Potential Changes with Revenue Recognition Within the Construction IndustryJanuary 01, 2011
Luke S. Ebersold, CPA
A critical accounting issue in the eyes of the Financial Accounting Standards Board revolves around the way businesses recognize revenue, and an exposure draft has been issued that could affect all industries, even the construction industry. For decades, the construction industry has been recognizing revenue according to one standard, which is Statement of Position 81-1, Accounting for Performance of Construction Type and Certain Production-Type Contracts. This standard outlined the percentage of completion and completed contract methods of recognizing revenue as well as proposed guidelines for when to use each of these methods.
This new proposal, however, would set the stage for revenue to be recognized in a consistent manner in the construction industry, as well as all other industries. We do not expect most of the current revenue recognition practices to be significantly impacted by the change, although we will have to consider some specific situations where the revenues could be recorded in a different manner.
This article addresses some of these proposed changes, particularly those that would seem to have the most impact on the industry.
Recognition of Revenue
The current manner to recognize revenue for construction contracts has been under the percentage of completion method, or the completed contract method (when accurate estimates are not available). These methods would no longer be acceptable going forward. Under the new proposal, revenue will be recognized upon the satisfaction of performance obligations, or when control of the goods transfers to the customer. The proposed standard also addresses performance obligations that are transferred to a customer continuously, such as performance of certain construction contracts. The methods they identify to measure this continuous transfer would be similar to the current standard, which would be some type of input method or output method. If the company has been utilizing the gross profit method, this will not be acceptable under the new standard.
Claims and Unapproved Change Orders
Under the current method, claim revenue and unapproved change order revenue are only recorded if they are likely to be received and the company can reasonably estimate the additional revenue. Profits on these are not to be recorded until they are realized. Under the new proposal, the revenue and related profit is recognized using a probability-weighted approach, assuming the amounts can be reasonably estimated.
Time Value of Money
Under the current method of revenue recognition, the discounting of revenues is required only in limited situations. Revenues on long-term contracts are recorded at their gross amount regardless of the amount of time to complete the contract, and the related receivables are recorded at their gross amount. Adjustments are made to the receivables if they are deemed to be uncollectible, but generally there are no discounts recorded for the time value of money. Under the new standard, contract revenue and the related receivables should reflect the time value of money whenever the effect to the company is deemed material. Management should use a discount rate that would reflect a financing transaction between the company and a financing entity.
Many contract provisions allow for the variations in the contract based on the company's performance on that contract. This can come in the form of a bonus when certain savings are attained. Under the current method, the standard generally requires that any amounts that are not initially fixed or determinable be considered part of the contract only when the uncertainty surrounding the amount is resolved. Under the proposed new standard, the initial measurement of the contract should include reasonably estimable variable consideration. The time value of money should also be considered in this variable consideration.
Accounting for Loss Contracts
Current standards dictate that when a loss is anticipated on a long-term contract, the entire loss on the contract is recognized no matter how much of the contract has been completed. For example, if the company anticipates a $100,000 loss when the contract is completed, that $100,000 loss is recognized when the contractor knows of the anticipated loss. The new proposed standard does not change the accounting for loss contracts. Even though this isn't a change from the current method, its interest to the industry warrants discussion.
These (and others) are substantive core changes to the way companies handle revenue recognition and, if ultimately approved, will require a number of adjustments to be made in order to comply. Awareness of these issues now, when the new standard is still in the exposure draft stage, can only be beneficial to construction companies and give them time to prepare.