Revenue RecognitionDeep DivePresenters: Tim Wilson and Tony Hakes
Revenue recognition is a hot topic forcontractors Lenders and sureties are monitoring thisclosely Very complicated in the construction industry General vs. Subcontractor Specifics for electrical contractors?
Revised Exposure Draft Issued November 14, 2011 – RevenueRecognition (Topic 605) Revenue from Contracts with Customers Goals Develop a common revenue standard for industries, jurisdictions &capital markets Condense 100+ rules into 1 “high quality” standard Will ultimately repeal/replace current accounting and reportingguidance (SOP 81-1 for those familiar with this pronouncement)
Let‟s take a look back to understand how wegot here on revenue recognition forcontractors…….
• Revised Exposure Draft comes after receiving substantial commentletter input from original exposure draft as well as from testimonygathered at public roundtables from around the globe.• Still a number of matters that were of consequence and concern to theconstruction industry remained.• 351 comment letters submitted in response to the Revised ExposureDraft.• Substantial redeliberations took place throughout most of last Springand early Summer.
• February 20, 2013, the redeliberations were concluded.• The final standard/rules are expected to be issued in the secondquarter of 2013.• Core principle:• To recognize and record revenue as goods and services aretransferred to the customer (ie – as work is performed).• Sounds similar to what we have been doing for 30+ years, but…• A number of matters that are of consequence and concern to theconstruction industry exist.
An entity shall recognize revenue to depict thetransfer of goods or services to customers in anamount that reflects the consideration the entityreceives, or expects to receive, in exchange forthose goods or services.
Recognize revenue as performanceobligations are satisfiedAllocate transaction price toperformance obligationsDetermine the transaction priceIdentify separate performanceobligations in the contract 2345(These steps areunchanged fromoriginal exposuredraft)Proposed Recognition Model – Steps InvolvedIdentify contract with the customer 1Rev. Rec. Exposure Draft
Four criteria for existence of a contract– Commercial substance– Approval by both parties– Identifiable rights regarding assets to betransferred– Identifiable payment terms (even if amount isuncertain)
Combination of Contracts– Contracts negotiated as a package– Amount paid on one contract depends on theprice or performance on the other contract(s)– Goods or services promised are oneperformance obligation– Segmenting –– Inherent in identification of separateperformance obligations if more than oneexists in the contract
Goods and services accounted for as a singleperformance obligation if risks are inseparable The goods or services are highly interrelated and theentity provides a significant „integration‟ service The entity significantly modifies the goods orservices as negotiated specifically with the customer Providing the goods or services requires commonresources that cannot be reasonably separated What does this mean for electrical contractors?
In all other cases, account for a good or serviceseparately if: It is distinct (i.e. is sold separately or has utility on itsown), and It has a different pattern of transfer In some cases, a whole contract may be oneperformance obligation What about change orders?
Transaction price: The amount of consideration to which an entityexpects to be entitled to receive in exchangefor transferring goods or services Time and material vs. fixed price? Variable consideration (constraint concept): Exact guidance to come with final standard.
Time value of money Discounting required only if there is asignificant financing component One year practical expedient Collectability Estimate bad debt and present separately as acomponent of SG&A expenses.
Allocate the amount an entity expects toreceive in exchange for satisfying eachseparate performance obligation. Use standalone selling prices of goods orservices (estimated if necessary).
If the performance obligation(s) satisfied overtime, effectively follow percentage-of-completion method entity‟s performance creates or enhances an asset thatthe customer controls, or another entity would not need to re-perform workcompleted to date, or entity has right to payment for work completed to date Time and material jobs?
Measuring progress toward completion Objective: depict the value of performance to date Output methods or input methods permitted If input method used, must exclude inputs that donot depict performance (owner provided materials,waste, uninstalled materials – key for electricalcontractors) Zero margin may be appropriate in somecircumstances (e.g. early stage of contract,uninstalled materials)
Got a lot of things right that we wereexpecting How a performance obligation is defined Clarifying continuous transfer criteria No preference for inputs vs. outputs methods onmeasuring progress Relief from disclosures for non-public entities But…
• There are some areas that are problematic in thestandard• Examples include:– Claims and unapproved change orders– Time value of money– Collectibility– Onerous Performance Obligations– Exclusion of inputs that are not reflective of progresstowards completion– Uninstalled materials
• Requirement for recognition:– Refer to the 4 criteria for contract existence– Key: Approval by both parties– Electrical contractors make changes on the fly….– Expected revision to final standard:– Contract modifications, including a contract claim, would beapproved when the modification creates or changes theenforceable rights and obligations of the parties to the contract.
If approved as to scope, even if un-priced,Company will be able to recognize estimatedmargin on change orders. What does this mean? More focus on treatment of “approved as toscope”? More focus on rationale for estimated margin?
• Views on claims– Some argue that a literal reading of the RevisedExposure Draft is a “claim killer” meaning norevenue and only costs are recognized whenclaims arise until agreement is reached– Others argue that proper interpretation of theRevised Exposure Draft permits claim revenuesand costs to be recognized.
• Unpriced Change Orders• Old Rule – reflect if the recovery is probable and reasonablyestimated• New Rule – reflect when the contractor expects the price changewill be approved and creates enforceable rights• Claims• Old Rule – reflect when probable and estimable up to the extentof costs incurred – no margin until realized• New Rule – include in transaction price when “reasonablyassured” of being entitled to receive the claim
• Requirement for application/discounting:• Transaction/contract price adjusted to reflect the timevalue of money if a significant financing componentexists.• Considerations:• Expected length of time between delivery of goods andservices and receipt of payment.• Whether amount of payment would differ substantiallyif cash payment was received in accordance withtypical credit terms.
• Exception:• Expectation at contract inception,• Period between payment and performance < 1year• Applicable to contracts > 1 year in duration ifperiod between performance and payment is < 1year
• Retention:• Will depend on contract terms and normal practices.• It is unclear whether the right of offset would exist ornot; therefore, financing of retention receivables wouldnot necessarily be able to be offset against retentionspayable.• Overbillings:• Also unclear if concept is intended to be applied tocontracts with significant under or over billings.
• Interplay with onerous performance obligationcriteria– Measure against contract revenue. Contract revenue excludes interestincome if net financing component is deemed to exist in contract. Inthis situation, you could have a contract with thin margins, but stillwith an overall profit; however, after applying the TV$ criteria inconnection with the onerous performance obligation criteria, you couldend up having to accrue a loss when the overall economic arrangementis actually a profit!– The inverse is true as well!
Current NewAccounting AccountingContract amount 1,000,000$ $917,000 **Estimated direct materials and labor (800,000) (800,000)Overhead applied (160,000) (160,000)Gross profit (loss) on contract 40,000$ (43,000)$** Discounted @ 6%Terms: Project requires completion of all work within a 24-monthperiod with payments of $500,000 each occurring at the end of the12th and 24th months.
• Collectibility criteria, as written, are based on morethan just the customer‟s inherent inability to pay.• It also refers to the risk that a Company will not beable to collect from its customer(s) the amounts thatit expects to be entitled.• What does this mean in practical application?• Choosing not to pursue certain amounts due from customers.• Gross up of revenue beyond “real” revenue offset by gross up ofbad debts expense.• Past practices may have focused on only recognizing revenue basedon expected collections
Current NewPresentation PresentationContract revenues 63,000,000$ 63,000,000$Cost of contract revenues 52,500,000 52,500,000Gross profit 10,500,000 10,500,000SG&A expense 7,500,000 7,250,000Bad debt expense - 250,000Total SG&A expenses 7,500,000 7,500,000Income from operations 3,000,000 3,000,000Other income (expense) (100,000) (100,000)Net income 2,900,000$ 2,900,000$ABC CONSTRUCTION, INC.STATEMENT OF COMPREHENSIVE INCOMEYear Ended December 31, 201X
Requirement is to exclude costs of inputs that are notreflective of contract progress When using an input method, an entity shall excludethe effects of any inputs that do not depict the transferof control of goods or services to the customer (e.g. thecosts of wasted material or labor). Arguably, the first dollar of labor on re-work shouldtheoretically be expensed as incurred and not includedin the measure of contract revenue Expected revision: Exclude such cost if performance would be distorted
• Requirement is to exclude the cost ofuninstalled materials that are not reflective ofcontract progress– Language in Revised Exposure Draft wasinaccurate– Desire to eliminate profit recognition onuninstalled materials (believed to be the intent)– Effect on financial statements if such costs can bebilled?– Effect on bonding/underwriting?
ForecastedContract AmtsContract amount 1,000,000$Estimated direct materials and labor (800,000)Overhead applied (80,000)Gross profit on contract 120,000$Terms: Project requires installation of 10 pre-fabricated units that willbe constructed offsite prior to installation. Duration of contract isestimated at 9 months and contract price is $1,000,000.
Current NewAccounting AccountingDirect materials and labor to date 400,000$ 400,000$Overhead applied 40,000 40,000Total costs incurred to date 440,000 440,000Less: Cost of uninstalled materials - (440,000)Adjusted total costs incurred to date 440,000$ -$Percentage complete - cost-to-cost method 50.00% 0.00%Revenue recognized 500,000$ -$Gross Profit recognized 60,000$ -$Contract billings 600,000$ 600,000$Contract under (over) billings (100,000)$ (600,000)$After 3 months, 5 of the pre-fabricatd units have been constructed offsite atthe contractors warehouse. None of the units have been installed.
Current NewAccounting AccountingContracts receivable (asset) 600,000$ 600,000$Inventory (asset) - 440,000Contract over billings (liability) 100,000$ 600,000$Contract revenues (revenue) 500,000$ -$Contract costs (cost of revenue) 440,000$ -$Selected financial statement line items:
As with SOP 81-1, contractors would accrue an anticipated lossonce identified However, proposed standard would not require that losses beaccrued on contracts of less than year duration
• Like so many other aspects of the standard, the challenge lieswith the interplay between various provisions.• An onerous performance obligation is one where the cost ofsettling the performance obligation is more than the transactionprice (ie – loss contract)• The transaction price includes amounts the entity expects to beentitled• “Expects to be entitled” can include claim revenue.• So…
So… Even if you don‟t yet recognize the claim revenue , you would/could count the claim revenue in the transaction price and indoing so, defer a loss that should have been recognized
• Other items:– Variable/contingent consideration– Disclosures – new– Effect on employee performance incentives– Effective date and transition
• Constraint concept:– Constrain the cumulative amount of revenuerecognized that should not be subject to significantreversal.– Assessment will be qualitative.– Need to assess all facts and circumstances of risksof revenue reversal.– Uncertain future events.– Magnitude of reversal if uncertain events were to occur.
• Application of constraint concept:– When are/will the following be recognized on acontract:– Performance award incentive for early completion– Performance award incentive for quality of construction– Performance award incentive for attaining LEED PlatinumCert.– Performance award penalty (contract reduction) for delays– Performance award penalty (contract reduction) for lowerquality material substitution
• Disaggregation of revenue by category– Type of good or service– Country or region– Type of customer– Type of contract– Reconciliation of contract balances and costs– Narrative disclosures
• Bank covenant requirements• Earnings metrics• Excess cash flow payments• Employee Performance Incentives – bonusesbased on revenues and/or net income
ForecastedContract AmtsBase contract amount (excluding incentive) 1,200,000$Estimated direct materials and labor (980,000)Overhead applied (147,000)Gross profit on contract 73,000$Terms: $1.2M project for refurbishment of an existing office building withtarget minimum LEED Gold Certification upon completion. Performanceincentive award of $200,000 if LEED Platinum Certification is obtained uponcompletion. Expected project duration: 2.5 years.
Contract ContractCurrent Accounting - Year 1 Incep. to Date Current YearDirect materials and labor to date 400,000$ 400,000$Overhead applied 60,000 60,000Adjusted total costs incurred to date 460,000$ 460,000$Percentage complete - cost-to-cost method 40.82% 40.82%Revenue recognized 489,796$ 489,796$Gross Profit recognized 29,796$ 29,796$Contract ContractCurrent Accounting - Year 2 Incep. to Date Current YearDirect materials and labor to date 880,000$ 480,000$Overhead applied 132,000 72,000Adjusted total costs incurred to date 1,012,000$ 552,000$Percentage complete - cost-to-cost method 89.80% 48.98%Base revenue recognized 1,077,551$ 587,755$Incentive revenue recognized 150,000 150,000Revenue recognized 1,227,551$ 737,755$Gross Profit recognized 215,551$ 185,755$The first 2 years (assume project start on day 1 of fiscal year) of project completion precedesrequired adoption of new revenue recognition standard/rules.
Contract ContractNew Accounting - Year 3 Incep. to Date Current YearDirect materials and labor to date 980,000$ 100,000$Overhead applied 147,000 15,000Adjusted total costs incurred to date 1,127,000$ 115,000$Percentage complete - cost-to-cost method 100.00% 10.20%Base revenue recognized 1,200,000$ 122,449$Incentive revenue recognized 200,000 200,000Revenue recognized 1,400,000$ 322,449$Gross Profit recognized 273,000$ 207,449$Assume new accounting guidance for revenue recognition is required on day 1 of thebeginning of the 3rd year of the contract. The transition effect of the contract on thecontractors financial statements is recorded as an adjustment to beginning equity. Theresults of the contract are reflected in the income statement for year 3 based on the newaccounting guidance - potential for reporting a portion of incentive revenue twice.
• January 1, 2018: effective date for non-publicentities• Early adoption is not permitted• Transition– Retrospective application – restate prior periodsupon adoption, or– Apply to existing contracts in progress on theeffective date and new contracts going forward– Requires cumulative effect adjustment and certainadditional transition disclosures.
Additional Discussion Material –FASB‟s Private CompanyReporting AICPA‟s Frameworkfor SMEs--as time permits
• „Exceptions‟ to US GAAP for non-publiccompanies• Opportunities to reduce complexities/costs• Serve needs of users• Without sacrificing– Quality– Fundamental level of comparability
• 6 differential factors• Key issues on their agenda:• Variable interest entities• Interest rate swaps• Intangibles including goodwill• Uncertain tax positions
• Other comprehensive basis of accounting• Non-GAAP• Simpler and not as rules-based• Work in progress• Concerns:• Acceptance by users• Consistency in application
• NASBP Survey on SMEs• 100+ responses• 90% are unsure of what it is• Majority believes a SME is less than $50 million• 51% said they would not accept this report• 72% said this framework would not be as consistentand reliable as GAAP• 81% said it would impact credit capacity and pricing
Tim Wilson, CPA, CCIFPNational Industry PartnerBKD, LLP1201 Walnut, Suite 1700Kansas City, MO email@example.com(816) 701-0208Anthony M. Hakes, CPA, CCIFPA/E/C Market Leader-PhoenixMayer Hoffman McCann, P.C.3101 N. Central Ave., Suite 300Phoenix, AZ firstname.lastname@example.org(602) 650-6225