Address New Accounting Standards Now to Ensure Business Stability

It’s easy for busy construction executives to view new accounting standards and related IRS guidance as technical issues for their finance teams to analyze and address. However, the latest revenue recognition standard from the Financial Accounting Standards Board may significantly impact contractors’ financial statements.

Banks and bonding companies pore over these statements to assess a company’s financial performance. They also use these statements to determine how to respond to contractors’ requests for more credit or bonding for new projects. So, contractors must comply with the new standards to maintain smooth business operations.

When FASB announced the new standards in 2014, one concern was that contractors would need to report revenue differently for financial statements and tax returns. Fortunately, the IRS recently issued guidance under Revenue Procedure 2018-29 that allows some companies to combine income tax methods with their financial statement methods.

However, the new revenue recognition standards still represent a major change in how some contractors report their revenue. The standards are effective for 2019 calendar year reporting, so contractors don’t have the luxury of time in implementing the internal processes needed to ensure compliance.

Examine revenue reporting

Essentially, the goal of the new FASB standards is to more-accurately reflect revenue reporting over the life of the contract. Contractors are already familiar with and use the percentage of completion method of accounting; the new FASB standards allow contractors to continue to record revenue in a similar fashion over time.

However, the new standards also require contractors to more accurately account for separate or new performance obligations, such as change orders, and variable considerations, such as performance bonuses or penalties, as part of their calculations. Contractors must make sure their accounting software can properly capture variable consideration and is capable of tracking costs for performance obligations separately.

Prior to these new standards, a contractor may only have reported revenue from a performance bonus on its financial statement when it received the full bonus. Under the new standards, however, contractors must make informed estimates about future contingent bonuses or concessions and apply these estimates to current financial statements. In other words, the contractor must adjust revenue over time based on the likelihood of receiving a bonus.

For example, a $1,000,000 contract may include a performance bonus of $50,000. Halfway through the project, if the contractor believes the likelihood of completing the project early and receiving the bonus is 60 percent, it must add $30,000 to the total anticipated revenue for the project. Throughout the life of the project, the contractor must re-analyze these estimates and the likelihood of occurrence and adjust revenue accordingly.

Clearly, some judgment is involved in determining how much revenue is recognized, and there is no fixed rule dictating how a contractor measures the estimates. Still, a contractor must have a clear rationale for its decisions and be consistent moving forward.

Set up the right processes

More-accurate revenue reporting can increase credibility with banks and bonding companies and avoid large, sudden changes in revenue and profits. To comply with the standards, contractors must implement thorough processes to capture all necessary information.

While a contractor’s finance department is responsible for the company’s financial statements, many others in an organization impact what is reported on financial statements. A team approach—including company owners, executives, legal counsel, and members of sales, estimation and project management departments—is needed to understand and comply with the new FASB standards.

Further, a contractor should consult with its tax advisers to ensure it understands how all the elements of the new standards apply to its specific situation and if the new financial statement standards can be adopted for tax purposes.

Finally, companies would be wise to test their contracts under various scenarios. These tests will allow a contractor to identify outcomes that could diminish the company’s reported revenue and potentially damage its reputation with banks or bonding companies. In response, the contractor can take pre-emptive action to address the problems and reclassify projects or seek changes to contract language.

Contractors must make compliance with the new revenue recognition standards a corporate priority. The organizations that do will preserve their reputations with lenders and bonding companies and maintain long-term business stability.