revenue recognition for contractors - neca now conference

NECA NOW2013

Revenue Recognition Deep

DivePresenters: Tim Wilson and Tony Hakes

Why This Topic?

Revenue recognition is a hot topic for contractors

Lenders and sureties are monitoring this closely

Very complicated in the construction industry

General vs. Subcontractor Specifics for electrical contractors?

Revised Exposure Draft Issued November 14, 2011 – Revenue Recognition (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 reporting guidance (SOP 81-1 for those familiar with this pronouncement)

Revenue Recognition Project Recap

Let’s take a look back to understand how we got here on revenue recognition for contractors…….

• Revised Exposure Draft comes after receiving substantial comment letter input from original exposure draft as well as from testimony gathered at public roundtables from around the globe.

• Still a number of matters that were of consequence and concern to the construction industry remained.

• 351 comment letters submitted in response to the Revised Exposure Draft.

• Substantial redeliberations took place throughout most of last Spring and early Summer.

Revenue Recognition Project Recap

• February 20, 2013, the redeliberations were concluded.• The final standard/rules are expected to be issued in the

second quarter of 2013.• Core principle:

• To recognize and record revenue as goods and services are transferred 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 the construction industry exist.

Revenue Recognition Project Recap

Rev. Rec. Revised Exposure Draft:Let’s get into the details!

An entity shall recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration the entity receives, or expects to receive, in exchange for those goods or services.

Rev. Rec. Revised Exposure Draft – Core Principle is Unchanged

Recognize revenue as performance obligations are satisfied

Allocate transaction price to performance obligations

Determine the transaction price

Identify separate performance obligations in the contract 2

3

4

5

(These steps are unchanged from original exposure draft)

Proposed Recognition Model – Steps Involved

Identify contract with the customer 1

Rev. Rec. Exposure Draft

Four criteria for existence of a contract– Commercial substance– Approval by both parties– Identifiable rights regarding assets to be

transferred– Identifiable payment terms (even if

amount is uncertain)

Identify Contract with the Customer

Combination of Contracts– Contracts negotiated as a package– Amount paid on one contract depends on the

price or performance on the other contract(s)– Goods or services promised are one

performance obligation– Segmenting –

– Inherent in identification of separate performance obligations if more than one exists in the contract

Identify Contract with the Customer

Goods and services accounted for as a single performance obligation if risks are inseparable The goods or services are highly interrelated and the

entity provides a significant ‘integration’ service The entity significantly modifies the goods or services

as negotiated specifically with the customer Providing the goods or services requires common

resources that cannot be reasonably separated What does this mean for electrical contractors?

Identify Separate Performance Obligations in the Contract

In all other cases, account for a good or service separately if: It is distinct (i.e. is sold separately or has utility on its

own), and It has a different pattern of transfer

In some cases, a whole contract may be one performance obligation

What about change orders?

Identify Separate Performance Obligations in the Contract

Transaction price: The amount of consideration to which an entity

expects to be entitled to receive in exchange for transferring goods or services

Time and material vs. fixed price? Variable consideration (constraint concept):

Exact guidance to come with final standard.

Determining the Transaction Price

Time value of money Discounting required only if there is a

significant financing component One year practical expedient

Collectability Estimate bad debt and present separately as a

component of SG&A expenses.

Determining the Transaction Price

Allocate the amount an entity expects to receive in exchange for satisfying each separate performance obligation.

Use standalone selling prices of goods or services (estimated if necessary).

Allocate Transaction Price to Performance Obligations

If the performance obligation(s) satisfied over time, effectively follow percentage-of-completion method entity’s performance creates or enhances an

asset that the customer controls, or another entity would not need to re-perform work

completed to date, or entity has right to payment for work completed

to date Time and material jobs?

Recognize Revenue as Performance Obligations are Satisfied

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

do not depict performance (owner provided materials, waste, uninstalled materials – key for electrical contractors)

Zero margin may be appropriate in some circumstances (e.g. early stage of contract, uninstalled materials)

Recognize Revenue as Performance Obligations are Satisfied

Got a lot of things right that we were expecting How a performance obligation is defined Clarifying continuous transfer criteria No preference for inputs vs. outputs

methods on measuring progress Relief from disclosures for non-public

entities But…

Revenue Recognition Revised Exposure Draft

• There are some areas that are problematic in the standard

• Examples include:– Claims and unapproved change orders– Time value of money– Collectibility– Onerous Performance Obligations– Exclusion of inputs that are not reflective of progress

towards completion– Uninstalled materials

Revenue Recognition Revised Exposure Draft

• 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

be approved when the modification creates or changes the enforceable rights and obligations of the parties to the contract.

Revised Exposure Draft – Claims & Unapproved Change Orders

If approved as to scope, even if un-priced, Company will be able to recognize estimated margin on change orders.

What does this mean? More focus on treatment of “approved as to

scope”? More focus on rationale for estimated

margin?

Revised Exposure Draft – Claims & Unapproved Change Orders

• Views on claims– Some argue that a literal reading of the

Revised Exposure Draft is a “claim killer” meaning no revenue and only costs are recognized when claims arise until agreement is reached

– Others argue that proper interpretation of the Revised Exposure Draft permits claim revenues and costs to be recognized.

Revised Exposure Draft – Claims & Unapproved Change Orders

• Unpriced Change Orders• Old Rule – reflect if the recovery is probable and

reasonably estimated• New Rule – reflect when the contractor expects the price

change will be approved and creates enforceable rights

• Claims• Old Rule – reflect when probable and estimable up to the

extent of costs incurred – no margin until realized• New Rule – include in transaction price when “reasonably

assured” of being entitled to receive the claim

Revised Exposure Draft – Claims & Unapproved Change Orders

• Requirement for application/discounting:• Transaction/contract price adjusted to reflect the

time value of money if a significant financing component exists.

• Considerations:• Expected length of time between delivery of

goods and services and receipt of payment.• Whether amount of payment would differ

substantially if cash payment was received in accordance with typical credit terms.

Revised Exposure Draft – Time Value of Money

• Exception:• Expectation at contract inception,• Period between payment and performance

< 1 year• Applicable to contracts > 1 year in duration

if period between performance and payment is < 1 year

Revised Exposure Draft – Time Value of Money

• Retention: • Will depend on contract terms and normal

practices.• It is unclear whether the right of offset would

exist or not; therefore, financing of retention receivables would not necessarily be able to be offset against retentions payable.

• Overbillings:• Also unclear if concept is intended to be applied

to contracts with significant under or over billings.

Revised Exposure Draft – Time Value of Money

• Interplay with onerous performance obligation criteria– Measure against contract revenue. Contract revenue excludes

interest income if net financing component is deemed to exist in contract. In this situation, you could have a contract with thin margins, but still with an overall profit; however, after applying the TV$ criteria in connection with the onerous performance obligation criteria, you could end up having to accrue a loss when the overall economic arrangement is actually a profit!

– The inverse is true as well!

Revised Exposure Draft – Time Value of Money

Revised Exposure Draft – Time Value of Money

Current NewAccounting Accounting

Contract 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-month period with payments of $500,000 each occurring at the end of the 12th and 24th months.

• Collectibility criteria, as written, are based on more than just the customer’s inherent inability to pay.

• It also refers to the risk that a Company will not be able to collect from its customer(s) the amounts that it 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 of bad debts expense.• Past practices may have focused on only recognizing

revenue based on expected collections

Revised Exposure Draft – Collectibility

Revised Exposure Draft – Collectibility

Current NewPresentation Presentation

Contract revenues 63,000,000$ 63,000,000$

Cost of contract revenues 52,500,000 52,500,000

Gross profit 10,500,000 10,500,000

SG&A expense 7,500,000 7,250,000 Bad debt expense - 250,000

Total SG&A expenses 7,500,000 7,500,000

Income from operations 3,000,000 3,000,000

Other income (expense) (100,000) (100,000)

Net income 2,900,000$ 2,900,000$

ABC CONSTRUCTION, INC.STATEMENT OF COMPREHENSIVE INCOME

Year Ended December 31, 201X

Requirement is to exclude costs of inputs that are not reflective of contract progress When using an input method, an entity shall

exclude the effects of any inputs that do not depict the transfer of control of goods or services to the customer (e.g. the costs of wasted material or labor).

Arguably, the first dollar of labor on re-work should theoretically be expensed as incurred and not included in the measure of contract revenue

Expected revision: Exclude such cost if performance would be

distorted

Revised Exposure Draft – Input Method

• Requirement is to exclude the cost of uninstalled materials that are not reflective of contract progress– Language in Revised Exposure Draft was

inaccurate– Desire to eliminate profit recognition on

uninstalled materials (believed to be the intent)

– Effect on financial statements if such costs can be billed?

– Effect on bonding/underwriting?

Revised Exposure Draft – Uninstalled Materials

Revised Exposure Draft – Uninstalled Materials

ForecastedContract Amts

Contract 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 will be constructed offsite prior to installation. Duration of contract is estimated at 9 months and contract price is $1,000,000.

Revised Exposure Draft – Uninstalled Materials

Current NewAccounting Accounting

Direct materials and labor to date 400,000$ 400,000$

Overhead applied 40,000 40,000

Total costs incurred to date 440,000 440,000

Less: 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 at the contractor's warehouse. None of the units have been installed.

Revised Exposure Draft – Uninstalled Materials

Current NewAccounting Accounting

Contracts receivable (asset) 600,000$ 600,000$

Inventory (asset) - 440,000

Contract 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 loss once identified

However, proposed standard would not require that losses be accrued on contracts of less than year duration

Revised Exposure Draft – Onerous Performance Obligations

• Like so many other aspects of the standard, the challenge lies with the interplay between various provisions.

• An onerous performance obligation is one where the cost of settling the performance obligation is more than the transaction price (ie – loss contract)

• The transaction price includes amounts the entity expects to be entitled

• “Expects to be entitled” can include claim revenue.

• So…

Revised Exposure Draft – Onerous Performance Obligations

So…

Even if you don’t yet recognize the claim revenue , you would/ could count the claim revenue in the transaction price and in doing so, defer a loss that should have been recognized

Revised Exposure Draft – Onerous Performance Obligations

• Other items:– Variable/contingent consideration– Disclosures – new– Effect on employee performance incentives– Effective date and transition

Revenue Recognition Revised Exposure Draft

• Constraint concept:– Constrain the cumulative amount of revenue

recognized that should not be subject to significant reversal.

– Assessment will be qualitative.– Need to assess all facts and circumstances

of risks of revenue reversal.– Uncertain future events.– Magnitude of reversal if uncertain events were to

occur.

Variable/contingent consideration

• Application of constraint concept:– When are/will the following be recognized on

a contract:– Performance award incentive for early completion– Performance award incentive for quality of

construction– Performance award incentive for attaining LEED

Platinum Cert.– Performance award penalty (contract reduction) for

delays– Performance award penalty (contract reduction) for

lower quality material substitution

Variable/contingent consideration

• 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

Disclosures – new

• Bank covenant requirements• Earnings metrics• Excess cash flow payments

• Employee Performance Incentives – bonuses based on revenues and/or net income

Effect on Traditional GAAP Benchmarks

Effect on Traditional GAAP Benchmarks

ForecastedContract Amts

Base 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 with target minimum LEED Gold Certification upon completion. Performance incentive award of $200,000 if LEED Platinum Certification is obtained upon completion. Expected project duration: 2.5 years.

Effect on Traditional GAAP Benchmarks

Contract Contract

Current Accounting - Year 1 Incep. to Date Current Year

Direct materials and labor to date 400,000$ 400,000$

Overhead applied 60,000 60,000

Adjusted 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 Contract

Current Accounting - Year 2 Incep. to Date Current Year

Direct materials and labor to date 880,000$ 480,000$

Overhead applied 132,000 72,000

Adjusted 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 150,000 150,000

Revenue 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 precedes required adoption of new revenue recognition standard/rules.

Effect on Traditional GAAP Benchmarks

Contract Contract

New Accounting - Year 3 Incep. to Date Current Year

Direct materials and labor to date 980,000$ 100,000$

Overhead applied 147,000 15,000

Adjusted 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 200,000 200,000

Revenue 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 the beginning of the 3rd year of the contract. The transition effect of the contract on the contractor's financial statements is recorded as an adjustment to beginning equity. The results of the contract are reflected in the income statement for year 3 based on the new accounting guidance - potential for reporting a portion of incentive revenue twice.

• January 1, 2018: effective date for non-public entities• Early adoption is not permitted

• Transition– Retrospective application – restate prior

periods upon adoption, or– Apply to existing contracts in progress on

the effective date and new contracts going forward– Requires cumulative effect adjustment and certain

additional transition disclosures.

Effective date and transition

Additional Discussion Material – FASB’s Private

Company Reporting AICPA’s Framework for SMEs

--as time permits

• ‘Exceptions’ to US GAAP for non-public companies

• Opportunities to reduce complexities/costs• Serve needs of users• Without sacrificing

– Quality– Fundamental level of comparability

FASB’s Private Company Reporting

• 6 differential factors• Key issues on their agenda:

• Variable interest entities• Interest rate swaps• Intangibles including goodwill• Uncertain tax positions

FASB’s Private Company Reporting

• Other comprehensive basis of accounting• Non-GAAP• Simpler and not as rules-based• Work in progress

• Concerns:• Acceptance by users• Consistency in application

AICPA’s Framework for SMEs

• 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

consistent and reliable as GAAP• 81% said it would impact credit capacity and

pricing

AICPA’s Framework for SMEs

Questions???

Tim Wilson, CPA, CCIFPNational Industry Partner

BKD, LLP1201 Walnut, Suite 1700

Kansas City, MO 64106twilson@bkd.com(816) 701-0208

Thank you for your participation.

Anthony M. Hakes, CPA, CCIFP

A/E/C Market Leader-PhoenixMayer Hoffman McCann, P.C.3101 N. Central Ave., Suite 300

Phoenix, AZ 85012ahakes@cbiz.com(602) 650-6225