By Lee H. Johnson
In June 2010, the Financial Accounting Standards Board issued its Exposure Draft, Revenue from Contracts with Customers.
If this Exposure Draft is adopted, it could have a negative impact on contractors’ financial statements and the percentage-of-completion method, as we know it, would largely disappear. At a minimum, it will make financial reporting more reliant on subjective decisions that will vary from contractor to contractor. In addition, financial performance will appear inconsistent, since revenue won’t be recorded until the project is transferred to the owner. As a result, financial institutions and bonding agents may misread financial information from construction companies under the new standard.
Presently, contractors are bound by current accounting standards, which measure income by looking at the entire contract and not its individual pieces. Revenue for a period is recognized based on the percentage of work completed at the end of the reporting period for each contract. The Exposure Draft requires the contractor to break down each contract into performance obligations with revenue recorded as each obligation is completed. An example of this includes a design-build contract, where the design work is required to be separated from the physical construction.
In all cases, the contract price is to be allocated across multiple performance obligations potentially requiring much subjective analysis. The effect of change orders on a contract will have to be determined based on whether they’re a change to an existing performance obligation or if they create a new performance obligation.
Since the Exposure Draft focuses on recording revenue based on the fulfillment of performance obligations within a contract, losses may have to be recognized much earlier than with present rules. Currently, losses from construction contracts are recorded as soon as the contractor anticipates the loss. The proposed rules would maintain this standard; however, loss recognition may be accelerated since the loss calculation would be done at the performance obligation level rather than by looking at the entire contract.
Even though the entire contract may be profitable, a loss on a specific performance obligation within the contract would have to be reported before the overall contract is completed.
Under current standards, contract costs are generally used to measure revenue, since the percentage of costs incurred is normally the factor employed to record revenue earned. The Exposure Draft requires revenue to be recognized as performance obligations are met, which may not relate to the underlying costs incurred. There are also new rules regarding capitalization of costs that may affect accounting for contracts.
A concept called “continuous transfer of goods or services” is introduced in the Exposure Draft. This is similar to the present “percentage-of-completion method.” This method generally would be limited to contracts where the customer owns the work-in-progress as it is built or developed. If a contract qualifies under this method, revenue may be recognized using either input or output measures, as appropriate. Input measures, based on efforts expended to date, could include labor hours or other input costs as under current methods. Output measures recognize revenue based on units produced, contract milestones or similar output methods. The Exposure Draft requires additional disclosures that include a reconciliation of changes in open contracts from the previous to the current reporting dates, methods used to record revenue when a contract qualifies as a continuous transfer, determination of liabilities related to anticipated losses and disclosure of how performance obligations are identified and satisfied including methods used in allocating the total contract price to the various performance obligations.
The accounting and reporting that will be required under the final version will undoubtedly require changes in the way contractors capture and report information pertaining to contracts. While the implementation date has not been established, those taking proactive measures to assess the impact on their company and to redesign their accounting systems to capture the information identified will be able to ease the burden of implementation.
Lee Johnson is a partner with Clifton Gunderson LLP. E-mail:Lee.Johnson@cliftoncpa.com or call 303-77-5710. The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Clifton Gunderson LLP to the reader.