The Financial Accounting Standards Board (FASB) recently issued an exposure draft, Revenue from Contracts with Customers, which potentially could have significant affects on Contractors.
The issuance of this exposure draft follows approximately 18 months of debate after FASB issued a similarly titled discussion paper in December 2008. The goal of the Revenue Recognition Project is to develop a common revenue standard for industries since there are currently more than 100 accounting standards that address revenue recognition. If adopted, the new guidance would completely repeal ASC 605 35, formerly known as SOP 81-1 (i.e., percentage of completion accounting).
Key Changes Affecting Contractors
The economic unit of measure/profit center under SOP 81-1 is the entire contract, which can be adjusted from time to time for change orders. The exposure draft, however, requires that contracts must be separated into various “performance obligations”. A performance obligation is defined as an “enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer.”
Under the exposure draft, it is anticipated that a single contract may have multiple performance obligations, with each performance obligation having different profit margins. Whereas change orders are currently treated as adjustments to the original contract, change orders under the new guidance may constitute a new performance obligation altogether.
Another significant difference between SOP 81-1 and the exposure draft is the decoupling of contract costs from contract revenues. Under SOP 81-1, most contractors use “costs incurred” to drive revenues. Under the exposure draft, however, revenue is recognized as performance obligations are satisfied, which are not necessarily tied to costs incurred.
As a result, the exposure draft prescribes new cost capitalization rules to help contractors that incur precontract costs. Many contractors incur mobilization costs during the early stages of a contract, which by definition are not related to the fulfillment of a specific performance obligation.
As a result, the exposure draft allows these precontract costs to be capitalized, which would have otherwise resulted in contractors experiencing negative profit margins during the early stages of many contracts. Contract costs related to contract fulfillment will be allowed to be capitalized under the new guidance as long as they relate to future performance obligations. Contract costs related to contract procurement will continue to be expensed as incurred.
Under SOP 81-1, there is a presumption that revenue is recognized ratably during the period of construction. The exposure draft introduces a concept referred to as a “continuous transfer of goods or services”. If the owner is responsible for initiating the project and the hiring of the contractor, then there is a strong presumption that the continuous transfer criteria will be met.
This will result in the contractor under the new guidance being able to recognize revenue ratably for each performance obligation using either output or input measures. Input measures can include costs incurred.
As a result, the exposure draft should allow the contractor to continue to report revenue in a manner consistent with the current percentage of completion method. The significant differences being that the revenue is recognized by performance obligation (rather than the entire contract) and that each performance obligation has different gross margins (rather than a single gross margin for the contract).
New Revenue Recognition Model Steps
The exposure draft prescribes the following steps under the new revenue recognition model:
- Identify contract with the customer
- Identify separate performance obligations in the contract
- Determine the transaction price
- Allocate transaction price to performance obligations
- Recognize revenue as performance obligations are satisfied
As discussed earlier, each different promised good or service could constitute a separate performance obligation under the exposure draft. Determining the transaction price becomes much more complex for contracts that are variable in nature. In addition, change orders, claims and backcharges can all affect the final transaction price. Under the exposure draft, the transaction price is allocated to each performance obligation in proportion to their relative stand alone selling price.
Performance obligations are considered to be satisfied when a customer obtains control of the related good or service. Indicators that a customer has obtained control including obligation to pay, legal title, and physical possession.
As a general rule, if the work has been commissioned by the owner, then there is a strong likelihood that the owner controls the work in process. However, if the contractor initiates the project acting in the role of developer, then the process becomes more complex. In addition, other questions still to be answered include:
- Who controls work in process during the design phase?
- Who controls work in process during off-site fabrication?
FASB is accepting comments on the exposure draft until October 22, 2010. The expected effective date for these proposed requirements is uncertain at this time. We will continue to update you on new developments as they arise.
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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