(Author’s note: This article is applicable for all industries but is written by someone who serves engineering and construction entities, thus the industry references included below.)
What’s the Big Deal?
“Why should I waste my time reading an article about financial statements? Shouldn’t we be putting a shovel in the ground instead to get some work done?”
Your financial statements matter, and you need to understand them. They are the prism through which your surety, financial institution, and investors see your company. There is no better time to get that understanding than in the calm before the storm. “What storm?” you might ask. The upcoming changes to revenue recognition from contracts with customers are going to be one heck of a storm, and many people don’t know it yet. It’s been brewing for a few years and it’s going to hit public entities hard in just a few short weeks (January 1, 2018). Nonpublic entities get a little more time to prepare: January 1, 2019. It’s coming fast though.
So what’s the big deal? You might be thinking, “We have contracts right now with our customers, and we earn revenue. They pay us, and everyone is happy. What’s changing?” Maybe a little, maybe a lot. It’s all going to depend on how your contracts are written. When we say contracts, we don’t just mean the long, boring legal agreements that only the attorneys and accountants actually read. Accounting Standards Codification (ASC) 606 defines a contract much more broadly than that. Contracts can be written agreements, verbal arrangements, or promises implied by the entity’s ordinary business practices.
That’s some important stuff right there, and that’s only Step 1! “Hmm,” you say. “‘Step 1’ implies there is more work to do.” Correct! There are four more steps to consider, each with various principles to consider. We’ll get into all five steps in future articles, but let’s back up and lay a foundation for this whole project. Every good construction project begins with a solid foundation, right? So let’s roll up our sleeves and get a little dirty.
The Dirty Details
Under current generally accepted accounting principles (GAAP), revenue is basically earned when the risk and reward of a good or service is transferred from the provider to the customer. That concept is changing from risk and reward to transfer of control. What does that mean? Control isn’t transferred until the project is complete, right? Not always. Control might mean physical possession, but it can also mean economic control. Think of it this way: When you leave a jobsite each day (assuming the customer owns the site), you are transferring a little more of the project each day. That would be physical control. However, what if you are creating a specialty concrete mix or specific steel panels that you couldn’t sell to another customer? While your customer may not physically control these items, they do essentially have economic control because it would be very difficult to find anyone else to purchase them.
That’s the primary operational reason why revenue recognition is changing. Transfer of control is deemed to be a better measure of performance than the right to receive the reward or responsibility for the risk. There are other reasons for the change, though from a financial perspective. The Financial Accounting Standards Board (FASB), which sets GAAP in the United States, wants to be on the same playing field with its international counterpart, the International Accounting Standards Board (IASB). The FASB and IASB have been working for a number of years toward a long-term goal of converging their standards. The ideal end result is to improve comparability across countries and markets as the world’s economy becomes more closely linked.
The other goal is to make revenue recognition and financial statements more comparable across industries. There are currently many inconsistencies when comparing construction companies to manufacturers or health care entities or technology companies or . . . the list goes on. You might be asking yourself, “Who cares about comparing companies across industries?” Your primary desire is to understand your competitors in your own industry and be stronger than them. Why should you care about other industries? Here’s why: Users of your financial statements have opportunities every day to invest their capital in your company, in competitors in your industry, or in entities in other industries. The top two users on your list from that perspective are financial institutions and investors. They don’t have to provide you with loans for working capital and equipment or put equity into your company. They can choose a competitor in your own industry or outside your industry who they might view as more stable or more likely to pay a higher return through income and dividends. That’s why this matters. You need capital, and they have it.
While ASC 606 is new and complicated, there are some significant benefits to it as well. Probably the greatest benefit is that it shifts revenue recognition to a principles-based model. Put simply, it allows for greater flexibility to recognize revenue based on your specific situation. You can craft a set of revenue policies that suit your company as long as they fit within the newly broadened principles. It will be necessary to consistently apply these principles to similar situations and then disclose in your financial statements how and why you recognized revenue the way you did.
One more thing: this isn’t just a compliance exercise. The principles of ASC 606 could change how quickly or slowly you recognize revenue, and that can change the bonding, financing, and investing decisions made by others about your company. Because of the potential timing change for recognizing revenue, the timing of your tax payments might change too. Who likes getting a tax bill, especially when it seems to come out of the blue?
What Should We Do?
At first, many entities may believe that ASC 606 will have little applicability to them and will want to brush it off as either something that doesn’t need any attention or can be pushed back until the last minute. That’s not going to be a smart move though. ASC 606 is not likely to be delayed or significantly changed, and the impacts are going to be significant. This article is just the tip of the iceberg.
What should you do now? Call your Wipfli relationship executive to start getting a handle on how this will impact your business. The second call you should make is to your software provider to make sure the software you use can handle ASC 606. You don’t want to be stuck in the office doing this all manually when you should be out getting some work done at a jobsite and earning some cash.