Engineering & ConstructionEngineering & Construction Construction Accounting The application of revenue recognition models in the engineering and construction industry May 2010 0 Contents Executive summary Revenue and Gross Profit methods Industry perspectives Selecting a policy Preferability Appendix A (Examples) Where can I get more information? Engineering and Construction industry contacts 2 3 4 5 5 6-7 8 9 1 . material quantities) or an output method (e.g. when determining which methods to apply. labor dollars. ASC Topic 605-35-25 (formerly Statement of Position 81-1." Within the Engineering and Construction industry. no one method is preferred. units produced. It is also acceptable that some contracts employ the Revenue method. machine hours." The use of either an input method or an output method to calculate percentage of completion. labor hours.g. these two methods commonly are referred to as the "Revenue method" and the "Gross Profit method. while others employ output methods for calculating percentage of completion. in a well controlled environment. costs of revenue and gross profit to date is determined by the measurement of progress toward completion using either an input method (e.Executive summary Companies in the Engineering and Construction industry have a number of different alternatives when applying the current construction contract standard. Once this "percent-complete" is derived. costs of revenue and gross profit to recognize is a matter of judgment. cost-to-cost. and the use of either the Revenue method or Gross Profit method to determine the amount of revenue. or the difference between total estimated contract revenue and total estimated contract cost.. contract milestones). physical progress.. This paper primarily focuses on the technical guidance. The portion of total revenue. while others employ the Gross Profit method for recognition purposes.. policy elections and accounting for those companies that use a method of calculating percentage of completion other than cost-to-cost (e. that certain contracts employ input methods. 2 . must be determined before the income earned on the contract for a period can be determined. costs of revenue and gross profit (Revenue or Gross Profit method). Companies should undertake a thoughtful process. It is acceptable. there are two different approaches for determining revenue.g. costs of revenue and gross profit. for example. Those options include selecting a method to calculate percentage of completion (input or output methods) and selecting a method of recognizing revenue. physical progress). Accounting for Performance of ConstructionType and Certain Production-Type Contracts indicates that total estimated gross profit on a contract. these two methods broadly are referred to as "Alternative A" and "Alternative B. Company controls must also ensure that selected policies are consistently applied. units delivered. is that gross profit percentages will vary from period to period. The excess of that amount over the amount of gross profit reported in prior periods is the gross profit that is recognized in the income statement for the current period. labor. any difference between actual contract costs incurred and the calculated cost of revenue is accounted for as "work-in-process" on the balance sheet. That is. Many entities prefer this for contracts that have an element of learning curve (i. b.Gross Profit method Those entities that favor the Gross Profit method do so because they believe that the cost of work performed on a contract (e. Gross profit earned on a contract is computed by multiplying the total estimated gross profit on the contract by the percentage of completion.Revenue method (Alternative A) Under the Revenue method. however. direct materials.g. the measurement of extent of progress towards completion is applied equally against both contract revenues and contract costs. The primary disadvantage. c. this method produces a consistent gross profit percentage from period to period. costs of revenue and gross profit are determined as follows: a. This difference occurs only when a method other than the cost-to-cost input method is used to determine the percentage of completion (see Appendix A). Downward revisions of percent-complete may cause a reduction of revenue in the period such revisions are made. The primary disadvantage. is because this method best reflects the "matching concept. the expected loss should be recognized as an expense as soon as the loss becomes probable. revenue. costs incurred early in the contract that benefit the totality of the contract). Revenue is the amount of gross profit earned on a contract for a period plus the costs incurred on the contract during the period.e. Advantages and Disadvantages . Advantages and Disadvantages . Downward revisions of percent-complete may cause a reduction of revenue in the period such revisions are made. c. therefore. costs of revenue and gross profit are determined as follows: a. The excess of this amount over the revenue reported in prior periods is the revenue that is recognized in the income statement for the current period. however.. because such incurred costs can be objectively determined and do not depend upon estimates. is that achieving the recognition of a consistent gross profit percentage is challenging because of the requirement to continually reassess and adjust estimates of contract revenues and costs over the contract period. b. excluding the cost of materials not unique to a contract that have not been used for the contract and costs incurred for subcontracted work that is still to be performed. unless the cost-to-cost method is used to measure the progress towards completion (see Appendix A). revenue.. If total contract costs exceed total contract revenue.Revenue method The primary benefit of the Revenue method. Cost of revenue to date is computed by multiplying total estimated contract cost by the percentage of completion on the contract. Revenue to date is computed by multiplying total estimated contract revenue by the percentage of completion. Entities that favor this approach. believe that recognizing a consistent gross profit percentage may be inconsistent with the true economics of the contract as it is being performed. The excess of that amount over the cost of revenue reported in prior periods is the cost of revenue that is recognized in the income statement for the current period." That is. 3 . the expected loss should be recognized as an expense as soon as the loss becomes probable. Cost of revenue is the cost incurred on a contract during the period. no amounts should be recognized on the balance sheet. and the reason why this method is favored among many companies in the Engineering and Construction industry. Gross Profit method (Alternative B) Under the Gross Profit method. and subcontractors) should be the cost of revenue reported during the period. In situations where there are no changes in estimates during the performance of the contract. If total contract costs exceed total contract revenue. Accordingly. Gross profit on a contract for a period is the excess of revenue over the cost of revenue. The difference between total cost incurred to date and cost of revenue to date (if any) is reported on the balance sheet. therefore. it is common for the actual cost per unit to decline over the life of the contract due to a normal learning curve (similar to many contracts in the Engineering and Construction industry with repetitive tasks). For example. In the performance of production-type contracts within the Aerospace and Defense industry. approximately 70% of these companies primarily use the cost-to-cost method. there is no one preferred approach within the Engineering and Construction industry. Likewise. some contractors in this industry prefer the use of an output measure to derive percent-complete and the Revenue method to recognize revenue. there is no difference in the recognition of revenue. costs deferred as an asset on the balance sheet are subject to impairment testing in accordance with existing asset impairment standards. Insight* Under the Revenue method. using publically available information for selected large-cap construction companies. When using cost-to-cost to determine percent-complete. this approach is more often seen in production-type contracts used in the Aerospace and Defense industry. Some companies believe costs incurred prior to the effect of the learning curve benefit the entirety of the contract and. 4 . costs of revenue and gross profit. While some companies in the Engineering and Construction industry do use output measures to derive the extent of progress towards completion. as the use of either an input or output method to derive the extent of progress towards completion is acceptable. believe matching revenues with costs is most reflective of the underlying economics of the transaction.Industry perspectives As both the Revenue and Gross Profit methods are acceptable alternatives. For this reason. Any impairment charge generally would be recorded in cost of sales and appropriately disclosed. there is no one preferred method in the industry. Our experience indicates that many entities use the cost-to-cost input method to measure the extent of progress towards completion. costs of revenue and gross profit between the Revenue method and Gross Profit method (see Appendix A). unless a company can justify a change on the basis of preferability. No one method is preferred and there are a number of potential alternatives to consider. for a grouping of similar contracts. they must be applied consistently when accounting for similar events and transactions. companies need to carefully consider the types of contracts into which they enter and determine which policies will most appropriately reflect the economics of their transactions. costs of revenue and gross profit. an entity should ensure that similar contracts employ consistent methods. it is possible that an entity could develop more than one policy for assessing percent-complete and recognizing revenue. Preferability Once a company selects its accounting policies. The policy decision process should be subject to the Company's normal internal control procedures.e. costs of revenue and gross profit. As described in ASC 250-10-45-12. a company may enter into a contract to drill 20 wells in an area in which no drilling previously occurred. the company may expect the actual costs per well to be constant (i. For example. Accordingly. If the Company then entered into a new contract to drill 50 wells in an adjacent location. while others employ the Gross Profit method. engineers and financial professionals is critical to ensuring that all of the relevant characteristics are considered when grouping similar contracts. costs of revenue and gross profit (i. for example. Making these accounting policy elections is a process that likely would extend far beyond the traditional accounting function. the company expects actual drilling costs per well to decline over the life of the contract due to a normal learning curve (i. costs incurred early in the contract benefit the totality of the contract). It is critical that an entity ensures that groups of contracts with similar characteristics employ consistent methods.. companies should analyze those contracts to determine characteristics of the groupings to which the policy will be applied. Leveraging input from operational planning..g. That is. it must be applied consistently to similar contracts. So. Examples of such characteristics might include labor intensive contracts and contracts with learning curve. It is acceptable. it would not be appropriate to change methods while a contract is in-process.. Further. input or output) and the method used to recognize revenue. We believe that the assessment of consistency must be performed on a contract-bycontract basis.e. Revenue method or Gross Profit method). An entity that wishes to change an accounting policy must justify that the allowable alternative accounting principle is preferable. physical progress to calculate percent-complete and apply the Revenue method for recognition purposes. From there.. Revenue method or Gross Profit method). an entity may use. for a different group of contracts. "a method of accounting that was previously adopted for a type of transaction or event that is being terminated or that was a single.g. Finally. Conversely. nonrecurring event in the past shall not be changed…" What does this mean in this context? Once a policy is elected for assessing percent-complete and recognizing revenue.Selecting a policy When selecting a policy to determine percent-complete or a policy for recognizing revenue. For these types of contracts an entity might elect a policy of using the Revenue method because they believe such costs benefit the whole contract and matching the revenue with these costs most appropriately reflects the economics of the transaction. For these types of contracts an entity might elect a policy of using the Gross Profit method because they believe that the costs of each well should be recognized as incurred as such costs don't benefit the totality of the contract. costs of revenue and gross profit (e. no learning curve because the previous experience is included in the cost model). an entity might use physical progress to calculate percent-complete and apply the Gross Profit method for recognition purposes. Accordingly. Insight* Either the Revenue method or Gross Profit method is acceptable so long as the policy chose is applied on a consistent basis. that certain contracts employ the Revenue method. 5 .e. a company should group contracts with similar characteristics and make a policy decision for these contracts as to the method used to derive percent-complete (e.. For example. how should companies select the most appropriate policies to follow? The first step would be to undertake an assessment of the types of contracts the company normally enters into. The company uses physical progress to measure percentage-of-completion. Because of learning curve efficiencies. 6 . there is no change in the company's estimated cost of the contract at completion. Assuming there is no change in estimates. the actual cost of production decreases over the contract. Contract details are as follows: Total wells 20 Total revenues $200 million Total estimated cost $160 million Total estimated margin $ 40 million Wells delivered in Year 1 4 Actual cost of wells delivered $ 38 million Assumptions: At the end of Year 1.Appendix A Example 1: A construction company enters into a contract with a customer to build 20 wells over the next five years. Calculate the income statement and balance sheet at the end of Year 1 under alternatives A (Revenue method) and B (Gross Profit method). while margin percentages under the Gross Profit method will vary period to period. Solution: Alternative A: (revenue method) Revenue ($200m x 4/20) Cost of sales ($160m x 4/20) Margin Margin % ($8m / $40m) Work in process ($38m-$32m) $40 million $32 million $ 8 million 20% $ 6 million Alternative B: (gross profit method) Revenue (cost + margin) Cost of sales (actual costs incurred) Margin ($40m x 4/20) Margin % (8m / $46m) Work in process ($38m-$38m) $46 million $38 million $ 8 million 17% $ 0 million Insight* This example demonstrates that. margin percentages are not. margin percentages under the Revenue method will remain at 20% period to period. while margin dollars are consistent between the Revenue method and Gross Profit method. Example 2: Assume the same fact pattern as Example 1. cost of revenues and work-in-process under alternative A and B Solution: Alternative A: (revenue method) Percent-complete ($38m/$160m) Revenue ($200m x $38m/$160m) Cost of sales ($160m x $38m/$160m) Margin Margin % ($9. cost of revenues or margin (percentage or dollars) recognized between the Revenue method and Gross Profit method. Compute revenue.75% $47.75% $47. 7 . there is no difference in the amount of revenues.5m / $47.5 million $38 million $ 9. except that the company uses the cost-to-cost input method to determine percentage-of-completion.5 million 20% $ 0 million Alternative B: (gross profit method) Percent-complete ($38m/$160m) Revenue (cost + margin) Cost of sales (actual costs incurred) Margin ($40m x $38m/$160m) Margin % (9.5 million $38 million $ 9.5m / $47.5m) Work in process ($38m-$38m) 23.5m) Work in process ($38m-$38m) 23.5 million 20% $ 0 million Insight* This example demonstrates that when using the cost-to-cost input method. and issues. .jhtml Visit our website to download our thought leadership publications for the engineering and construction industry. learn more about the E&C issues that our global network of functional and industry professionals specialize in to help address client needs. we will be hosting a client dinner on the evening of June 29.pwc. In addition to leading ading a panel discussion that will focus on surety industry trends.com/us/en/industrial-products/engineering products/engineering-construction. which will be held on June 26-30 26 in Kona. 2010. Upcoming PwC industry sponsorship CFMA 2010 Conference The Construction Financial Management Association’s (CFMA) annual conference and exhibition serves as a premier source of information concerning all aspects of construction financial management.Where can I get more information? PwC US Engineerinig & construction industry website http://www. PwC is a proud to sponsor the 2010 CFMA conference. free of charge. concerns. Hawaii. Hope to see you there! Corruption orruption prevention in the E&C industry Engineering growth Government compliance & reporting 13th Annual Global CEO Survey Engineering & Construction supplement: Setting a smarter course for growth Global engineering & construction Economic stimulus dollars bring new rules E&C companies face a to the E&C industry disproportionately higher risk quarterly M&A analysis Engineering change: (IFRS) The impact of IFRS on the E&C industry Revenue recognition discussion papers and podcast series Potential impact of revenue recognition on the E&C industry Unraveling new business combination standards Global economic crime survey Implementing new accounting standards E&C industry summary: Survey (FAS 141R & 160) in the E&C industry scrutinizes fraud & associated risks 8 . Also. where we will provide our guests with a brief update on the joint IASB/FASB revenue recognition project pr and enjoy fine dining and spectacular views. to the extent permitted by law. PricewaterhouseCoopers LLP.National Office Phone: 1-973-236-4571 Email: dan. Dunleavy Partner . and does not constitute professional advice. employees and agents do not accept or assume any [email protected] Houston.pwc.f.com This publication has been prepared for general guidance on matters of interest only. its members. Information contained in this document comes primarily from ASC Topic 605-35-25 and the AICPA Audit and Accounting Guide for Construction Contractors .com Michael Matthews Director . Texas Phone: 1-713-356-8133 Email: [email protected] Michael Collier Halliburton Global Engagement Partner US Energy M&A Leader Houston. Texas Phone: 1-713-356-4034 Email: joseph. and.pwc. or refraining to act.zwarn@us. responsibility or duty of care for any consequences of you or anyone else acting. You should not act upon the information contained in this publication without obtaining specific professional advice.p.pwc. Kent Goetjen US Engineering and Construction Leader Phone: 1-860-241-7009 Email: h.National Office Phone: 1-973-236-4975 Email: michael.sobolewski@us. Texas Phone: 1-713-356-4615 Email: michael.Engineering and construction industry contacts H.pwc.collier@us. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this [email protected] Joseph P.Advisory Houston.com Daniel Zwarn Partner .kent. in reliance on the information contained in this publication or for any decision based on it.com Michael Sobolewski Senior Manager .pwc.pwc.