Under construction Current financial reporting issues impacting the engineering and construction industry

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1 Under construction Current financial reporting issues impacting the engineering and construction industry

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3 Table of contents Special report: 2 Revenue recognition: progress toward completion Overview 2 Defining the contract 3 Determining the transaction price 4 Accounting for multiple performance obligations 6 Allocating the transaction price to multiple 7 performance obligations Recognize revenue 8 Other considerations 11 Contract costs 12 Final thoughts 13

4 Revenue recognition: progress toward completion Overview Entities in the engineering and construction (E&C) industry applying US GAAP or IFRS have primarily been following either Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1, as codified in Topic ), or International Accounting Standards 11, Construction Contracts (IAS 11), to account for revenue. These standards were developed to address particular aspects of long-term construction accounting and provide guidance on a wide range of industry-specific considerations including: Defining the contract, such as when to combine or segment contracts, and when and how to account for change orders and other modifications Defining the contract price, including variable consideration, customer furnished materials, and claims Recognition methods, such as the percentage-of-completion method (and in the case of US GAAP, the completed contract method) and input/output methods to measure performance Accounting for contract costs, such as precontract costs and costs to fulfill a contract Accounting for loss-making contracts In June 2010 the FASB and IASB released an exposure draft, Revenue From Contracts with Customers, proposing a model that will have a significant impact on current revenue recognition under both US GAAP and IFRS. Redeliberations by the boards began in January The boards have focused their discussions on common themes in the comment letters received from constituents, and have reached several tentative decisions. Some decisions confirm conclusions in the exposure draft and others significantly change direction from what was proposed previously. Tentative decisions made during redeliberations address several areas key to the E&C industry, including transfer of control, identification of performance obligations, determining the transaction price, accounting for warranties, and transition, among others. The boards decided to re-expose the proposed revenue standard in August or September 2011, with a 120-day comment period. The revised exposure draft will include questions that ask for feedback on the more significant changes from the June 2010 exposure draft. These questions are expected to address the following: (1) performance obligations satisfied over time (i.e., service arrangements), (2) presentation of the effects of credit risk adjacent to revenue, (3) the reasonably assured constraint on revenue recognition, and (4) applying the onerous test. The proposed model employs an asset and liability approach, the cornerstone of the FASB s and IASB s conceptual frameworks. Current revenue guidance focuses on an earnings process, but difficulties often arise in determining when revenue is earned. The boards believe a more consistent application can be achieved by using a single, contract-based model where revenue recognition is based on changes in contract assets (rights to receive consideration) and liabilities (obligations to provide a good or perform a service). Under the proposed model, revenue is recognized based on the satisfaction of performance obligations. In applying the proposed model, entities would follow the following five-step process: Identify the contract with a customer. Identify the separate performance obligations in the contract. Determine the transaction price. Allocate the transaction price to the separate performance obligations, and Recognize revenue when each performance obligation is satisfied. Once the new revenue recognition standard becomes effective, SOP 81-1, IAS 11, and all existing revenue recognition guidance under US GAAP and IFRS will be replaced. This includes the percentage-of-completion method and the related construction cost accounting guidance as a standalone model. 2 Under construction Current financial reporting issues impacting the engineering and construction industry

5 Defining the contract Current guidance covers: When two or more contracts should be combined and accounted for together When one contract should be segmented and accounted for separately as two or more contracts When a contract modification should be recognized These situations and, in particular, contract modifications such as change orders, are commonplace in the E&C industry. The proposed standard applies only to contracts with customers when such contracts: Have commercial substance Have been approved by the parties to the contract and such parties are committed to satisfying their respective obligations Have enforceable rights that can be identified regarding the goods or services to be transferred Have terms and manners of payment that can be identified We do not expect current practice in the area of contract combinations to be significantly affected by the proposed standard. The boards have tentatively decided to not require contract segmentation under the proposed model, which will have an impact on those companies that now segment contracts under current guidance. Construction companies currently exercise significant judgment to determine when to include change orders and other contract modifications in contract revenue and, therefore, there is diversity in practice. We expect that the use of judgment will continue to be required and do not expect current practice (or existing diversity) in this area to be significantly affected by the proposed standard, including the accounting for unpriced change orders. Proposed standard Current US GAAP Current IFRS Combining contracts Two or more contracts (including contracts with different customers) should be combined and accounted for as one contract if the contracts are entered into at or near the same time and: The contracts are negotiated with a single commercial objective The amount of consideration in one contract depends on the other contract, or The goods or services in the contracts are interrelated in terms of design, technology, or function Contract modifications (for example, change orders) A contract modification should be accounted for as a separate contract if it is for the addition of a distinct good or service (as defined below) at a price that is commensurate with that additional good or service. In all other circumstances, the entity should combine the modification with the original contract, reevaluate its performance obligation(s), and reallocate the transaction price to each separate performance obligation. Combining and segmenting contracts is permitted provided certain criteria are met, but it is not required so long as the underlying economics of the transaction are fairly reflected. A change order is generally included in contract revenue when it is probable that the change order will be approved by the customer and the amount of revenue can be reliably measured. US GAAP also includes detailed revenue and cost guidance on the accounting for unpriced change orders (or those in which the work to be performed is defined, but the price is not). Combining and segmenting contracts is required when certain criteria are met. A change order (known as a variation) is generally included in contract revenue when it is probable that the change order will be approved by the customer and the amount of revenue can be reliably measured. There is no detailed guidance on the accounting for unpriced change orders. Current financial reporting issues impacting the engineering and construction industry 3

6 Determining the transaction price The transaction price (or contract revenue as it is called today in the E&C industry) is the consideration the contractor expects to receive in exchange for satisfying its performance obligations. When the contract price is fixed, this determination is simple. When the contract price is not fixed, however, the determination is more complex. Common considerations in this area for the E&C industry include the accounting for awards/incentive payments, customer-furnished materials, claims, liquidated damages, and time value of money. Revenue related to awards/incentive payments might be recognized earlier under the proposed standard. We do not expect a significant change in practice as it relates to customer-furnished materials, claims, liquidated damages, or time value of money. Proposed standard Current US GAAP Current IFRS Awards/incentive payments Awards/incentive payments are included in contract revenue using a probability-weighted or most-likely-amount approach (whichever is more predictive). These amounts are recognized as the entity satisfies its related performance obligations, provided such payments are reasonably assured of being received. Such amounts are reasonably assured generally when the contractor has experience with similar types of contracts and that experience has predictive value (i.e., experience is relevant to the contract). Customer-furnished materials If a customer contributes goods or services (for example, materials, equipment, or labor) to facilitate the fulfillment of the contract, the value is included in contract revenue if the entity controls these goods or services. Any noncash consideration is measured at fair value unless fair value cannot be reasonably estimated, in which case it is measured by reference to the selling price of the goods or services transferred. Awards/incentive payments should be included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. The value of customer-furnished materials is included in contract revenue when the contractor has the associated risk for these materials. Awards/incentive payments should be included in contract revenue when the specified performance standards are probable of being met or exceeded and the amount can be reliably measured. There is no explicit guidance on the accounting for noncash consideration in the construction contracts standard. Management would follow general principles on nonmonetary exchanges, which generally require companies to use the fair value of goods or services received in measuring the amount to be included in contract revenue. continue next page 4 Under construction Current financial reporting issues impacting the engineering and construction industry

7 Proposed standard Current US GAAP Current IFRS continued from previous page Claims Claims are included in contract revenue using a probability-weighted or most-likely-amount approach (whichever is more predictive). These amounts are recognized as the entity satisfies its related performance obligations, provided such payments are reasonably assured of being received (see above). Time value of money Contract revenue should reflect the time value of money whenever the contract includes a significant financing component. As a practical expedient, however, a contractor does not need to consider time value of money if the period between payment and the transfer of the promised goods or services is one year or less. A claim is recorded as contract revenue (to the extent of contract costs incurred) only if it is probable and reliably estimable (determined based on specific criteria). Profits on claims are not recorded until they are realized. Revenue is discounted in only limited situations, including receivables with payment terms greater than one year. When discounting is required, the interest component should be computed based on the stated rate of interest in the instrument or a market rate of interest if the stated rate is considered unreasonable. A claim is included in contract revenue only if negotiations have reached an advanced stage such that it is probable the customer will accept the claim and the amount can be reliably measured. Revenue is discounted when the inflow of cash or cash equivalents is deferred. An imputed interest rate should be used to determine the amount of revenue to be recognized as well as the separate interest income to be recorded over time. Current financial reporting issues impacting the engineering and construction industry 5

8 Accounting for multiple performance obligations Performance obligations are defined as promises to deliver goods or perform services. Today, contractors often account for each contract at the contract level; that is, contractors account for the macro-promise in the contract to build a road or build a bridge, etc. Current guidance permits this, although a contractor effectively promises to provide a number of different goods or perform a number of different services in delivering such macro-promises. Clearing, grading, and paving, for example, may qualify as separate performance obligations within the macro-promise to build a road. Determining when to separately account for these performance obligations under the proposed model is, therefore, a key determination and will require a significant amount of judgment. Under the proposed model, it is possible to account for the contract at the contract level (e.g., macro-promise to build a road), but we expect that contractors might have to separately account for more obligations within each contract compared to current guidance. Significant judgment will be required, for example, in the case of design/build or EPC contracts. Proposed standard Current US GAAP Current IFRS Performance obligations separation An entity should separately account for performance obligations only if the pattern of transfer is different and they are distinct. A good or service is distinct if either: The entity regularly sells the good or service separately, or The customer can use the good or service on its own or together with other readily available resources An entity should account for two or more performance obligations as a single performance obligation if the risks to the entity of providing these goods or services are inseparable. Making this determination will require significant judgment. Considerations might include, but would not be limited to: The goods are highly interrelated. The entity provides a significant integration service (e.g., combining goods or services for which the customer has contracted). The entity significantly modifies the goods in the contract. An entity may promise to provide both goods and services in a contract. In these circumstances, an entity must first determine whether the goods and services are separate performance obligations. If not, the goods and services should be combined and accounted for as a service. The basic presumption is that each contract is the profit center for revenue recognition, cost accumulation, and income measurement. That presumption may be overcome only if a contract or a series of contracts meets the conditions described above for combining or segmenting contracts. There is no further guidance for separately accounting for more than one deliverable in a construction contract. The basic presumption is that each contract is the profit center for revenue recognition, cost accumulation, and income measurement. That presumption is overcome when a contract or a series of contracts meets the conditions described for combining or segmenting contracts. There is no further guidance around separately accounting for more than one deliverable in a construction contract. 6 Under construction Current financial reporting issues impacting the engineering and construction industry

9 Allocating the transaction price to multiple performance obligations Performance obligations are measured at the amount of consideration the contractor expects to receive (i.e., the transaction price as described above). This consideration must then be allocated to the performance obligations in a contract that require separate accounting. We expect that contractors might have to separately account for more performance obligations than today if the risks of providing two or more goods or services are not inseparable (as described above), so the allocation of the transaction price (i.e., contract revenue) will be new to many E&C companies. Of particular interest will be the allocation of variable consideration (e.g., award/incentive payments) associated with only one separately accounted for performance obligation, rather than the contract as a whole. Proposed standard Current US GAAP Current IFRS Allocating the transaction price For performance obligations that require separate accounting, contract revenue (and any subsequent changes) is allocated to each performance obligation based on relative actual or estimated selling prices. An estimation method will not be prescribed nor will any method be precluded. For example, a contractor might use cost plus a reasonable margin in estimating the selling price of a good or service. If the standalone selling price is highly variable, entities may use a residual technique to estimate the standalone selling price (i.e., total transaction price less the standalone selling prices of other goods or services in the contract). An entity may also allocate the transaction price entirely to one (or more) performance obligations if certain conditions are met. Except for allocation guidance related to contract segmentation, there is no explicit guidance on allocating contract revenue to multiple deliverables in a construction contract, given the presumption that the contract is the profit center for determining revenue recognition. Except for allocation guidance related to contract segmentation, there is no explicit guidance on allocating contract revenue to multiple deliverables in a construction contract, given the presumption that the contract is the profit center for determining revenue recognition. Current financial reporting issues impacting the engineering and construction industry 7

10 Recognize revenue Revenue recognition under existing guidance is based on the activities of the contractor; that is, provided reasonable estimates are available, revenue can be recognized as the contractor performs (known as the percentage-ofcompletion method). The boards have proposed that revenue is recognized upon the satisfaction of a contractor s performance obligations, which occurs when control of a good or service transfers to the customer. Control can transfer either at a point in time or continuously over the contract period. The change to a control transfer model will require careful assessment of when a contractor can recognize revenue. We expect that many construction-type contracts will transfer control of a good or service continuously to the owner over the contract term and, therefore, might produce similar results compared to today. This should not, however, be assumed. Contractors will not be able to default to the method used today. Cost-to-cost may be used today, for example, to measure revenue under an activities-based recognition model. It may not be appropriate for measuring the extent to which control has transferred under a continuoustransfer model. 8 Under construction Current financial reporting issues impacting the engineering and construction industry

11 Proposed standard Current US GAAP Current IFRS Recognize revenue Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or, perhaps most important for the E&C industry, continuously over the contract period. Determining when control transfers will require a significant amount of judgment. Indicators that may be considered in determining whether the customer has obtained control of a good include: The customer has an unconditional obligation to pay. The customer has legal title. The customer has physical possession. The customer has the risks and rewards of ownership. This list is not intended to be a checklist or all-inclusive. No one factor is determinative on a standalone basis. The customer has satisfied a performance obligation over time for services when: The entity s performance creates or enhances an asset that the customer controls, or The entity s performance does not create an asset with alternative use to the entity, and - The customer receives a benefit as the entity performs each task - Another entity would not need to reperform the tasks performed to date, or - The entity has a right to payment for performance to date Revenue is recognized using the percentageof-completion method when reliable estimates are available. In circumstances in which reliable estimates cannot be made, but there is an assurance that no loss will be incurred on a contract (e.g., when the scope of the contract is ill-defined, but the contractor is protected from an overall loss), the percentage-of-completion method based on a zero-profit margin is used until more precise estimates can be made. Where reliable estimates cannot be made, the completed-contract method is required. Revenue is recognized using the percentageof-completion method when reliable estimates are available. In circumstances in which reliable estimates cannot be made, but there is assurance that no loss will be incurred on a contract (e.g., when the scope of the contract is ill-defined, but the contractor is protected from an overall loss), the percentage-of-completion method based on a zero-profit margin is used until more precise estimates can be made. The completed-contract method is prohibited. continue next page Current financial reporting issues impacting the engineering and construction industry 9

12 Proposed standard Current US GAAP Current IFRS continued from previous page Measuring continuous transfer of control For contracts where control transfers continuously, and progress toward successful completion can be reasonably measured, a contractor can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones), or the passage of time to measure the extent to which control has transferred. The method that best depicts the transfer of goods or services to the customer should be applied consistently throughout the contract and to similar contracts with customers. Once the metric is calculated to measure the extent to which control has transferred, it must be applied to total contract revenue to determine the amount of revenue to be recognized. This is currently referred to as the revenue method. The use of the gross profit method is prohibited. Estimates to measure the extent to which control has transferred (e.g., estimated cost to complete when using a cost-to-cost calculation) should be continually evaluated and adjusted using a cumulative catchup method. A contractor can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a percentage complete is derived, there are two different approaches for determining revenue, cost of revenue, and gross profit: the revenue method and the gross profit method. A contractor can use either an input method (e.g., cost-to-cost, labor hours, labor cost, machine hours, material quantities), an output method (e.g., physical progress, units produced, units delivered, contract milestones), or the passage of time to measure progress towards completion. Once a percentage complete is derived, IFRS requires the use of the revenue method. The gross profit method is prohibited. 10 Under construction Current financial reporting issues impacting the engineering and construction industry

13 Other considerations Warranties The accounting for warranties in the proposed standard is based primarily on whether the customer has the option to purchase the warranty separately. There is currently diversity in the way E&C companies account for warranties. We therefore expect practice to become less diverse and also potentially significantly change in this area, resulting in delayed revenue recognition and complex accounting calculations for those warranties in which the customer has the option to purchase separately. Proposed standard Current US GAAP Current IFRS Warranties Warranties that the customer has the option to purchase separately give rise to a separate performance obligation. A portion of the transaction price is allocated to that separate performance obligation at contract inception. If a customer does not have the option to purchase a warranty separately from the entity, the warranty should be accounted for as a cost accrual. In certain circumstances, an entity provides a warranty that calls for a service to be provided to the customer (e.g., maintenance) in addition to a promise that the entity s past performance was as specified in the contract. In these circumstances, the entity should account for this warranty as a separate performance obligation. Contractors typically account for warranties that protect against latent defects outside of the contract and in accordance with existing loss contingency guidance. A contractor recognizes revenue and concurrently accrues any expected cost for these warranty repairs. Revenue is deferred for warranties that protect against defects arising through normal usage and recognized over the expected life of the contract. Contractors are required to account for the estimated costs of rectification and guarantee work, including expected warranty costs, as contract costs. However, contractors typically (due to materiality considerations) account for standard warranties protecting against latent defects outside of the contract and in accordance with existing provisions guidance. A contractor will recognize revenue and concurrently accrue any expected cost for these warranty repairs. Revenue is deferred for warranties that protect against defects arising through normal usage and recognized over the expected life of the contract. Current financial reporting issues impacting the engineering and construction industry 11

14 Contract costs Existing construction literature contains a substantial amount of cost capitalization guidance, both related to pre-contract costs and costs to fulfill a contract. The proposed model also includes contract cost guidance and may result in a change in the measurement and recognition of contract costs as compared to today (in particular for those contractors that use the gross profit percentage-of-completion method). Proposed standard Current US GAAP Current IFRS Contract costs All costs relating to satisfied performance obligations and costs related to inefficiencies (i.e., abnormal costs of materials, labor, or other costs to fulfill) should be expensed as incurred. Incremental costs of obtaining a contract are eligible for capitalization so long as these costs are expected to be recovered. Other direct costs incurred in fulfilling a contract are expensed as incurred unless they are within the scope of other standards (e.g., inventory, intangibles, fixed assets), in which case the entity should account for such costs in accordance with those standards. If the costs are not within the scope of other standards, the entity should recognize an asset only if the costs relate directly to a contract, relate to future performance, and are probable of recovery under a contract. There is a significant amount of detailed guidance relating to the accounting for contract costs. This is particularly true with respect to accounting for pre-contract costs. Pre-contract costs that are incurred for a specific anticipated contract generally may be deferred only if their recoverability from that contract is probable. Other detailed guidance is also prescribed in the standard and should be appropriately considered. There is a significant amount of detailed guidance relating to the accounting for contract costs. Costs that relate directly to a contract and are incurred in securing the contract are included as part of contract costs if they can be separately identified and measured reliably and it is probable that the contract will be obtained. Other detailed guidance is also prescribed in the standard and should be appropriately considered. Capitalized costs would be amortized as control of the goods or services to which the asset relates is transferred to the customer. 12 Under construction Current financial reporting issues impacting the engineering and construction industry

15 Final thoughts The above commentary is not all inclusive. Other potential changes include, for example, the accounting for options and a significant expansion in disclosure requirements (with certain disclosure exceptions for private companies).a final standard is now expected in 2012, with an effective date likely no earlier than 2015 or The proposed standard might permit either full or limited retrospective application. Limited retrospective application would reduce the burden on preparers by (a) not requiring the restatement of contracts for comparative periods that began and ended in the same accounting period; (b) allowing the use of hindsight in estimating variable consideration; (c) not requiring the onerous test to be performed in comparative periods unless an onerous contract liability was recognized previously; and (d) not requiring disclosure of the maturity analysis of remaining performance obligations in the first year of application. Although the proposed standard does not address early adoption, the FASB prefers to prohibit early adoption; the IASB proposes to allow first-time adopters of IFRS to adopt early. Companies should continue to evaluate how the model might change current business activities, including contract negotiations, key metrics (including debt covenants, surety, and prequalification capacity calculations), budgeting, controls and processes, information technology requirements, and accounting. Current financial reporting issues impacting the engineering and construction industry 13

16 Authored by: H. Kent Goetjen US Engineering and Construction Leader Phone: Dusty Stallings Partner, National Professional Services Group Phone: Mike Sobolewski Senior Manager, US Engineering and Construction Client Service Specialist Phone: This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers and PwC refer to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate legal entity. This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. NY