It’s Here: The New Revenue Recognition Standard

1. It’s Here: The New Revenue Recognition Standard Presented by: Timothy Wilson, CPA, CCIFP September 26, 2014

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

3. Revenue from Contracts with Customers―Finally!!ASU 2014-09

4. 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)

5. 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 2014

6. 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

7. 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 … Revenue Recognition Standard

8. 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 Revenue Recognition Standard

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

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

11. 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?

12. Revenue Recognition Standard Recognition Model – Steps Involved Identify contract with customer 1 Identify separate performance obligations in contract 2 Determine transaction price 3 Allocate transaction price to performanceobligations 4 Recognize revenue when (or as) performance obligations are satisfied 5

13. Revenue Recognition StandardStep 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

14. Revenue Recognition StandardStep 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

15. Revenue Recognition StandardStep 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

16. Revenue Recognition StandardStep 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)

17. Revenue Recognition StandardStep 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

18. Performance ObligationsFact 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

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

20. Revenue Recognition Standard Step 3: Determining Transaction Price • 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

21. Revenue Recognition Standard • Step 3: Determining Transaction Price • 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

22. 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

23. 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

24. 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?

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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 asignificant 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

35. 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)

36. 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

37. Allocation of Consideration

38. 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

39. 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

40. 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

41. 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?

42. 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

43. 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? • Nowthat you mention it―it does look familiar, doesn’t it?

44. 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

45. 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

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

47. Revenue Recognition Standard 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

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

49. 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

50. 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