Construction contractors could soon face a dramatic change in the way they can book revenue in their financial statements. The proposed revenue recognition rule would affect many industries, but perhaps none more so than the construction industry, which has used the current method for more than three decades. The rule could have implications for how contracts are written, jobs are priced and managed, banking and bonding credit decisions are made, and performance is measured.
The proposed change is part of a larger initiative to converge accounting rules in the United States with international standards. The standard-setting bodies have published an exposure draft on revenue recognition, which has drawn criticism from the construction industry, such as the proposal is too broad and does not adequately address the unique aspects of the industry. In addition, some argue the costs of the proposed rule outweigh any benefits.
Currently, contractors utilize the percentage-of-completion method of revenue recognition, which recognizes revenue based on a percentage of the contract price. The percentage is calculated based on the contract costs incurred to date as a proportion of the estimated total contract cost. This method is simple, cost-effective, and understood by the industry and its stakeholders.
The proposed rule continues to allow the use of the percentage-of-completion method to the extent that a customer controls the work-in-process. If the customer specifies the design or function of a construction project, which is most often the case, the customer is considered to have control of the work-in-process. If the customer does not control the work-in-process, revenue is recorded at the completion of the project.
Most contractors utilize the cost-to-cost method to calculate percentage of completion.
Components of the Proposed Rule
Although the proposed rule continues to allow the cost-to-cost method, other methods—such as units produced or delivered, contract milestones, or surveys of goods or services transferred to-date relative to the total goods or services to be transferred—also are acceptable. The proposed standard even appears to recommend these methods by stating they “often result in the most faithful depiction of the transfer of goods or services.”
In addition, the proposed rule gives contractors more flexibility in determining a profit center. Under the current rule, the entire contract generally is accounted for as a single profit center. This includes any change orders that modify the original contract. The proposed rule allows for distinct performance obligations to be accounted for as separate profit centers. A performance obligation is considered distinct if it can be sold separately or if it has a distinct function and profit margin. For example, a contractor might determine site preparation and site finishing are separate performance obligations from other construction services.
Under the proposed rule, the contract price for separate performance obligations is based on its standalone selling price. Therefore, the total contract price must be allocated to each individual performance obligation. However, in the absence of a standalone price for a performance obligation, a contractor must estimate this amount. Many contractors are concerned this would be impractical, as generally there are no standalone selling prices for individual performance obligations within a construction contract.
Contractors Foresee Challenges
Without further guidance, the implementation of the proposed standard could prove inconsistent. For example, it would not be uncommon for two similar contractors to draw different conclusions as to when a performance obligation has been satisfied and at what price. This could decrease comparability of financial information and lead to manipulation of revenue recognition.
Another difference between current practices and the proposed standard is the accounting for un-priced change orders, claims, customer credit risk and contract options. The current standard provides a fairly specific framework for how to handle these issues, whereas the proposed rule simply requires the probability-weighted outcome to be calculated. For example, if a contractor determines there is only a 50 percent chance that a $100,000 change order will be realized in full, only $50,000 should be included in the estimated transaction price (i.e., contract value).
The proposed standard also requires additional disclosures about the amount, timing and uncertainty of revenue. This includes the disaggregation of revenue into categories such as the type of contract, customer, market or geography.
Furthermore, the proposed rule requires that contract backlog be disclosed in categories as to when the backlog will be performed; for example, not later than one year, later than one year but not two years, later than two years but not three years, and later than three years. (The current standard recommends, but does not require, contract backlog to be disclosed.)
The effective date of the proposed rule has yet to be announced, and there may be further revisions based on public comments, but the final standard is scheduled to be issued in the second half of 2011. One thing appears certain: Change is coming soon, and it could be significant.