Revenue Reporting Change Looms Over Contractors
In June 2010, the Financial Accounting Standards Board (FASB) issued its Exposure Draft, Revenue from Contracts with Customers.
If this Exposure Draft is adopted, it could have a negative impact on contractors’ financial statements and the percentage-of-completion method, as we know it, would largely disappear. At a minimum, it will make financial reporting more reliant on subjective decisions that will vary from contractor to contractor. In addition, financial performance will now appear inconsistent, as revenue won’t be recorded until the project is transferred to the owner. As a result, financial institutions and bonding agents may misread financial information from construction companies under this new standard.
At present, contractors are bound by current accounting standards that measure income by looking at the entire contract, not at its individual pieces. Revenue for a period is recognized based on the percentage of work completed at the end of the reporting period for each contract. The draft requires the contractor to break down each contract into performance obligations with revenue recorded as each obligation is completed. An example of this includes a design-build contract, where the design work is required to be separated from the physical construction.
In all cases, the contract price is to be allocated across multiple performance obligations, potentially requiring highly subjective analysis. The effect of change orders on a contract will have to be determined based on whether they’re a change to an existing performance obligation or whether they create a new performance obligation.
Since the draft focuses on recording revenue based on the fulfillment of performance obligations within a contract, losses may have to be recognized much earlier than at present. Currently, losses from construction contracts are recorded as soon as the contractor anticipates the loss. The proposed rules would maintain this standard; loss recognition, however, may be accelerated because the loss calculation would be done at the performance obligation level, rather than by looking at the entire contract.
Even though the entire contract may be profitable, a loss on a specific performance obligation within the contract would have
to be reported before the overall contract is completed.
Under current standards, contract costs are generally used to measure revenue, since the percentage of costs incurred is normally the factor employed to record revenue earned. The Exposure Draft requires revenue to be recognized as performance obligations are met, which may not relate to the underlying costs incurred. There are also new rules regarding capitalization of costs that may affect accounting for contracts.
A concept called “continuous transfer of goods or services” is introduced in the draft. This is similar to the present “percentage-of-completion method.” This method generally would be limited to contracts where the customer owns the work-in-progress as it is built or developed.
If a contract qualifies under this method, revenue may be recognized using either input or output measures, as appropriate. Input measures, based on efforts expended to date, could include labor hours or other input costs as under current methods. Output measures recognize revenue based on units produced, contract milestones or similar output methods.
The Exposure Draft requires additional disclosures, including a reconciliation of changes in open contracts from the previous to the current reporting dates, methods used to record revenue when a contract qualifies as a continuous transfer, determination of liabilities related to anticipated losses and disclosure of how performance obligations are identified and satisfied including methods used in allocating the total contract price to the various performance obligations.
The accounting and reporting required under the final version will no doubt require changes in the way contractors capture and report information pertaining to contracts. While the implementation date has not been set, those taking proactive measures to assess the impact on their companies and to redesign their accounting systems to capture the information identified will be able to ease the burden of implementation. 
Matt Robertson is a partner in Clifton Gunderson's office in St. Joseph, Mo.
P | 816.232.8441
E | matthew.robertson@cliftoncpa.com
Return to Ingram's November 2010