New Revenue Recognition Rules are Coming - What's Next for the Construction Industry By Joseph Natarelli, CPA, National Construction Group Leader
Over the past two years, the construction industry, as with most industries, has been weathering the daunting economic climate. As the economy slowly makes a comeback the hope is that the construction industry will as well. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working in conjunction to propose new revenue recognition requirements for the development of a common standard that will replace the various standards currently in use, including those that are industry specific. These proposed standards are expected to have a significant impact on businesses within the construction industry that will present more problems than opportunities.
Since 1981, the industry has been using the same revenue recognition rules. There have been no changes to the rules because what’s in place, is effectively working well already. Most construction projects are complex and extend over long periods of time. Revenue is recognized based on estimated contracts.
The new provision will require contractors to “break-down” contracts into individual performance obligations and allocate a contract price for each obligation – a dramatic change for the construction industry. Revenue will be required to be recorded at the end of each individual performance obligation. Considering the complexity of construction projects, the contract price will need to be allocated across numerous performance obligations within one contract – resulting in a subjective process and, in the case of long-term construction-type contracts, it will delay revenue recognition.
This “new way” of recognizing revenue can potentially pave the way for companies to influence earnings with each contract. For example, the contract price for a specific performance obligation may be overstated based on that performance obligation’s ability to earn substantial revenue. On the other hand, the price may be derived from its history of losing revenue and a company will need to skillfully determine the contract price to avoid recording losses prior to contract completion.
Businesses within the construction industry rely heavily on financing to fund their projects. Under the new standard, financial institutions may be hesitant to lending money. Since financial reporting that is a subjective process will be inconsistent from contractor to contractor, financial institutions will take this into consideration when determining credit availability and finance rates. Ultimately, this could hinder business development initiatives for construction companies. Negotiations between contractors and vendors and contractors and clients will greatly be affected.
With construction projects facing enormous financial risks, the amount of bonding that project owners and contractors can obtain will be impacted as well as the price of those bonds. For owners, the bonding premium, which is based on a percentage of a project price, can significantly increase. For contractors, their bonding capacity may be limited. In order to qualify, a company’s financial reporting, which will now be reliant on subjective decisions, will be thoroughly investigated by a surety company.
As with any major change in accounting standards, construction companies will need to rethink their technical processes for gathering and reporting contract information. A system to keep track of the creation and release of performance obligations will need to be established and customized to generate the required data in a timely manner. Retrofitting or designing software to be compliant with the new standard can be a daunting and costly process.
In addition to allocating resources, construction companies will need to carefully consider the allocation of time and people to initiate and dedicate to this new business practice. This will be a significant challenge for companies where increasing staffing levels may not be an option during a time when they are downsizing. With the sparse number of employees left, many of them have added responsibilities and they may be unable to commit to this huge undertaking.
The FASB and IASB expect to issue several final standards in 2011. While they continue to work out the details for a common revenue standard, construction companies can begin initial steps to prepare their businesses for successful implementation and avoid potential pitfalls.
Most importantly, a thorough understanding, in detail, of the revenue recognition rules will be critical. Be aware of its implications, especially of the aspects of the standards that will raise “red flags.” Stay abreast of developments on this topic and continue to think about, and plan for, the effects of adopting these new standards. In addition, the proposed revenue recognition standard includes a section with useful implementation guidance and illustrations.
Companies should determine how the proposed guidance will affect their current business models, transactions, systems, internal controls, and financial reporting methodologies and procedures. Transition teams of key employees can help communicate radical changes within an organization that will greatly impact all stakeholders, including employees, vendors, third parties and clients.
It may be some time before the FASB and IASB realize that a single revenue-recognition standard may not apply to all customer contracts and that an alternative approach may be needed for some contracts, especially those generated within the construction industry. Until then, a proactive approach may be a company’s best line of defense.