In June the International Accounting Standards Board (IASB) and U.S. Financial Accounting Standards Board (FASB) published a draft to improve and align the financial reporting of revenue from contracts with customers and related costs. While an honest effort to reduce U.S. revenue industry standards from more than 100 to five or less and mesh U.S. and international standards, the proposal became impractical, unwieldy and will increase business costs. Construction firms should resist it.
The deadline for comments on the proposal is Oct. 22. The potentially negative impact on construction firms has most industry accountants, sureties and trade groups opposing the change. Company owners should add their voice to the mix. Read on; we’ll tell you how.
Titled, “Exposure Draft, Revenue from Contracts with Customers,’’ the proposal seeks to create a single-revenue recognition standard for International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles. It would be applied across various industries and capital markets. At present, contractors generally follow ASC 605-35 (formerly known as SOP 81-1). Under ASC 605-35, the economic unit of measurement is the entire contract, meaning contract is not subdivided for the purpose of determining how revenue is recognized. Also, change orders are treated as adjustments to the original contract, not as separate economic units.
A major difference proposed is the separation of contract costs from contract revenues. Most contractors use “costs incurred’’ to measure revenue, hence the recognition of revenue aligned with costs. In the draft, revenue is recognized only when “performance obligations’’ are satisfied. In some cases that is not tied to costs incurred. This is how decoupling of contract costs and contract revenues is done. For example, a design-build contractor separates a project’s design and building aspects into at least two performance obligations.
Once a separation such as this is established, the contract price is allocated among the performance obligations based on a known or estimated stand-alone selling price for each.
This is problematic for many reasons. For one, sureties and lenders would want contracts re-aggregated into a single unit of measurement, driving up the cost of accounting.
Another problem is the “continuous transfer of goods or services’’ provision. The draft provides some criteria that reporting entities can use to determine whether the contract provides for a continuous transfer of goods or services, and therefore ratable revenue recognition. In situations where a continuous transfer is deemed to exist, the contractor would recognize revenue ratably for that performance obligation using an input or output measure. The draft considers output measures to be more representative than input measures.
Sound confusing? It is. And the murkiness goes on. Cost capitalization is turned on its head. If approved, costs incurred in fulfilling a contract are eligible for capitalization. Costs may be incurred during the procurement phase that relate to fulfillment, such as some design costs. If the costs are integral to the fulfillment of the contract, they may be capitalized, but only for contracts awarded to the contractor.
Anticipated losses would be redefined. Now, on simple contracts, these accrue when identified. The draft keeps this, but says anticipated losses will be accrued for each discrete performance obligation where loss is anticipated, even if a profit is anticipated overall. Decisions made after a contract incurs added costs in one phase, to save cost later, may trigger a loss even if the overall project is more profitable.
The proposal is filled with potential pitfalls. Software can’t provide the kind of segmentation to track activity at the performance obligation level and re-aggregate contracts for billing-management purposes. Purchase orders and other direct construction costs will span multiple performance obligations. More challenges involve tying costs to source documents. Lenders and sureties will have difficulty reconciling interim information to year-end information. The changes may result in more departures from tax-basis financial statements. This is no time to increase costs for construction firms. We hope the misguided proposal will be altered. Join us in opposing it.
Submit your comments by Oct. 22, via e-mail to email@example.com and mention “File Reference No. 1820-100.” Or mail to Technical Director, File Reference No. 1820-100, FASB, 401 Merritt 7, P.O. Box 5116, Norwalk, CT, 06856-5116. For more info, visit cfma.org or agc.org.