revenue recognition for contractors - neca now conference
DESCRIPTION
A copy of the revenue recognition for Contractors presentation given at the NECA NOW Conference in April 2013.TRANSCRIPT
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 [email protected](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 [email protected](602) 650-6225