Is construction accounting headed for a troublesome shake-up? A proposed new rule aimed at aligning financial reporting by construction firms with other industries could bring sweeping changes to long-held, generally accepted accounting principles. Critics warn the new rule could significantly raise administrative costs, open the door to financial manipulation and dampen surety credit.
The Financial Accounting Standards Board (FASB), which is the designated private-sector organization in the U.S. that establishes financial accounting and reporting standards, and the International Accounting Standards Board have released a draft standard to create a single revenue-recognition standard across multiple industries, including construction.
“The idea is to provide better information to users of the financials,” says Prasadh Cadambi, a practice fellow working on the standard at FASB. “We want to create a single model, rather than multiple models for the same economics.”
The draft standard, which was released in June, is open for public comment until Oct. 22. Directions for submitting comments appear at www.fasb.org.
Some observers suggest the recently announced departure of FASB Chairman Robert Herz, who will leave his post on Oct. 1., could cause a delay in the adoption of any new standard. Still, even critics admit that new rules are on the horizon.
“It is very likely a new revenue standard will be put in place, and revenue recognition for construction will change,” says Jerry Henderson, a partner with accountant BKD and member of the Construction Financial Management Association, Princeton, N.J. “There is still open dialogue on this, so what the final standard would be is hard to say.”
Critics warn that this one-size-fits-all approach will erode accounting principles that are specifically tailored to the construction industry. For decades, contractors have used a percentage-of-completion method for revenue recognition. Based on the percentage of completion, proportionate revenue and earnings can be determined.
Under the proposed rule, contractors would be required to recognize revenue using a series of performance obligations. For example, the contractor might classify utility work as one obligation and structural work as a separate obligation. The net effect is that a project covered under a single contract today could be split into multiple performance obligations, essentially acting as individual contracts on a job.
Henderson says that by breaking up performance obligations, FASB is introducing considerable subjectivity into the process. For example, if two companies were each hired to build an identical freestanding store for a national retailer, one company might decide the job should be broken into two parts, while the other company might see it in six parts.
The new latitude granted to contractors in how they recognize revenue could lead to chaos—and deception. For example, a contractor could choose to put 40% of the revenue in the first obligation, while another might decide to put 20% percent in the same obligation.
“What this does is open the door for significant manipulation that doesn’t exist in the revenue model today,” Henderson says, adding that contractors could intentionally accelerate profitability to improve a company’s financial statements.
With such a subjective range of choices, the new process could have a dampening effect on surety credit, says Darrin Weber, president of IMA of Texas, a Dallas-based risk consultant and surety bond broker. “Surety companies will be more suspect of the numbers because more judgment is in play,” he adds. “If there’s more suspicion, less consistent numbers or less credible numbers, the sureties are likely to move much slower and ask more questions.”
Although the new standard would be required for reporting, many contractors could continue to follow the existing percentage-of-completion method. While accountants could learn the new standard,...