Are Construction Accounting Rules Changing?

Understand how the new proposed FASB/IASB accounting rules could change the way you report revenue.

Editor’s note: This analysis is based on the status of FASB and IASB’s joint revenue recognition project as it was understood on July 15, 2011. When the updated draft standard is re-exposed later this year, the information provided here could potentially change.

In June 2010, the Financial Accounting Standards Board (FASB) issued its highly anticipated Exposure Draft, Revenue from Contracts with Customers, which would have had significant negative implications for contractors.

As part of the rulemaking process, interested parties were encouraged to express their concerns about the proposed rules. Remarkably, more than 900 constituents sent comment letters to FASB/IASB, and approximately 25 percent came from construction industry stakeholders, such as the Construction Financial Management Association (CFMA).

The comment letters stimulated significant re-deliberations throughout the first half of 2011, which led to significant revisions to the proposed standard. Due to the magnitude of these revisions, FASB/IASB has now taken an extremely rare step and is expected to re-issue the proposed standard in September 2011.

What to Expect

The good news is that the revenue recognition rules are very much aligned with the existing percentage of completion rules for contractors. Since the percentage of completion rules were adopted 30 years ago, they have been widely embraced by construction industry owners, financial managers, sureties and lenders. These rules are easy to understand and can be applied in a consistent manner.

Specific differences exist between the proposed revenue recognition standard and the existing percentage of completion rules; contractors should prepare for this.

Revenue and Costs Incurred

The most important difference is that the accounting for revenues are separate from the accounting for costs. Under the current percentage of completion rules, costs incurred result in the recognition of incremental revenues in almost all cases. Under the proposed standard, the correlation of costs and revenues are not as direct. This distinction becomes clearer when a revision occurs in estimated total costs.

For example: Assume a contractor enters into a $2 million contract in which he or she accepts the risk of differing site conditions. The contractor estimates the project will yield a 20 percent gross margin, and job costs will total $1.6 million.

When the contract is 20 percent complete based on actual progress (and costs incurred at that point), the contractor incurs $200,000 of incremental and unanticipated costs to address structural matters related to differing site conditions. Under the existing percentage of completion rules, the $200,000 would be added to the original estimated $1.6 million total costs to arrive at a new estimated total cost of $1.8 million and a total estimated margin of 10 percent.

The $1.8 million would represent the denominator in a percentage of completion calculation, and costs incurred to date would be $520,000 (20 percent of $1.6 million + $200,000), resulting in a simplified calculated percent complete of 29 percent ($520,000/$1.8 million) and simplified revenue of $577,000.

By contrast, under the new rules, if the project is 20 percent complete based on actual progress, the contractor would recognize $400,000 of revenue on the $2 million without consideration to the additional costs incurred relating to structural matters. At the same time, the contractor would have incurred $520,000 of costs, so a $120,000 negative margin would be recognized on the contract.

Project Revisions

Current rules smooth estimate revisions and actual experience over the contract’s life, but this process is eliminated under the proposed rules. The reported gross margin can vary significantly over the course of a contract as revisions in estimates and actual experience occur.

The cost-to-cost method will still be permitted to calculate progress toward completion and the amount of revenue to be recognized. But, contractors cannot solely rely on this approach as a virtual safe harbor.

Instead, they will be required to critically evaluate whether the most reliable measure of the progress toward completion is based on costs incurred to date compared to estimated total costs. More judgment will be required to determine the amount of revenue that should be recognized at any given time.

Estimate revisions are a reality that will exist in nearly every contract, and the new rules will not prevent routine revisions using an approach such as the cumulative catch-up method. Contractors may find input measures to be the most cost-effective and reliable measures of progress toward completion (such as costs incurred to date compared to estimated total costs).

Performance Obligation

Besides the progress toward completion changes, the new rules may require a more critical evaluation of whether contract warranties represent a separate performance obligation. When a separate performance obligation exists, the anticipated costs of fulfilling the warranty may have to be accrued, and a profit margin on those costs may need to be calculated and accrued as well, which lowers current revenues and profits.

Change Orders and Incentives/Penalties

The accounting for certain change orders and incentives/penalties may also operate differently. Many contractors today take a conservative view of recognizing revenue associated with contract changes, but the new rules will provide slightly more latitude with the recognition of revenues and profit margins on change orders—particularly change orders that are approved regarding the contract’s scope, but not the price.

Contractors will be compelled to more explicitly consider the presence of incentives and penalties in contract revenue calculations. However, the purpose of the rules is not to accelerate bonuses.

Re-exposure Process

When FASB and IASB re-expose the revenue recognition rules (expected in September 2011), a 120-day comment period will be available. After that time, the boards will take the comments into consideration and release a final standard no earlier than late in the second quarter of 2012.

Once the standard is issued, the effective date will likely be after December 31, 2014, for calendar-year reporting entities.

Construction Business Owner, September 2011