How the New Revenue Recognition Standards will Impact Construction Entities

Transcription

1 How the New Revenue Recognition Standards will Impact Construction Entities Presented by: John Armour June 19, 2014

2 Disclaimer The information in this presentation is a brief summary of new standards that may change existing practice in the construction Industry and may not include all the details relevant to your situation. Please contact your service provider to further discuss the impact on your business. 2

3 FASB S NEW REVENUE RECOGNITION STANDARD BACKGROUND

4 Reasons for the New Guidance The FASB and the IASB initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRS that would: 1. Remove inconsistencies and weaknesses in existing revenue recognition standards and practices. U.S. GAAP has multitude of Industry and transaction specific standards. IFRS has two standards on Revenue Recognition IAS 11 and IAS Provide a more robust framework for addressing revenue recognition issues. Weaknesses exist in both set of standards. 3. Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets. 4. Simplify the preparation of financial statements by reducing the number of requirements to which entities must refer. 4

5 Reasons for the New Guidance - continued The new guidance utilizes a contract-based approach that places the focus on the assets and liabilities that are created when an entity enters into and performs under a contract. While some of the concepts in the new guidance are similar to existing guidance, other may change existing practice leading to changes in the amount and timing of revenue recognized. 5

6 REVENUE RECOGNITION CURRENT PRACTICE

7 Revenue Recognition Basics The current revenue recognition model followed under U.S. Generally Accepted Accounting Principles is focused on the earning process (CON-5). Generally, it is appropriate to recognize revenue upon the culmination of the earnings process. This means the seller must determine when the earnings process is completed (when the seller has substantially completed what it agreed to do). This determination is not always readily apparent for a variety of reasons. The determination of earned focuses on measurement and recognition thresholds (e.g., the four basic revenue recognition criteria) Industry guidance originally published as SOP 81-1 plays a significant role in revenue recognition. Percentage of completion Input/Output measurement Profit Center typically the entire contract as modified. Guidance on contingent income, change orders, claims, etc. 7

8 Basic Revenue Recognition Criteria Revenue is generally realized, or realizable, and earned when all of the following criteria are met: Persuasive evidence of arrangement Price is fixed or determinable Delivery has occurred or service has been rendered Collectability is reasonably assured 8

9 CHANGES TO REVENUE RECOGNITION UNDER THE NEW GUIDANCE

10 Revenue Recognition The Future has Arrived FASB Accounting Standard Update No Revenue from Contracts with Customers (Topic 606) Standard applies to all transactions which relate to and include Contract, and Customer Terminology has changed first step is to gain understanding of the new language of revenue recognition 10

11 Taking your crutch away Industry guidance from SOP 81-1 will no longer be relevant Decisions relative to Revenue and, to some degree, Costs will be guided by the principles of ASU FASB expects industry practice guidance to be developed but it will not be under the authority of the FASB AICPA has formed multiple industry groups to address and modify current audit and accounting guides these will not be GAAP unless designated by FASB Engineering and Construction Task Force Aerospace and Defense Task Force 11

12 Core Principle and Five-Step Process Core principle: The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods, or services, to customers in an amount that reflects the consideration to which the entity expects to be entitled, in exchange for those goods or services. Five steps to apply the core principle: 1. Identify the contract(s) with a customer. 2. Identify the performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfied a performance obligation. 12

13 Core Principle and Five-Step Process Basic Observations On the surface the five step process does not seem overly complex and arguably, it appears to include much of what is currently done to determine revenue recognition. However, each of the five steps will require significant judgments by management and auditor in applying the underlying principles included in the new guidance. The transfer of control to the customer becomes the driving issue in evaluating the appropriateness of revenue recognition under the new guidance. Currently, the evaluation of risk and reward often drives the determination of revenue recognition. While it remains an important consideration, it is no longer determinant under the new guidance. 13

14 Identify the Contract with the Customer Issue 1. Contracts can include implied or verbal agreements. Existing GAAP does not require written agreements although many entities follow conservative processes of not recognizing revenue on verbal agreements How does an auditor verify a verbal or implied agreement? What criteria will be applied to determine if enforceable rights and obligations have been created in the absence of a written agreement? What will be the timing of recognition? Transaction price is driven by expected receipt for the goods or service The new constraint provision will impact recognition 14

15 Identify the Contract with the Customer Issue 2. Change Orders (including unpriced change orders) Under current guidance change orders are accounted for as a modification of the original contract but large variance in practice exists for timing of measurement and recognition. Under current guidance change orders with agreement on scope but no agreement on price are accounted for under claim guidance New standard guidance is Contract Modification Determination of whether the change order is a new contract, a new performance obligation that is distinct, or a change in the original agreement. The conclusion of regarding the above will change timing of recognition, presentation, and possibly disclosures May require evaluation under new Variable Consideration standard 15

16 Contract Modification A contract modification exists when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract. there are two paths to consider when evaluating the accounting related to the modification. An entity shall account for a contract modification as a separate contract if both of the following conditions are present: The scope of the contract increases because it results in the addition of promised goods or services that are distinct. The price of the contract increases by an amount of consideration that reflects the entity s standalone selling prices of the additional promised goods and services and any appropriate adjustment to that price to reflect the circumstances of the particular contract. 16

17 Contract Modification If a contract modification is not accounted for as a separate contract, an entity shall account for the promised goods or services not yet transferred at the date of contract modification in whichever of the following ways is applicable: An entity shall account for the contract modification as if it were a termination of the existing contract and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. An entity shall account for the contract modification as if it were part of the existing contract if the remaining goods or services are not distinct, and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. 17

18 Contract Modifications If the remaining goods or services are a combination of the items above, then the entity shall account for the effects of the modification on unsatisfied (including partially unsatisfied) performance obligations in modified contract in a manner that is consistent with the objectives of the relevant paragraph. 18

19 Identify the Contract with the Customer Issue 3. Claims Four conditions precedent to recognize claim revenue under current standards are not carried into the new standard Pre-resolution revenue recognition limited to costs incurred under current standards New standard guidance is Contract Modification Determination of whether the claim is a new contract, a new performance obligation that is distinct, or a change in the original agreement. The conclusion of regarding the above will change timing of recognition, presentation, and possibly disclosures May require evaluation under new Variable Consideration standard May require evaluation under new Financing standard Margin can be recognized if estimated recovery exceeds costs. 19

20 Identify the Contract with the Customer Issue 4. Combining Contracts Current standards allow combining contracts but rules based criteria are very difficult to satisfy New standard guidance may create more opportunity to measure multiple contracts in a single step Goes against surety separate risk on single projects but this third party risk is not part of the criteria for combining Will require evaluation including considering proper treatment when multiple contracts with a single customer exist. Note that the decision to combine contracts occurs before the evaluation of performance obligations 20

21 Contract Combination An entity shall combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer), and account for the contracts as a single contract if one or more of the following criteria are met: The contracts are negotiated as a package with a single commercial objective. The amount of consideration to be paid in one contract depends on the price or performance of the other contract. The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation. Note that these standards are similar but not identical for tax qualifications for combining contracts 21

22 Identifying Performance Obligations Current practice evaluates profit centers which typically are the entire contract. A performance obligation is a promise in a contract with a customer to transfer to the customer: A good or service (or bundle of goods or services) that is distinct. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. This is the standard that permits multiple performance obligations to be bundled and reported on a total contract basis. Generally explicit but may also include promises that are implied by an entity s customary business practices, published policies or specific statements, if at the time of entering into the contract those promises create a valid expectation of the customer that the entity will transfer a good or service to the customer. 22

23 Distinct A promised good or service is considered distinct if both of the following conditions are met: The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct). The entity s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the good or service is distinct within the context of the contract) 23

24 Distinct A customer can benefit from a good or service, if the good or service could be used, consumed, sold for an amount greater than scrap value, or otherwise held in a way that generates economic benefit. Various factors may provide evidence that the customer can benefit from the good or service either on its own or in conjunction with other readily available resources. For example, the fact that an entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources. 24

25 Distinct Determining whether the good or service is distinct within the context of the contract is a critical aspect of identifying the performance obligations. Factors that indicate that an entity s promise to transfer a good or service to a customer is separately identifiable include but are not limited to: The entity does not provide a significant service of integrating the goods or services into the bundle of goods or services that the customer has contracted for. Most construction contracts will include a bundle of services The good or service does not significantly modify or customize another good or service promised in the contract. Most construction contracts will include modification or customizing The good or service is not highly dependent on, or highly interrelated with, other goods or services promised in the contract. Most construction contracts will be dependent and interrelated with other goods or services. 25

26 Distinct If a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation. The construction industry will likely adopt a practice that the presumption is that the goods or services are not distinct and are therefore combined and the contract is reported as a single performance obligation - unless there is evidence to the contrary. This will require each contract to be evaluated. 26

27 Possible contracts with multiple PO Contracts that provide both services and product Design/Build contract EPC contracts IDIQ contracts Contracts with separate deliverables Add-on change orders 27

28 Determining the Transaction Price The transaction price is the amount of consideration that an entity expects to be entitled to in exchange for transferring promised goods or services to a customer. Issues that impact the determination of the transaction price include the following: Variable consideration Constraining estimates of variable consideration The existence of a significant financing component in the contract Non cash consideration Consideration payable to a customer. 28

29 Variable Consideration Often, part of the contractual consideration related to a good or service is variable in nature or contingent on future events. (not an all inclusive list): Discounts Rebates Refunds Credits Incentives Performance bonuses - early completion, savings sharing, etc. Royalty Unit pricing Economic price adjustments Latent defects 29

30 Variable Consideration An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled: The expected value the expected value is the sum of probability weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics. The most likely amount the most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of an amount of variable consideration if the contract has only two possible outcomes. 30

31 Constraint on Transaction Price An entity shall include in the transaction price some or all of an amount of variable consideration only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. 31

32 Constraint on Transaction Price Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to any of the following: The amount of consideration is highly susceptible to factors outside the entity s influence. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time. The entity s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value. The entity has a practice of either offering a broad range of price concessions or changing payment terms and conditions of similar contracts in similar circumstances. The contract has a large number and broad range of possible consideration amounts. 32

33 Significant Financing Component In determining the transaction price, a contract must be adjusted for the effects of the time value of money when the contract contains a financing component. A practical expedient is provided that allows an entity to ignore the time value of money when the time between the transfer of the goods/services and payment is less than one year. This is allowable even when the contract itself exceeds one year. The following factors should be considered when determining whether a significant financing component is present in the contract. The length of time between when the transfer of goods or services to the customer occurs and when payment is made. Whether the amount of consideration in the contract would substantially differ if the customer paid cash when the transfer of the goods or services occur. The interest rate in the contract and the prevailing interest rate in the relevant market. 33

34 Significant Financing Component - Retention Example 27 Withheld payments on long-term contract concludes that retention will normally not be a financing because the withholding is intended to protect the customer from the contractor failing to adequately complete its obligations under the contract!!!!!! 34

35 Reassessment At the end of each reporting period, an entity shall update the estimated transaction price (including updating its assessment of whether an estimated variable consideration is constrained) to represent faithfully the circumstances present at the end of the reporting period and the changes in circumstances during the reporting period. 35

36 Allocate the Transaction Price The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer. To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation in the contract on a relative stand-alone selling price basis. Relative selling price is best evidenced by the observable price of a good or service when sold separately in similar circumstances and to similar customers. If a stand-alone selling price is not directly observable, an entity shall estimate the standalone selling price. 36

37 Allocate the Transaction Price 4. Allocate the Transaction Price When estimating the relative stand-alone selling price, management should maximize the use of observable inputs. The following are some possible estimation methods (not all inclusive): Adjusted market assessment approach Expected cost plus a margin approach Residual approach (in certain circumstances). 37

38 Five-Step Process becomes Three-Step If the performance obligation qualifies to be reported at the contract level the revenue model becomes: 1. Identify the contract(s) with a customer. 2. Determine the transaction price. 3. Recognize revenue when (or as) the entity satisfied a performance obligation. 38

39 Recognize Revenue as Performance Obligation is Satisfied An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. Control of an asset refers to the customer s ability to direct the use of and obtain substantially all of the remaining benefits from the asset. Indicators that a customer has obtained control are as follows: The entity has a right to payment for the asset. The entity transferred legal title to the asset. The entity transferred physical possession of the asset. The customer has the significant risk and reward of ownership. The customer has accepted the asset. 39

40 Performance Obligation Satisfied Over Time An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time if one of the following criteria are met: The customer simultaneously receives and consumes the benefits provided by the entity s performance as the entity performs. The entity s performance creates or enhances an asset (WIP) that the customer controls as the asset is created or enhanced. The entity s performance does not create an asset with an alternative use to the entity and the entity has a right to payment for performance completed to date. 40

41 Measurement of PO Satisfied Over Time Similar to current practice Output measurement Units of delivery or production Milestones Generally create audit challenges Input measurement Cost to cost Labor based Measurement should be reflective of transfer of control of the asset to the customer. Zero margin in early stages of completion is acceptable Uninstalled materials Excluded from cost to cost PCM measurement Revenue recognized equal to costs incurred (no margin) Exclude costs that do not contribute to performance if cost to cost Wasted materials, inefficiencies, owner provided materials 41

42 Performance Obligation Satisfied at a Point in Time If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a point in time. The specific point in time is dependent on when the customer obtains control of the promised asset and the entity satisfies the performance obligation. 42

43 Costs to Obtain a Contract An entity should recognize as an asset the incremental costs of obtaining a contract that the entity expects to recover. Incremental costs are those costs that the entity would not have incurred if the contract had not been obtained Practical expedient expense costs if amortization period is 1 year or less 43

44 Costs to Fulfill a Contract Follow existing guidance under other standards, if applicable. Otherwise, recognize as an asset if those costs meet all of the following criteria: Relate directly to a contract (or a specific anticipated contract) Generate or enhance resources of the entity that will be used in satisfying performance obligations in the future Are expected to be recovered Examples Pre-construction costs Mobilization 44

45 Disclosures Disclosures The objective of the disclosure requirements (Topic 606) is for an entity to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The disclosure requirements found in the new revenue recognition guidance are significantly in excess of what is currently required under U.S. GAAP. 45

46 Disclosures Disclosures An entity shall disclose qualitative and quantitative information about all of the following: Its contracts with customers The significant judgments, and changes in the judgments made in applying the guidance in Topic 606 to those contracts Any assets recognized from the costs to obtain or fulfill a contract with a customer. 46

47 Disclosures Disclosures Contracts with customers Disaggregation of Revenue Contract balances Performance obligations Transaction price allocated to the remaining performance obligations Significant judgments in the application of the guidance in Topic 606 Determining the transaction price and the amounts allocated to performance obligations Practical expedients 47

48 PREPARING FOR THE CHANGE NEXT STEPS

49 Next Steps Effective Date of Adoption (Public Entity) For a public entity, the amendments in Topic 606 are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. 49

50 Next Steps Effective Date of Adoption (Nonpublic entities) For all other entities (nonpublic entities) the amendments in Topic 606 are effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, A non public entity may elect to apply the guidance in Topic 606 earlier, however, only as of the following: An annual reporting period beginning after December 15, 2016, including interim periods within that reporting period (public company effective date) An annual reporting period beginning after December 15, 2016 and interim periods with annual periods beginning after December 15, 2017 An annual reporting period beginning after December 15, 2017, including interim periods within that reporting period. 50

51 Next Steps It is hard to imagine a more significant event to financial reporting than the significant overhaul of historical revenue recognition guidance. History tells us that many entities will misjudge the amount of time, effort and expertise that is required when extensive changes are made to significant accounting guidance. The adoption of fair value and consolidation accounting guidance is a relatively recent example for us to consider. 51

52 Next Steps The impact from the adoption of the new revenue recognition standard will likely be complex and farreaching and involve many different functions within an organization. Information systems may require adjustment. Standard sales contracts and other sales agreements should be evaluated in light of the changes. Sales incentives/commissions should be considered. Internal control processes may need updating. Executive compensation arrangements Debt covenants Tax Implications 52

53 Next Steps Changing Business Models? Existing sales strategies and legal documents used in the selling process may require change or no longer be required under the new guidance. Over the years many selling strategies have developed to deal with the bright-line accounting rules. Upon adoption of the new revenue recognition guidance there is a unique opportunity to rethink the way business is done. 53

54 Next Steps Those entities that are currently subject to significant industry guidance are likely to experience the most significant impact. Telecommunication Software Construction/Aerospace and Defense Real Estate Entertainment and Media Multiple Deliverable Contracts 54

55 Next Steps Transition The FASB has allowed two methods for transition: Retrospectively to each prior reporting period presented. Practical expedients provided Retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial adoption. Certain disclosures are required: The amount by which each financial statement line item is affected in the current reporting period by the application of Topic 606 as compared to the guidance that was in effect before the change. An explanation of the reasons for significant changes. 55

56 Next Steps Transition and Implementation Challenges for entities with contracts that span multiple years. What do investors expect? What are your peers likely to do? 56

57 Next Steps Transition and Implementation The implementation of the new revenue recognition standard should be a team effort across many different corporate functions. The level of effort and amount of time necessary will be contingent on a number of variables including the size, complexity and previous reliance on industry related revenue recognition guidance. Start early. With the long on-ramp that FASB has allowed for, it is easy for entities to get lulled into a false sense of security. Large public companies with three year P&L presentations face the most time pressure. 57

58 Next Steps Transition and Implementation Consider the use of an implementation team approach. Existing pricing committees might be a good way to govern the implementation process. Talk with your auditor and/or professional advisors. Watch for further education opportunities from the FASB Revenue Recognition Implementation Group. 58

59 Questions? # 59