Hoping to Avoid Implementation of the New Revenue Recognition Standard?
Effective for 2019 calendar year end reporting, private company revenue recognition practices for contracts with customers (Topic 606) under accounting standards generally accepted in the United States (US GAAP) have changed. Several new requirements under the new standard could mean a significant amount of effort on the part of contractors to ensure compliance. The new standard requires a five-step approach to be taken on each and every contract with customers.
- Identify the contract.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations.
- Recognize revenue when (or as) the entity has satisfied a performance obligation.
We believe the most challenging issues for contractors to implement and account for the new standard will include the following:
- Determining when to recognize revenue on contracts at a specific point in time vs. over time.
- Determining when combination of multiple contracts into one, or segregation of one contract into multiple performance obligations is appropriate.
- Accounting for variable consideration (such as performance bonuses) and contract modifications (such as change orders).
- Allocation of contract price to multiple performance obligations (design-build contracts for example).
- Identification of upfront fulfilment “contract” costs, that must be deferred.
- Accounting for uninstalled materials.
The Financial Accounting Standards Board (FASB) has indicated that it will not be offering any relief for private companies through formal accounting alternatives issued by the FASB Private Company Council. Further, to continue to account for construction contracts under the percentage of completion method of accounting in accordance with FASB Statement of Position (SOP 81-1) would be ignoring the new standard under Topic 606. While this would certainly be easier than overhauling the entire system of accounting for long-term construction contracts, your Company’s financial statements will no longer be compliant with US GAAP. Many contractors may believe that they can just take a GAAP exception for revenue recognition and disclose as such in their financial statements in order to avoid implementation of the new standard. However, the Auditing Standards Board has indicated that revenue recognition is such a pervasive and signification assortation in financial statements, failure to account for it in accordance with GAAP will cause the entire financial statement to be out of compliance with US GAAP.
Alternatively, there are several Other Comprehensive Bases of Accounting (OCBOA) that your company can utilize to prepare financial statements, including cash basis, modified cash basis, Financial Reporting Framework for Small-and-Medium-Sized Entities (FRF for SME’s) and the income tax basis, that would allow a company to avoid adoption and implementation of the new revenue recognition standard. It must be understood, however, that these frameworks are not US GAAP as well and do not allow an entity to pick and choose only select accounting principles to apply within the OCBOA.
Income tax rules for revenue recognition on contracts with customers are not changing! If a contractor chooses to present its financial statements on the income tax basis of accounting, it could continue to account for long-term contracts using the percentage of completion method. However, the entity must also report the rest of the balance sheet and income statement using the income tax basis. For example, presentation of fixed asset depreciation expense on the income tax basis of accounting would result in the recognition of any accelerated depreciation (Section 179 or Bonus Depreciation) within the company’s current year reported income statement. Depending on the volume of capital expenditures, the company could appear less profitable than it truly is, simply as a result of taking advantage of tax incentives. In addition, as mentioned above, OCBOA are not considered US GAAP, therefore your company’s financial statements could fall out of compliance with bonding or banking requirements, which often require US GAAP financial statements to be provided.
Some sureties have expressed that they would prefer to continue to be able to evaluate contract performance on a percentage of completion basis, regardless of the changing accounting rules. In addition, as mentioned above, the income tax code for revenue recognition on contracts is not changing from the current methodology, meaning that many contractors will need to continue to account for their contracts using the percentage of completion method for income tax reporting. Although US GAAP will require entities to report their financial statements using the new revenue recognition standard, there is nothing precluding contractors from continuing to present a supplemental schedule of contract performance on the percentage of completion method along with issued GAAP financial statements.
Topic 606 could prove to be challenging for most contractors to implement. There are other options available for reporting revenue on construction contracts, however, as discussed above, there can be unintended consequences of choosing not to comply with the new standard under US GAAP. It is important that all possible impacts be considered so that you may make an informed decision. For any questions regarding accounting alternatives to the new revenue recognition standard for contracts with customers, please contact Benjamin A. Sumner, CPA.