current standards to recognize claim revenue are not being carried forward in ASC 606. Change orders, including those that are unpriced, will be considered as contract modification, and the new standard may enable contractors to record more change orders than were previously allowed. However, you will need to determine whether the change order is a new contract, a new performance obligation that is distinct, or a change in the original agreement. That will affect the timing of revenue recognition, presentation, and possibly disclosures. This may require evaluation under the new “variable consideration” standard.
Unlike the current standards that includes indicators for whether two or more contracts should be combined, ASC 606 requires that you combine contracts that were entered into at or near the same time if they meet the following criteria: The contracts must be negotiated as a package with a single commercial objective, they must have interdependent pricing, and the goods or services are a single-performance obligation.
Current practice evaluates “profit centers” which are the entire contract. A performance obligation is a promise in a contract to transfer a good or service (or bundle of same) that is distinct. Determining whether the good or service is “distinct within the context of the contract” is a critical aspect of identifying the performance obligations. If a promised good or service is not distinct, goods or services must be combined with others until it achieves that qualification. Then it becomes a single-performance obligation. This will require each contract to be evaluated.
Determining the transaction price will be impacted by variable consideration, constraining estimates, financing, non-cash consideration and consideration payable to a customer.
Variable consideration may include discounts, rebates, refunds, credits, incentives, performance bonuses, economic price adjustments, latent defects and more. Variable consideration should be included in the transaction price only to the extent that it is probable that a significant reversal in revenue will not occur when the uncertainty associated with it is resolved.
At the end of each reporting period, an update of the estimated transaction price (including updating its assessment of whether an estimated variable consideration is constrained) must be provided to represent the circumstances present at the end of the reporting period and the changes in circumstances that have occurred.
The objective in allocating the transaction price is to tie each performance obligation (or distinct good or service) to the consideration it expects to receive. An estimation of the stand-alone selling price is allowable.
If the performance obligation qualifies to be reported at the contract level, the revenue model can be simplified to a three-step process:
- Identify the contract(s) with a customer.
- Determine the transaction price.
- Recognize revenue when a performance obligation is satisfied.
For those projects satisfied over time, measurements can be made in a manner similar to current practices and reflective of the gradual transfer of control of the asset to the customer.
The costs of obtaining a contract that a business expects to recover can be recognized as long as they would not have been incurred if the contract had not been obtained. Costs to fulfill a contract also follow the existing guidance. Otherwise, they may be recognized as an asset if they are expected to be recovered. Examples of this include pre-construction costs and mobilization.
The disclosure requirements of ASC 606 are significantly in excess of what is currently required under U.S. GAAP, and the overhaul of your revenue recognition practices will likely take more time, effort and expertise than expected. The functions within your organization that will be affected include information systems, sales contracts and agreements, sales incentives and commissions, internal control processes, executive compensation arrangements, debt covenants, and tax implications.
The effective date for public entities to adopt the amendments in ASC 606 is for annual reporting periods beginning on or after December 15, 2016, including interim periods. For all other (nonpublic) entities, the annual reporting periods begin after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Nonpublic entities may elect to adopt the standard earlier.
The FASB allows contractors two options when transitioning to the guidance under the new standard. Contractors may opt for full retrospective application of the new standard, which requires reflecting the cumulative effect of the change in all contracts on the opening retained earnings of the earliest period presented, along with adjusting the financial statements for each prior period presented to reflect the effect of applying the new accounting standard. Retrospective application would be applied to interim periods, as well as annual periods presented.
As an alternative, contractors may apply the amendments to the new standard retrospectively with the cumulative effect of initially applying the amendments recognized at the date of the initial application. When using this method, the contractor should provide additional disclosures in the reporting periods related to the reasons for significant changes.
You may benefit by talking with your auditor and other professional advisors. Additional advice on making this transition will be forthcoming from the FASB Revenue Recognition Implementation Group.
CONTRACTORS & DEVELOPERS BONDING
Philip E. Vega