Industry Insights

On November 14, 2011, the Financial Accounting Standards Board issued a revised exposure draft addressing “Revenue from Contracts with Customers.”

This revised exposure draft comes on the heels of approximately 16 months of evaluation and input following the issuance of the original exposure draft in June 2010.

The core principle and five-step application of the core principle are unchanged from the original exposure draft. According to the core principle, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount reflecting the consideration to which the entity expects to be entitled in exchange for those goods or services.

The five-step application is as follows:
Step 1:  Identify the contract with a customer.
Step 2:  Identify the separate performance obligations in the contract.
Step 3:  Determine the transaction price.
Step 4:  Allocate the transaction price to the separate performance obligations in the contract.
Step 5:  Recognize revenue when the entity satisfies a performance obligation.

The original exposure draft drew significant input from the construction industry, which was generally critical of the idea under Step 2 that a single construction contract would be accounted for as multiple performance obligations (see the original BKD Alert on this topic issued in June 2010).

With nearly 1,000 comment letters received pursuant to the original exposure draft—and more than 25 percent of those letters coming from respondents within or serving the construction industry—key revisions have been made in the revised exposure draft to address principal concerns expressed by the construction industry. Modifications in the revised exposure draft likely will prove beneficial to design firms as well.

Identifying Separate Performance Obligations

While the original exposure draft prescribed criteria that would frequently have required a single contract to be accounted for as more than one performance obligation, the revised exposure draft contains language reversing that proposed guidance.

Specifically, the revised exposure draft contains guidance indicating that if an entity promises to transfer more than one good or service, the entity would account for each separate good or service as a separate performance obligation only if it is distinct. If the promised good or service is not distinct, the entity would combine that good or service with other promised goods or services until the entity identifies a distinct bundle of goods and services. While “distinct” is defined within the revised exposure draft, additional guidance is provided to clarify a good or service in a bundle of promised goods or services is not distinct (and, therefore, the entire bundle of promised goods and services would be accounted for as a single performance obligation) as long as the goods or services in the bundle are highly interrelated and transferring them to the customer requires the entity to provide significant integration services; the bundle of goods or services also must be significantly modified or customized during fulfillment of the contract.

With the incorporation of the above language into the revised exposure draft, it is now likely most construction contracts will be accounted for as a single performance obligation, not unlike the current guidance contained in Accounting Standards Codification 605-35 (previously known as SOP 81-1).

Recognizing Revenue as Performance Obligations Are Satisfied

The revised exposure draft also contains clarifying language likely to be welcomed by the construction industry. Specifically, for performance obligations satisfied over time, an entity shall recognize revenue by measuring the progress toward complete satisfaction of that performance obligation.

The objective when measuring progress is to depict the entity’s actual performance toward satisfying its promise to deliver goods or services. As circumstances change over time, the revised exposure draft calls for an entity to update its measure of progress to depict the entity’s performance completed to date. Any change must be accounted for as a change in accounting estimate in accordance with Subtopic 250-10 on accounting changes and error corrections.

Caution is given in measuring progress toward completion by requiring an entity to exclude from a measure of progress any goods or services for which the entity does not transfer control to the customer. Significant waste, scrap or rework should be excluded from the measurement of progress toward completion.

Considerable guidance is provided on the use of input and output methods in measuring progress toward completion. In summary, input methods are generally permissible, particularly when output methods are difficult and costly to measure.

An improvement for design firms also has been achieved in the revised exposure draft.

One of the main principles in determining qualification for continuous revenue recognition is the notion that the customer controls the work in process. While fairly easy to satisfy in most construction contracts, this is rarely true until the later stages of a design contract. The revised exposure draft contains a safe harbor provision allowing for continuous recognition of revenue, as long as the design work does not benefit the design entity itself (for example, by creating a design that can be sold to other customers in the future or used in its own development activities) and as long as the design firm is entitled to payment from the customer for work performed as the design contract progresses and the designer expects to complete the contract. 

Had the safe harbor not been included, design firms likely would have had to defer revenue recognition until later stages of a design project. It should be noted one board member opposed this language, feeling that allowing design firms this safe harbor violated the core principle of the standard.

Other Areas of Consideration

The revised exposure draft also contains guidance related to contract modifications, measuring and recognizing variable consideration (for example, performance incentives), warranties, contract costs, onerous performance obligations (that is, contracts with an anticipated loss) and disclosure requirements. Contractors and designers should watch for additional guidance on these and other topics from industry trade organizations.

Both the Construction Financial Management Association and The Associated General Contractors of America sent letters in response to the original exposure draft.

For more on the revised exposure draft, contact your BKD advisor.