Oliver Holmes is an audit partner in Atlanta specializing in providing accounting services to mid-market private companies in numerous industries. He offers significant expertise to technology firms, construction companies, manufacturing and distribution companies, and not-for-profit organizations. Holmes also provides specialty services including employee benefit plan audits (both 401k and 403b), SOX procedures, and merger and acquisition (M&A) assistance including due diligence.
The Financial Accounting Standards Board (FASB) of the American Institute of Certified Public Accountants (AICPA) proposed a dramatic change in the way companies—including those in construction—accounted for revenue under Generally Accepted Accounting Principles (GAAP). These changes are a direct result of plans to converge GAAP and the International Financial Accounting Standards (IFRS). The goal is to reconcile different accounting standards and practices in revenue recognition, with debates going back to 2008. Unfortunately, the proposed new rules contained in the 2010 exposure draft would negatively impact the construction industry.
The new standard requires contractors to recognize revenue at the performance obligation level, a departure from the traditionally used percentage-of-completion method (PCM). Various construction associations have voiced concerns and produced strong arguments to include the PCM principles. Additionally, there have been many requests to delay the effective date for implementation of any new standards for two years in order to give construction companies time to fully understand and implement the changes.
When the FASB held a “Revenue Recognition Roundtable Meeting,” four points were discussed at length.
1) Recognizing Revenue (“Goods” or “Service”)
Today, long-term construction contracts follow two generally accepted accounting methods: PCM and completed contract method (CCM). The original exposure draft’s new accounting standard could have eliminated PCM for long-term contracts because it follows the principal that companies should recognize revenue only for the transfer of “goods.”
So are construction projects a good or service? For example, are custom fabricated products for buildings considered goods or services? If construction projects were considered a good, then revenue would need to be recognized upon delivery to the customer, which is similar to the CCM.
Since the initial roundtable meeting, FASB has been considering a compromise that splits the model between goods and services. For goods, the standard would consider the transfer of control of ownership to be the event for recognizing revenue. Construction services could be defined as “the continuous transfer of a benefit to a customer through the performance of a task or series of tasks under a contract.” Under this definition, a construction contract would be considered a continuous delivery, and it would be considered a service under the new standard. In this case, revenue could be recognized ratably (basically CCM). The jury is still out regarding this compromise, but it might offer an acceptable option for contractors.
2) Single Performance Obligation
Also under the initial exposure draft, contract revenue would be recognized when distinct “performance obligations” are satisfied. The question is whether a construction contract constitutes a single performance obligation or several performance obligations. Most of us involved in the construction industry believe that a contract should be considered a continuous delivery and constitute a single performance obligation.
FASB is still working to clarify how and when to separate the components of a construction contract, with a stated objective of breaking up a contract to report useful profit margins and report the pattern of transfer of benefit to the customer. The following guidance for when to separate a performance obligation is being considered:
A) Separate a good or service if the entity regularly sells a virtually identical good or service; if an entity does not sell the good or service separately, then an entity must use judgment and consider the timing of transfer, function, and risks when evaluating when to break-up a contract. Since timing, function, and risks are part and party to most construction projects, then most construction contracts would result in one performance obligation. Since no two projects are exactly alike, this outcome would measure progress similarly to the percentage-of-completion method.
3) Construction Claims and Bonuses
What about the handling of claims resulting from the completion of “projects” - whether construction or technological? Accounting for technology companies related to warranty/maintenance recalls for software and hardware is quite complicated, and these companies are struggling with how to handle them.
It is highly probable that the new FASB pronouncement will allow the construction industry to expense maintenance/warranty expenses as they occur on completed work.
4) Retrospective Application
A mandatory retroactive application of the revenue recognition accounting standard would require companies to go back and change their accounting for prior years. This process would be a problematic and highly costly, especially for smaller private companies that don’t have the resources to perform changes to prior years’ books. At the exposure draft meeting, participants asked that private companies be exempt from retroactive application.
Where are we now?
Earlier this year, FASB and IASB held a webinar and another roundtable meeting with the latest word being that the implementation timeframe is targeted between Q4 2012 and Q1 2013. Once the newly revised exposure draft becomes final, all previously existing industry guidance will be eliminated. Therefore, construction-specific guidance around how to account for claims, unapproved change orders, and even the methods of calculating percentage-of-completion will be eliminated. However, FASB indicates that they are not eliminating percentage-of-completion accounting, but with the industry guidance that is going to be eliminated (as mentioned above); the prescribed methods for calculation percentage-of-completion accounting will be eliminated. Today, contractors must use one of two alternatives, and they will have opportunities to use other methods