By Kent Goetjen and Mike Sobolewski
A significant increase in required disclosures is among the key changes resulting from the long-anticipated new converged standard on revenue recognition released earlier this year by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).
Engineering and construction (E&C) firms subject to US GAAP or IFRS financial accounting standards have long followed industry guidance for construction contracts to account for revenue. The new standard is principles based—a big shift from today’s industry-specific guidance. Changes resulting from the new standard will vary by industry and certain areas will likely create significant challenges for E&C companies.
The new standard will require a five-step approach:
Identify the contract: When it comes to whether contracts should be combined, major changes aren’t expected. Construction companies that segment contracts might not be significantly affected because of the requirement to account for separate performance obligations. There is an expected increase in significant judgments on how organizations determine when to include unpriced change orders and other contract modifications in contract revenue.
Identify performance obligations: Contractors often account for each contract at the contract level. Under the new standard, contract promises must be for distinct goods or services to be a performance obligation that requires separate accounting. Some construction contracts may have only one performance obligation.
Determine transaction price: Under the new standard, revenue related to variables including awards and incentive payments might be recognized earlier. A significant change in practice as it relates to claims, liquidated damages, and the time value of money isn’t expected.
Allocate transaction price: Transaction price is allocated to the performance obligations in a contract that requires separate accounting. Of interest will be the allocation of variable consideration (awards, incentive payments) associated with only one performance obligation, rather than the contract as a whole. An entity can allocate transaction price entirely to one (or more) performance obligation when certain conditions are met.
Recognize revenue when/as performance obligation(s) satisfied: Under existing guidance, revenue recognition is based on contractor activities; provided reasonable estimates are available, revenue can be recognized as the contractor performs. Under the new standard, revenue is recognized when a performance obligation is satisfied, which occurs when control of a good or service transfers to the customer.
The standard is also expected to impact:
- Warranties – Warranties are currently accounted for within contract accounting or outside contract accounting in accordance with existing loss contingency guidance. Change may occur for some businesses that use a cost-to-cost input method for measuring progress and don’t include warranty as a contract cost.
- Contract costs – Direct costs of fulfilling a contract are capitalized under the new standard if not within the scope of other standards and if they relate directly to a contract/future performance, and are expected to be recovered under the contract. Incremental direct costs of obtaining a contract are recognized as an asset if expected to be recovered. There could be a significant change for contractors currently using the gross profit method for calculating revenue/cost of revenue.
- Contract assets and liabilities – Cost in excess of billings and billings in excess of cost initially recognized on the balance sheet under current GAAP should be similar to the contract asset and contract liability recognized under the new standard. However, the transfer from a contract asset to an account’s receivable balance (when the contractor has a right to payment) may not coincide with timing of the invoice as is required under existing guidance.
E&C companies should continue to evaluate the new standard’s impact on business activities, including contract negotiations, key metrics, taxes, budgeting, controls and processes, information technology requirements and accounting.
About the Authors: Kent Goetjen (email@example.com) is PwC’s U.S. Engineering & Construction industry sector leader. He has more than 30 years of experience providing service to clients in the engineering and construction industry. Michael Sobolewski, (firstname.lastname@example.org) is a partner at PwC US and an engineering & construction industry specialist. He has extensive industry experience, including work with private companies that have operations locally, nationally and globally.