Contractors are beginning to implement new rules by the Financial Accounting Standards Board that will provide a clearer picture of projects and as a result a truer gauge of contractors overall financial condition.
The rules, first spelled out in 2014, aren’t as onerous as first thought for the construction industry, although contractors will still have to make some changes in how they report revenue, experts say.
Large, publicly-traded construction companies and engineering firms will face the biggest changes, having to break out revenue from different segments of large megaprojects as separate “performance obligations.”
Still, there are other changes that will be more universal in their impact, affecting companies large and small. They include the way change orders – redubbed “contract modifications” – are dealt with, as well as incentives and penalties.
Contractors also will have to change the way they report revenue on uninstalled construction materials, claims and financial incentives.
But the rules are not as sweeping as initially discussed by FASB, the independent organization that establishes accounting principles, due to the intervention of the Construction Financial Management Association and other industry groups that sought modifications to the final versions.
Publicly-traded companies will have to follow the new rules in their first-quarter financial reports, which kicked in on Dec. 15 for larger firms, with privately held companies having another year to comply.
“Originally, it was draconian,” said Jack Callahan, a partner at accountant Cohn Reznick. “Overall, this is a case where the construction industry did a great job of intervening with FASB.”
However, all companies face more paperwork.
Financial executives of large contractors will have to decide whether revenue from different parts of major projects should be broken out as separate performance obligation, said Tim Wilson, a national industry partner at Springfield, Mo.-based accounting firm BKD LLP.
One example might be an airport project. The contractor would probably have to classify the revenue coming from the construction of the rental car building as a separate performance obligation from that of the airport terminal, he said.
Sometimes it may not be as clear. A contractor building a new high school might have to decide whether the new athletic facility five blocks away should be wrapped into the main school project or broken out as a separate revenue obligation, Wilson said.
Other changes involve core activities and financial risk.
With materials, a common current practice is to charge whatever has been delivered to the site to the job.
Under the new rules, contractors will be required to wait until the materials are installed before booking the revenue to their balance sheets, Callahan said.
Incentives and liquidated damages are not typically recorded now until money changes hands, often well down the line in the life of the project and the contract governing it.
Incentive and Penalty Estimates Required
Under the new rules, construction companies will have to estimate at the start of the contract the likelihood of either hitting the incentive marks or incurring penalties and, if it is a high probability, they will have to factor that into their revenue calculations early on, Wilson said.
Another big change involves change orders, which will now be referred to as contract modifications. Contractors will also have to pay particularly close attention to whether the changes being ordered up really do fall under the definition of a contract modification or rise to the level of a new contract altogether, Wilson said.
“If the owner comes through and issues a change order for $500 million for a separate structure, they may have to treat it as a new contract,” he noted.
There is also a new category called “wasted materials or labor,” according to Callahan. Under the new accounting standards, contractors will have to identify wasted material and labor and report it as an operating cost rather than as contract revenue.
For contractors of all sizes, the new FASB rules will require an initial adjustment, with a significant amount of new paperwork involved.
Contractors will not only have to estimate at the start of the contract the likelihood of netting performance-based revenue incentives, but they will have to revise that estimate across the life of the contract, backing up their assertions as they go along, Callahan said.
That will increase the number of disclosures contractors are required to make in their financial reports, leading to a big expansion in footnotes, he said.
Footnotes for Honeywell and General Dynamics
Two big government contractors, Honeywell and General Dynamics, have already started reporting revenue under the new FASB system. While the new requirements have not had a significant impact on their balance sheets, they have generated several pages of footnotes.
“There is going to be a lot more documentation now,” Callahan said.
While the new FASB requirements won’t be world changing, experts fear that firms under $1 billion in revenue may take the wrong message and not change their financial reporting practices at all.
That would be the wrong approach, requiring auditors to put companies through an expensive and time-consuming crash course in the new rules when they show up to look at the numbers, said Anthony Hakes, who leads the Phoenix architecture/engineering/construction services group for accounting and financial services firm CBIZ.
“If they are subject to audit, I am going to have tp ask clients ‘have you evaluated the new revenue rules and applied them to your business?’ If they haven’t done anything, it will take a lot more time to do that audit and the contractors won’t like it,” Hakes said. “For those that procrastinate, it will not be a fun process.”