INDUSTRY INSIGHTS | SUMMER 2010 EFFECTWhipping Old Standards Into Shape
by Tom Bessel
| Abbreviations Key |
| AICPA: American Institute of Certified Public Accountants |
| ASC: Accounting Standards Codification |
| FASB: Financial Accounting Standards Board |
| IFRS: International Financial Reporting Standards |
| SOP: Statement of Position |
| SOP 81-1: Accounting for Performance of Construction-Type and Certain Production-Type Contracts |
Changes are not always easy to accept, especially when we’ve been using the same revenue recognition techniques on contracts since 1981. The construction industry had limited guidance on accounting for construction contracts until AICPA SOP 81-1, which came out the same year Indiana Jones was dodging boulders and lethal spikes on the big screen in
Raiders of the Lost Ark.
The guidance in SOP 81-1 has recently been codified in what is now called ASC Topic 605: Revenue Recognition. The FASB is working to conform its standards with the IFRS, which when completed will change the current guidance on revenue recognition. One of the goals is to create a uniform standard that applies to all industries and geographic locations. The FASB published a discussion paper that includes proposed revisions to the standards and has sought feedback from various associations and industries.
FASB discussion paper
The proposed revisions to the standards focus on revenue being recorded on the basis of increases in an entity’s “net position” in a contract with a customer. Under this theory, the net position is the difference between the remaining rights or contract assets, and the contract obligations or contract liabilities. Revenue is recognized as the net position increases (e.g., when a contract asset increases, or as a contract liability decreases, or some combination of the two).
This approach strongly parallels the current standard. The contract obligation would only be satisfied when the customer has obtained control of the asset. Professor Jones would translate this into plain English by stating, “You recognize revenue when the customer believes they have received an artifact (good) or service.” For example, a contractor completing a remodel of a floor in a building would meet this requirement, or Indiana retrieving the Ark of the Covenant for the U.S. Army intelligence agents.
Calculating revenue and gross profits
One of the main differences between the old and new versions involves relaxing the rules for segmenting contracts. For example, an agreement to construct a building may be broken out into several sub-jobs (net positions). Each sub-job could have its own separate calculation of revenue and gross profit. Sub-job one may have gross profit of 50 percent, while sub-job two may have a gross profit of zero. Here’s how they’d pan out:
- Under the old standards outlined in SOP 81-1, a contractor would look at the job’s total estimated gross profit, compute a percent-complete calculation, and in theory recognize gross profit evenly over the term of the contract.
- Under the new standard, if sub-job one has a higher profit margin, a contractor may be recognizing a 50 percent gross profit margin at the beginning of the project even though the entire job has a total estimated gross profit of 5 percent.
Potential benefits and issues with the proposed standards
For Indiana Jones, the journey and the risks are worth the treasure. Contractors may discover some “treasures” in new standards:
- Uniform principles create more comparative information when evaluating business and investment decisions.
- Companies operating in multiple countries can use a streamlined process for internal financial reporting.
- Breaking contracts into multiple components forces project managers to analyze their costs more closely, which could result in more accurate estimates.
Just as Indiana faced enemies and a pit of venomous snakes, contractors too could face some rough situations:
- Similar to current guidance under IFRS, the new propsed standard lacks the definitive guidance provided by SOP 81-1.
- Sub-jobs could create complex issues for tracking contract revenue in accounting software packages.
- The suggested rules could potentially create more ways for contractors to manipulate income by completing sub-jobs with higher gross margins at the beginning of the contract or by shifting costs between sub-jobs to recognize accelerated gross profits.
Although the new proposed revenue recognition principles appear complex, the FASB has only published a discussion paper at this point. The final standard is expected by the second quarter of 2011. Overall, the new standards will help to provide more uniform principles and present the FASB with an opportunity to address new issues that have emerged since SOP 81-1’s debut almost than 30 years ago. Hopefully the standards will be clarified, and we won’t need to hire Indiana Jones and his archeological team to dig up the old relic rules in SOP 81-1.