IT’S HERE: THE NEW REVENUE RECOGNITION STANDARD Presented by: Timothy Wilson, CPA, CCIFP September 26, 2014

 Where Have We Been?  Truth or Myth?  The New Recognition Model  Disclosures  Effective Dates  Q&A Session (If Time Allows) Agenda 2

Revenue from Contracts with Customers―Finally!! ASU

Revenue Recognition Standard Where Have We Been?  Revised Exposure Draft Issued November 14, 2011  Goals  Develop a common revenue standard for all industries, jurisdictions & capital markets  Condense 100+ U.S. GAAP rules into one high-quality standard  Intended to repeal/replace current accounting & reporting guidance (including all existing construction-specific revenue & cost guidance) 4

Revenue Recognition Standard Where Have We Been?  Revised Exposure Draft comes after receiving substantial comment letter input from original exposure draft―nearly 1,000 comment letters  Nearly 350 comment letters from construction industry submitted in response to Revised Exposure Draft  A number of matters that were of consequence & concern to the construction industry remained  Substantial redeliberations took place throughout most of 2013, with additional meetings through early

Revenue Recognition Standard Where Are We Now?  New Accounting Standard issued on May 28, 2014  New definitions, terminology & disclosures  Introduces new complexities for construction industry  Financial statement users, e.g., lenders & sureties, are monitoring this closely 6

Revenue Recognition Standard  Got a lot of things right that we were expecting  How a performance obligation is defined  Clarifying continuous transfer criteria  No preference for inputs vs. outputs methods on measuring progress  Relief from disclosures for nonpublic entities  But … 7

Revenue Recognition Standard  There are some areas that may create unique challenges  Examples include  Claims & unapproved change orders  Time value of money  Estimation of variable consideration  Exclusion of inputs that are not reflective of progress toward completion―waste/rework  Uninstalled materials 8

Revenue Recognition Standard Revenue Recognition Final Standard Let’s Start Looking!! 9

Truth or Myth?  Did Percentage of Completion go away?  Can you recognize profit on uninstalled materials?  Will most contracts have multiple performance obligations? 10

Truth or Myth?  Will I have to recalculate all completed contracts under the new standard?  Is cost to cost still valid to determine percentage complete?  Will I have to add 10 pages of footnotes to my audit report? 11

Revenue Recognition Standard Recognition Model – Steps Involved Recognize revenue when (or as) performance obligations are satisfied Allocate transaction price to performance obligations Determine transaction price Identify separate performance obligations in contract Identify contract with customer 1 12

Revenue Recognition Standard Step 1: Identify Contract with Customer  Five criteria for existence of a contract  Commercial substance  Approval by both parties  Identifiable rights regarding assets to be transferred  Identifiable payment terms (even if amount is uncertain)  Probable that you will collect consideration you are entitled to 13

Revenue Recognition Standard Step 1: Identify Contract with Customer  Combination of contracts  Contracts are negotiated with a single commercial objective  Amount of consideration in one contract depends on the other contract  Goods or services are a single performance obligation  Segmenting  Inherent in identification of separate performance obligations 14

Revenue Recognition Standard Step 1: Identify Contract with Customer  Contract modifications  New contract if distinct goods or services are at standalone selling price  Prospective accounting  Continuation of contract if remaining goods or services are distinct from existing contract  Prospective accounting  Continuation of contract if goods or services are not distinct from existing contract  Cumulative catch-up  15

Revenue Recognition Standard Step 2: Identify Separate Performance Obligations in the Contract  Performance obligation: Promise to deliver a good or provide a service  Separately account for a performance obligation if “distinct”  Distinct  Customer can benefit from the good/service on its own  Good/service is separable from other goods/services in contract  All promises for distinct goods or services must be evaluated (even if inconsequential) 16

Revenue Recognition Standard Step 2: Identify Separate Performance Obligations in the Contract  A whole contract may be one performance obligation―how?  A good or service is not distinct if  Goods & services are highly interdependent & interrelated  Entity provides a significant integration service  Goods or services significantly modify or customize other goods & services in contract As a result, expectation is typically one performance obligation for many (not all) construction-type contracts 17

Performance Obligations Fact Pattern  Design/build contract for new high-rise building  Contract includes  Engineering  Clearance  Excavation  Soil sampling  Foundation  Procurement of materials  Installation of systems  Overall project management 18

Performance Obligations  One―but why?  Goods & services are highly interrelated & interdependent  Significant service of integrating goods or services is provided How many different products & services would you separately account for? 19

Revenue Recognition Standard  Transaction price  The amount of consideration to which an entity expects to be entitled to receive in exchange for transferring goods or services  Variable consideration  Examples include awards/incentives, liquidated damages, claims, unpriced change orders  Estimate expected value (probability-weighted) or most likely amount  Constraint: Probable that a significant reversal will not occur  Qualitative assessment Step 3: Determining Transaction Price 20

Revenue Recognition Standard  Time value of money  Discounting required only if there is a significant financing component (receivable or payable)  One-year practical expedient  Retention?  Collectability  Estimate bad debt & present separately as a component of SG&A expenses Step 3: Determining Transaction Price 21

Revenue Recognition Standard Variable/Contingent Consideration  Application of constraint concept  When are/will the following be recognized on a contract  Performance award incentive for early completion  Performance award incentive for quality of construction  Performance award incentive for attaining LEED Platinum Cert.  Performance award penalty (contract reduction) for delays  Performance award penalty (contract reduction) for lower-quality material substitution 22

Revenue Recognition Standard Claims & Unapproved Change Orders  Requirement for recognition  Refer to the five criteria for contract existence  Key: Approval by both parties  Contractors make changes on the fly …  Contract modifications, including a contract claim, would be approved when modification creates or changes enforceable rights & obligations of parties to the contract 23

Revenue Recognition Standard Claims & Unapproved Change Orders  If approved as to scope, even if unpriced, company may be able to recognize estimated margin on change orders  What does this mean?  More focus on treatment of “approved as to scope”?  More focus on rationale for estimated margin? 24

Revenue Recognition Standard Claims & Unpriced Change Orders  Unpriced change orders  Old rule – Generally reflect if recovery is probable & reasonably estimated  New rule – Generally reflect when contractor expects the price change will be approved & there is not an expectation that the estimate will have a significant reversal in the future  Claims  Old rule – Generally reflect when probable & estimable up to the extent of costs incurred―no margin until realized  New rule – Generally include in transaction price when there is not an expectation that the estimate will have a significant reversal in the future 25

Unpriced Change Orders Fact Pattern  Single performance obligation to construct a hospital  Change order is for goods that are a necessary part of contractor’s service of integrating goods/services to construct the hospital  Typically agree on price shortly after work associated with change order begins 26

Unpriced Change Orders What is the impact to the transaction price?  History indicates price will ultimately be approved  Therefore, estimate transaction price using variable consideration principles How do you account for this change order?  The goods/services associated with this change order are not distinct  Therefore, account for this change order using a cumulative catch-up adjustment, i.e., “catch up” the amount of revenue recognized as if this change order had been in place since contract inception 27

Revenue Recognition Standard Time Value of Money  Requirement for application/discounting  Transaction/contract price adjusted to reflect the time value of money if a significant financing component exists  Considerations  Expected length of time between delivery of goods & services & receipt of payment  Whether amount of payment would differ substantially if cash payment was received in accordance with typical credit terms 28

Revenue Recognition Standard Time Value of Money  Exception  Expectation at contract inception  Period between payment & performance < 1 year  Applicable to contracts > 1 year in duration if period between performance & payment is < 1 year 29

Revenue Recognition Standard Time Value of Money  Retention  Will depend on contract terms & normal practices  Retainage is generally intended to protect the customer & is typically not a form of financing 30

Award Fee Fact Pattern  Construct an airport baggage system  One-year contract with due date December 31  Contract price  $30m fixed fee  $2m award fee if completed by October 31  Baggage system is “off the shelf” & has been sold before in substantially same form  Contractor has ability to complete job by October 31 31

Award Fee What is the most appropriate estimation method?  Most likely amount (best estimate)  Possible outcome is binary―“all or nothing” How much revenue would I recognize & when?  $32m ($30m fixed price plus $2m best estimate)  Outcome in contractor’s control  History of performing similar contracts  Recognize total amount of transaction price as the baggage handling system is constructed, so long as it’s probable a significant reversal will not take place 32

Claims Fact Pattern  Customer has caused significant delay on contract  Contractor initiates a claim of $5m to recover costs & profit  Contractor & customer have history of negotiating claims & settling for an amount typically different than initial claim 33

Claims What is the most appropriate estimation method?  Expected value  Many possible outcomes likely exist When would you include this claim in the transaction price?  When an amount is not likely to undergo a significant reversal in the future  In its early stages, this might be a portion of the claim When would a contractor know to recognize a “minimum amount”?  One example is when a contract gives the contractor a right to recover costs for customer-caused delays 34

Revenue Recognition Standard Step 4: Allocate Transaction Price to Performance Obligations  Allocate the amount an entity expects to receive in exchange for satisfying each separate performance obligation  Use standalone selling prices of goods or services (estimated if necessary) 35

Allocation of Consideration Fact Pattern  Contract to build a school & an adjacent football field for $100m  Assume the school & field are separate performance obligations  Standalone selling price  School: $100m  Field: $11m 36

Allocation of Consideration FieldSchool Standalone selling price11M (10%) 100M (90%) Total combined consideration100M Relative standalone selling price10M90M 37

Revenue Recognition Standard Step 5: Recognize Revenue when (or as) Performance Obligations Are Satisfied  Recognize revenue over time when  Customer receives benefits as entity performs  Cleaning services  Creates or enhances an asset that the customer controls, or  Building on land owned by customer  Does not create an asset with alternative use & entity has right to payment for work completed to date  Consulting work 38

Revenue Recognition Standard Step 5: Recognize Revenue when (or as) Performance Obligations Are Satisfied  Measuring progress toward completion  Output methods or input methods permitted  Examples of input methods  Labor hours/dollars, machine hours, costs incurred, time  Examples of output methods  Units delivered, surveys completed  If input method is used, must exclude inputs that do not depict performance (owner-provided materials, waste, uninstalled materials―key for contractors)  Zero margin may be appropriate in some circumstances, e.g., early stage of contract, uninstalled materials 39

Revenue Recognition Standard Step 5: Recognize Revenue when (or as) Performance Obligations Are Satisfied  Recognize revenue at a point in time only if control doesn’t transfer over time  Factors to consider  Entity has present right to payment  Customer has accepted the asset  Physical possession of asset transferred  Customer has significant risk & rewards  Customer has legal title to asset 40

Revenue Recognition Standard Uninstalled Materials  Requirement is to exclude the cost of uninstalled materials that are not reflective of contract progress  If customer obtains control of goods before they are installed, recognize revenue equal to cost of goods transferred  Impacts input method (cost to cost) of determining progress  Effect on bonding/underwriting? 41

Recognize Revenue Fact Pattern  Two-year contract to build a new football stadium for $600m  Estimated contract cost is $500m. Cost incurred at end of year one is $200m  Specifications are customized  Interim progress payments are agreed upon to coincide with job progress  Physical possession & title do not pass until completion  Contractor determined that there is one performance obligation  Contractor concludes that cost is the best measure of control transfer 42

Recognize Revenue How much revenue is recognized at the end of year one?  $240m How is that amount calculated? Cost incurred to date: $200m Total cost: $500m Percent complete: 40% Total consideration: $600m Revenue recognized: $240m Doesn’t that look like the percent complete calculation I used to do?  Now that you mention it―it does look familiar, doesn’t it? 43

Recognize Revenue Fact Pattern  Assume same fact pattern as in previous example, except  Estimated contract cost is $500m, including $75m for specialized equipment. Cost incurred at end of year one is $200m  At the end of year one, $75m of the estimated contract cost relates to specialized equipment & is not installed, but customer obtained control of equipment upon delivery to construction site 44

Recognize Revenue How much revenue is recognized at the end of year one?  $227m How is that amount calculated? Cost incurred to date: $200m Equipment cost: ($75m) Total: $125m Percent complete: 29% (125m/425m); ($425 = $500 expected cost less $75m equip. cost) Total consideration: $600m Equipment cost: ($75m) Total: $525m Progress revenue: $152m Equipment revenue: $75m Total revenue: $227m 45

Revenue Recognition Standard  Other items  Contract costs  Onerous (loss) contracts  Disclosures  Effective date & transition 46

Contract Costs  Incremental cost to obtain a contract  Must capitalize if expect to recover  May be expensed if amortization period is one year or less  Contract fulfillment costs  Look to other guidance first (inventory)  If not in other guidance, capitalize only if  Relate directly to a contract  Relate to future performance &  Expect to recover Revenue Recognition Standard 47

Revenue Recognition Standard Contract Costs  Amortize capitalized costs as control transfers  Caution: Will need to consider impairment 48

Revenue Recognition Standard Onerous (Loss) Contracts  As with current guidance, contractors would accrue an anticipated loss once identified  Cost of settling performance obligation is more than transaction price 49

Revenue Recognition Standard Onerous (Loss) Contracts  Challenge lies with interplay between various provisions  Transaction price includes amounts the entity expects to be entitled to  “Expects to be entitled to” can include claim revenue  Even if you don’t yet recognize claim revenue, you might count the claim revenue in the transaction price & in doing so defer a loss 50

Revenue Recognition Standard Disclosures  Disaggregation of revenue by category  Type of good or service  Country or region  Type of customer  Type of contract  Reconciliation of contract balances & costs  Narrative disclosures  Some relief for nonpublic entities 51

Revenue Recognition Standard Effect on Traditional GAAP Benchmarks  Bank covenant requirements  Earnings metrics  Excess cash flow payments  Employee performance incentives – Bonuses based on revenues &/or net income 52

Revenue Recognition Standard Effective Date & Transition  Public companies: Annual periods (& interims within) beginning after December 15, 2016 (2017 for calendar-year companies)  Early adoption is prohibited  Nonpublic companies: Annual periods beginning after December 15, 2017 (2018 for calendar-year companies)  Early adoption is permitted, no earlier than public company date  Transition  Retrospective application – Restate prior periods upon adoption, or  Apply to existing contracts in progress on the effective date & new contracts going forward  Requires cumulative effect adjustment & certain additional transition disclosures 53

Revenue Recognition Standard What’s Going on Now?  FASB – Transition Resource Group for Revenue Recognition-  AICPA – established task forces to develop content, focus on guidelines for implementation-principles based  Working closely with Aerospace & Defense task force  Content reviewed/approved by Revenue Recognition Working Group before it goes to TRG 54

Revenue Recognition Standard What’s Going on Now?  AICPA published a Learning and Implementation Plan: Documents/ _LIPlan.pdf  AICPA also published a primer for Audit Committees: Documents/ _ACPrimer.pdf 55

FOR MORE INFORMATION Timothy T. Wilson, CPA, CCIFP | |

FOR MORE INFORMATION Timothy T. Wilson, CPA, CCIFP | |