Revenue Recognition for the AE Industry Presented by: M. Scott Hursh, CPA, CCIFP®, CDA Managing Shareholder AE Industry Group Stambaugh Ness, PC Brian W. Rosenberg, CPA, MBA Senior Manager Brown, Schultz, Sheridan & Fritz

Revenue Recognition for the AE Industry Agenda  Background  Overview of new revenue recognition model  Contract costs  Disclosures  Effective dates and transition  Examples  Questions / Discussion

Revenue Recognition for the AE Industry Current Guidance  Accounting Standards Codification (ASC) Topic  Pre-Codification SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”  Specific to issues unique to the construction industry New Guidance  Initial Exposure Draft June 2010 – Revised Exposure Draft November 2011  Intended to apply consistently across all industries  Joint project with IASB  FASB ASU – Revenue from Contracts with Customers (Topic 606) -Issued May 2014

Core Principle  “An entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”  Transfer is based on control – Who has the ability to direct the use of and receive the benefit of the asset? (Work in Process)  Factors to consider when determining whether a transfer exists: Unconditional obligation to pay Legal title Physical possession Customer-specific design

Revenue Recognition - 5 Steps Identify the contract(s) with a customer Identify the performance obligations in the contract Determine the transaction price Allocate the transaction price to the performance obligations in the contract Recognize revenue when (or as) the entity satisfies a performance obligation

Step 1 – Identify the Contract Identify the contract(s) with a customer

Identify the Contract(s) with a Customer  Contracts meet the following criteria: Approval and commitment of the parties Identification of the rights of the parties Identification of the payment terms Contract has commercial substance Probable that the entity will collect the consideration (transaction will be completed)  Combining Contracts Contracts negotiated as a package with a single commercial objective Amount of consideration to be paid in one contract depends on the price or performance of the other Goods or services promised in the contracts are a single performance obligation

Identify the Contract(s) with a Customer - continued  Contract Modifications Accounted for as separate contract if: 1. addition of distinct good or service and 2. price of the contract increases by an amount equal to standalone selling prices If not required to account for as separate contract, accounted for as a change to transaction price Approved change in scope, but not price, estimate the change in price Adjustment made on a cumulative catch-up basis on date of modification (prospective accounting) Claims and change orders (approved and unapproved) b Recognize estimated margin if scope approved, but price not agreed

Contract Modifications  May exist even if dispute in price, scope or both  Scope may be approved but price has not been approved  May be written, verbal, or customary business practice  This is a change in current practice  Must determine whether rights and obligations created by the modification are enforceable  Facts and circumstances

Step 2 – Identify Performance Obligations Identify the contract(s) with a customer Identify the performance obligations in the contract

Identify the Performance Obligations in the Contract  Performance Obligation – Promise in a contract with a customer to transfer a good or service to the customer  Account for each distinct, or series of distinct, goods or services as a separate performance obligation  Distinct 1. Customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer, and 2. Promise to transfer good or service is separately identifiable from other promises in the contract  Series of distinct goods or services – goods and services that are substantially the same and have the same pattern of transfer

Identify the Performance Obligations in the Contract - continued  An entire contract can be accounted for as one performance obligation  A good or service is not distinct if: The goods or services are highly interdependent and interrelated The entity provides a significant integration service The goods or services significantly modify or customize other goods or services in the contract  Assurance-type warranties are not distinct performance obligations  One performance obligation for many, but not all, AE contracts

Step 3 – Transaction Price Identify the contract(s) with a customer Identify the performance obligations in the contract Determine the transaction price

Determine the Transaction Price  Transaction Price – Amount of consideration to which an entity expects to be entitled in exchange for transferring goods or services  Variable Consideration Incentives, penalties, claims, performance bonuses, liquidated damages Estimate the expected value or most likely amount b Sum of probability-weighted amounts b Most likely of two possible outcomes (achieve performance bonus or not) Constraint for estimates – only included to the extent it is probable that a significant reversal of revenue recognized will not occur

Determine the Transaction Price - continued  Other Considerations: Time value of money (only if significant financing component) Noncash consideration

Step 4 – Allocate Transaction Price Identify the contract(s) with a customer Identify the performance obligations in the contract Determine the transaction price Allocate the transaction price to the performance obligations in the contract

Allocate Transaction Price to Separate Performance Obligations  The transaction price is allocated to all separate performance obligations in proportion to the stand- alone selling price of each (at contract inception)  If a stand-alone selling price is not directly observable, must be estimated When estimating, an entity “shall maximize the use of observable inputs” Cost plus margin approach – forecast costs and add anticipated margin Adjusted market assessment approach – what a customer would have paid if it were a separate transaction  Subsequent changes to transaction price Allocate any changes in the transaction price to separate performance obligations on same basis as at contract inception.

Step 5 – Recognize Revenue Identify the contract(s) with a customer Identify the performance obligations in the contract Determine the transaction price Allocate the transaction price to the performance obligations in the contract Recognize revenue when (or as) the entity satisfies a performance obligation

Recognition of Revenue – Satisfaction of Performance Obligations  Revenue is recognized when (or as) a performance obligation is satisfied by transferring goods or services to a customer.  Transfer occurs when (or as) the customer obtains control. Ability to direct the use and obtain substantially all the benefits Point in time or over time

Recognition of Revenue – Satisfaction of Performance Obligations - continued  Control is transferred over time if one of the following criteria are met: 1. Customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs 2. Entity’s performance creates or enhances an asset (work in process) that the customer controls as the asset is created or enhanced 3. Entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date

Recognition of Revenue Over Time  Customer simultaneously receives and consumes This includes cases in which another firm would not need to substantially reperform the work completed to date to fulfill the remaining performance obligation (aside from practical or contractual limitations) This applies to services, not goods  Customer controls asset Generally applies on customer's land  No alternative use, and right to payment Drawings, site plans, technical specs 1. Firm is restricted from selling to or using for another customer - customer could enforce rights 2. Right to payment for work completed to date at any time in contract, if terminated without cause - must consider laws and contractual terms

Recognition of Revenue – Satisfaction of Performance Obligations  Revenue recognized over time - consistently apply a method to measure progress toward completion:  Methods to measure progress: 1.Output Methods – basis of units produced or delivered, contract milestones 2.Input Methods – basis of efforts expended to date relative to total efforts expected to be expended. (cost to cost, labor hours, machine hours, etc.) b Exclude the effects of inputs that do not depict the transfer of goods or services (material or labor overruns)

Recognition of Revenue – Satisfaction of Performance Obligations - continued  Updates to measure of progress accounted for as change in accounting estimate in the period the change is determined  Reasonable measure of progress – early stages of a contract, recognize revenue only to the extent of the costs incurred (zero margin)

Recognition of Revenue – Satisfaction of Performance Obligations - continued  If control not transferred over time, revenue recognized the point in time when performance obligation is satisfied and control is transferred  Indicators of transfer of control include, but not limited to: Entity has a present right to payment Customer has legal title Transfer of physical possession Customer has significant risks and rewards of ownership Customer has accepted the asset

Contract Costs  Incremental costs of obtaining a contract Capitalized as an asset if expect to recover b can be expensed as incurred if the amortization period is one year or less b amortized on a systematic basis consistent with the pattern of transfer of the goods or services Costs that the entity would not have incurred if the contract had not been obtained  Costs to fulfill a contract Look to other guidance first (inventories, software development costs) Recognize as an asset if costs relate directly to a contract and are expected to be recovered based on future performance

Contract Costs - continued  Costs to Fulfill a Contract Direct labor Direct materials Allocations of costs that relate directly to the contract or contract activities b Depreciation of equipment, tools, supervision, insurance, etc. Costs explicitly chargeable to the customer under the contract provisions Other costs incurred only because the entity entered into the contract b Subcontract costs  Uninstalled materials Exclude from measurement of progress Recognize revenue equal to cost (zero margin)

Disclosures  Revenue recognized from contracts disclosed separately from other sources of revenues  Impairment losses recognized on any contract receivables or contract assets  Disaggregation of Revenue Revenue recognized as of point in time and over time Qualitative information about how economic factors (type of customer, geographical location of customers, and type of contracts)

Disclosures - continued  Opening and closing balances of receivables, contract assets, and contract liabilities  Methods used to recognize revenue (input/output methods), information regarding variable consideration recognition  Contract Asset = Costs in Excess / Contract Liability = Billings in Excess

Effective Dates and Transition  Effective Dates Public entities – Annual reporting periods beginning after 12/15/17 (calendar year 2018); early adoption prohibited Non-public entities – Annual reporting periods beginning after 12/15/18 (calendar year 2019); early adoption permitted to public entity effective date  Transition Retrospective application – restate prior periods upon adoption, or Apply to existing contracts in progress on the effective date and new contracts going forward b Requires cumulative effect adjustment and certain additional transition disclosures

Example – Contract Modifications  Example 8 - Contract to design a commercial building for $1 million and a bonus of $200,000 if construction costs are less than $100,000,000.  At contract inception – Transaction price= $1m; est. cost $700K  Exclude $200K bonus from transaction price  Input measure – costs incurred, 60% complete after first year ($420K)  Q1, Year 2 – no additional costs incurred; modification to contract - price increased $150K, costs $120K, modifications not distinct, bonus now probable (Estimates received)  Cumulative catch-up adjustment % complete($420/$820) on $1,350,000 transaction price = $91,200 revenue adjustment

Example – Claims  Example 9 – Disputed claim  Customer-caused delays result in additional costs (Overhead rate and labor costs increased)  Contractor has legal basis in claim (included in contract terms)  Does not result in any additional goods or services provided to customer and all remaining goods or services to be provided after the modification are not distinct  Adjust transaction price for estimated amount of claim (considering constraint concept) – cumulative catch-up adjustment

Example – Performance Obligation  Example 10 – Goods and Services Are Not Distinct  Contract to design a bridge - responsible for design, engineering, survey, permitting  Promised goods and services are capable of being distinct, but  Promise to transfer individual goods and services in the contract are not separately identifiable from other promises in the contract. Provides the service of integrating the goods and services into the bridge Account for all goods and services in the contact as a single performance obligation

Example – Revenue Recognized Over Time  Example 14 – Consulting Service  Provides professional opinion to customer  If contract terminated, successor firm would need to substantially reperform work in process because no benefit from predecessor  Benefit is only received at delivery of opinion  But: No alternative use since facts and circumstances specific Firm has enforceable right to bill for time incurred to date (including profit)  Thus revenue is recognized over time

Example – Revenue Recognized at Point in Time  Example 16 – Build WWTP for Customer  Contract specifies 10% payment at inception, regular payments over work period of 50%, then final 40% due at completion - payments nonrefundable unless firm fails to perform - if customer terminates contract, firm can only retain progress payments to date  Cumulative payments are not expected at all times to correspond to work done (no right to payment for performance to date)  Thus cannot recognize revenue over time

Example – Uninstalled Materials  Example 19  Highway construction, including installation of precast bridge. Bridge delivered 3 months prior to being installed.  Exclude cost of bridge from progress measurement (% complete)  Revenue recognized up to cost of bridge (zero margin)

Example – Variable Consideration / Retainage  Example 20 – Penalty provision = variable consideration Must determine amount to include in transaction price  Example 21 - Estimating variable consideration Expected value method used for portion including multiple outcomes Most likely method when only 2 outcomes  Example 27 – Retainage Retainage not determined to be financing component – intended to protect the customer from the contractor failing to complete its obligations

Questions / Discussion M. Scott Hursh, CPA, CCIFP®, CDA Managing Partner AEC Industry Group Stambaugh Ness, PC Phone: _____________________ Brian W. Rosenberg, CPA, MBA Senior Manager Brown, Schultz, Sheridan & Fritz Phone: