By Matthew Boland, CPA of McCarthy & Company, PC
Published August 2020
Many contractors were relieved that the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) on June 3, 2020. It grants a one-year effective date delay for certain companies and organizations applying the revenue recognition and lease accounting standards. Early application continues to be permitted.
Revenue from Contracts with Customers
The deferral of the effective date applies to certain entities that have not yet issued their financial statements (or made the financial statements available for issuance) reflecting the adoption of ASU 2014-09 Revenue from Contracts with Customers (Topic 606).
The ASU permits private companies and NFP organizations that have not yet applied the revenue recognition standard to do so for annual reporting periods beginning after December 15, 2019, and interim reporting periods within annual reporting periods beginning after December 15, 2020.
The ASU also provides the revenue recognition deferral to certain other private companies and organizations that have not yet issued (or made available) financial statements that reflect adoption of the guidance.
The effective date for a public business entity, an NFP entity that has issued, or a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market, and an employee benefit plan that files or furnishes financial statements with or to the SEC is not affected by the amendments in this update.
Revenue Recognition Requirements
The ASU requires that revenue is recognized when the good or service is transferred or as control over the good or service is transferred. Revenue can be recognized over time (services) or at a point in time (goods).
Recognizing revenue over time is similar to the percentage of completion method of accounting with slight adjustments that may or may not impact the amount of revenue on each job. One of the following two conditions must be met:
- The customer must have control of the asset as it is built or improved, or
- The asset must have no use to you; therefore, you have right to the payment.
Recognizing revenue at a point in time involves recording revenue for each performance obligation as it is completed or when the customer takes control of the asset. Control of the good or service is defined as “when the customer has the ability to direct the use of or can benefit from the transferred good or service.”
Impact of the Revenue Recognition Standard
The revenue recognition standard will significantly affect the current revenue recognition practices of most contractors. It could also impact the timing and amount of revenue reported, key performance indicators (KPIs), debt covenant ratios, bond programs, contract negotiations, performance agreements, business activities and budgets. It is important to look at the capitalization of costs associated with deferred revenue and its impact on the balance sheet.
The timing of contract-related costs will have a significant impact on a contractor’s balance sheet. It could change how contract accounts are organized and the presentation of contract-related assets and liabilities on the balance sheet. These include the cost to obtain and fulfill the contract.
Contractors are required to maintain the financial metrics outlined in the terms of a loan or bond agreement. This can include everything from minimum working capital ratio and maximum debt-to-equity ratio requirements. Lenders and sureties use this information to determine if the contractor is financially healthy.
Financial ratios and KPIs may be negatively impacted by an increase in liabilities on the balance sheet. It is important for contractors to have a conversation with their banker and surety to explain why and develop a pro forma of what the balance sheet will look like once revenue is recognized to demonstrate the impact.
Variable Considerations
Under the revenue recognition standard, variable consideration should be estimated and recognized throughout the life of the contract. Contractors should consider if it is probable that a significant reversal in the amounts of cumulative revenue recognized will not occur. At the end of each reporting period, contractors should update the estimated transaction price to represent the circumstances present at the end of the reporting period. Contractors may want to update their assessment of whether an estimate of variable consideration was constrained. Contractors should also consider if the circumstances and uncertainty caused by COVID-19 should be included in the assessment.
Lease Accounting Standard
FASB deferred the implementation date for the lease accounting standard for private companies, private not-for-profit organizations, and public not-for-profit organizations that have not yet issued (or made available) their financial statements reflecting the adoption of the guidance. It is intended to provide near-term relief for certain entities for whom the lease accounting standard adoption is imminent.
Private companies and private not-for-profit organizations may apply the new leases standard for fiscal years beginning after December 15, 2021, and to interim periods within fiscal years beginning after December 15, 2022. Public not-for-profit organizations that have not yet issued (or made available to issue) financial statements reflecting the adoption of the lease accounting guidance may apply the standard for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.
The International Accounting Standards Board (IASB) has not proposed any delays to its new lease accounting standard, International Financial Reporting Standards (IFRS) 16. That standard will still become effective for private companies for fiscal years beginning after December 15, 2020. Public companies were required to comply with the leasing standard for fiscal years beginning after December 15, 2018. Any companies planning to go public will need to comply with the new IFRS standard in advance of filing for an initial public offering.
Private companies with international operations and reporting obligations under IFRS must be ready to adopt IFRS 16 under the standard’s original timeline. These companies should consider implementing the FASB standard at the same time.
Lease Accounting Standard Requirements
Generally, all entities that lease assets (lessees) such as real estate, equipment, or vehicles must be in compliance with the ASU. It requires that capital (finance) and operating leases are recognized on the balance sheet. The “right-of-use” value of property or equipment must be recorded as an asset and the present value of scheduled lease payments as a liability. Right-of-use assets include initial direct costs (legal fees, advanced payments, lease incentives, etc.).
The lease accounting standard applies to related party leases based on the “legally enforceable” terms of the agreement. Short-term leases of 12 months or less that do not include an option to renew may be exempt.
Implementing the lease accounting standard has proven to be complex. Since leases were often decentralized across a company, identifying how many leases a company had entered into was challenging. Contractors can:
- Collaborate with all departments and projects to identify existing leases and their terms.
- Review service contracts for embedded or implied leases (as defined in the standard).
- Create or update a complete lease inventory.
- Identify data gaps, such as the market value of a leased asset or the discount rate used in the lease’s valuation.
- Evaluate software to support lease tracking and reporting requirements.
- Work with external auditors, investors, and banks to discuss the implications of the new standard.
Impact of the New Lease Accounting Standard
The lease accounting standard could impact a contractor’s:
- Balance Sheet – Lease obligations generally increase assets and liabilities.
- Financial Ratios – A contractor’s working capital ratio and debt-to-equity ratio may be pushed above the acceptable threshold.
- Expense Recognition – Capital leases typically result in accelerated expense recognition for financial statement purposes under the ASU. Operating leases have a constant annual cost. The “right-ofuse” cost can generally be amortized over the lease term on a straight-line basis. The lease liability is based on an effective interest rate calculation.
- Sale and Leaseback Transactions – Real estate transactions may qualify for sale and leaseback accounting.
- Taxable Income and Deductions – Contractors may have to recognize deferred assets and deferred liabilities in reporting excess on “right-of-use” assets and the related lease liabilities according to generally accepted accounting principles (GAAP).
- Valuation Allowance – Changes recorded in deferred tax assets and liabilities, as well as how book-to-tax differences are reversed under the ASU. A contractor’s valuation allowance and net operating loss (NOL) carry forwards can be impacted.
There are many other factors to consider regarding the lease accounting standard, such as the tax implications of leverage leases; state sales and use taxes, franchise, net worth, and other non- income-based taxes; and interest expense, personal property or real estate taxes and transfer pricing.
Lease modifications require the lessee to determine whether the proposed changes are a modification of the existing lease contract or are an entirely new contract. The potential difference can have a big impact on financial statements. Contractors entering into lease modifications should analyze the potential effect.
A contractor’s KPIs may be negatively impacted by the revenue recognition and lease accounting standards. Sureties need to be aware that a contractor’s financial results may be under or overstated.
Sureties may need to look beyond the numbers during this transition period. In most cases, a true year-over-year or month-over-month comparison of a contractor’s KPIs will not be possible during the initial transition to these ASUs. We can help you explain the changes in KPIs and provide a pro forma and/or analysis of the changes to your balance sheet and financial ratios because of these ASUs.
Matthew J. Boland, CPA, is director—audit and assurance with McCarthy & Company. He gets to know his clients on a professional and personal level to fully understand their vision for the future and what they would like to achieve. He is responsible for the quality and technical review of the firm’s audit, review and compilation reports. He can be reached at Matthew.Boland@MCC-CPAs.com or 610.828.1900.