International Accounting Standards: Revenue Recognition in construction Industry - Essay Example

? International Accounting Standards: Revenue Recognition in construction Industry Introduction The IASB and FASB have been working on producing a new standard on revenue recognition for several years now. One of the industries which have been particularly affected by the uncertainty surrounding the development of the new standard is construction industry and the International Accounting Standard 11 (IAS 11) relating to construction industry is expected to be replaced by the new standard in due course. Bradley Richards is a leading firm of accountants with many clients in the construction industry. The accounting practices adopted by these companies need to be reoriented in the light of these developments. This paper seeks to discuss about the important aspects with regard to revenue recognition in accounting of the construction contracts for updating our clients with the developments in this front. We have outlined the objective of revenue recognition and current practices adopted in the construction industry, the methods used by companies for revenue recognition, the process of development of the new standard, practical issues involved in developing a new standard for revenue recognition underlining its importance and the changes that are expected to be introduced for accounting under the new standard. Understanding of revenue recognition in proper perspective will enable the companies in the construction industry to reorient their accounting practices to fall in line with international accounting standards and IFRS regime. Revenue recognition and current practices The objectives of the IASB and IFRS are: “To remove inconsistencies and weaknesses in existing revenue recognition standards by providing clear principles for revenue recognition in a robust framework” (IFRS, 2013) Under IAS 11 relating to construction contracts, the main accounting issue is concerned with matching contract revenue and contract cost to the accounting period under consideration if the contracts span over several accounting periods. Currently, this accounting standard lays down rules for accounting of construction contracts in the books of construction companies. The standard is applied separately to each contract. For the purpose of this standard, contract consideration should be measurable and it includes the initial contracted amount, variations and escalations in contracts. The cost in this context includes direct cost allocations to the contract as well as apportionment of general costs on some equitable manner to the specific contract. Stage of completion is important in estimating revenue and the associated costs in respect of the completed construction or the portion of the contract completed for the purpose of revenue recognition. If the company is not in a position to reasonably estimate the outcome, the cost incurred during the account period that could be recovered can only be considered. Therefore, in these circumstances the company cannot adopt stage of completion method in accounting of construction contracts. The excess of the cost over and above the revenue relating to the contract shall be recognized as expenses during the accounting period. Under IAS 18, reliable measurability of the benefits that flow to the company is very important. This standard specifies the grounds for revenue recognition and the basis to be adopted for this purpose inter alia in respect of services. However, IAS 11 is applicable if percentage-of-completion method is adopted for revenue recognition and estimates in respect of the contract can be made in a reliable manner during the progress of the contract in the future. Methods used for revenue recognition Under IAS 11 matching contract revenue and contract cost to the accounting period is very important if the contract spans over more than one accounting period. Generally, the companies prefer percentage of completion method in the industries since this method obviates the problem of fluctuations in profits from year to year. Under the completed contract method, profit on the construction contract is deferred till completion. The accrual concept of matching income and expenses in the accounting year for revenue recognition is defeated in this method. Revenue during the accounting period in the percentage of completion method is considered with reference to the completed work during the accounting period. There are several methods to work out the stage of completion or percentage of completion. There are two methods ‘value based’ and ‘cost based’ used by companies in this regard. In the value based method, work completed is calculated as a percentage of the total contract price based on work certified as completed as per terms of the contract or number of units completed as a percentage of total number of units involved in completion of the contract. In the cost based method, cost incurred during the period as a percentage of the total contract cost is considered for revenue recognition. However, when the outcome of the contract is uncertain, companies cannot adopt the stage of completion method for revenue recognition in the construction projects. Accounting under IAS 11 is done on the basis of actual completion during the accounting period. Therefore, if the outcome of the contract is uncertain, profit cannot be recognized. Under these circumstances, the companies can consider revenue only to the extent of costs incurred and recoverable. Development of new standard Important aspects have been considered in Exposure Draft in respect of revenue recognition in the construction industry relating to the projects spanning over several accounting periods. “The Boards have made certain changes from the original ED, which are relevant to the real estate and construction industries.” (Ernst & Young 2011, 1). The Exposure Draft encourages continuous evaluation of the projects and measurements based on cost incurred on the projects. It must be due to the fact that the accounting standard aims at discouraging discretion in the accounting of the contracts relating to the construction projects by the industries with the intention of making the process more reliable and transparent. Disclosure in respect of interim financial statements as decided on October 19, 2011 by FASB/IASB Joint Board is relevant for discussions relating to revenue recognition. (Annexure: I). It could be inferred from the decisions included in the Exposure Draft that the discretion in revenue recognition should be justifiable and based on a scientific basis to avoid disputes and to portray a fair picture of the financial status relating to the company. ‘Maturity analysis’ is a broader term that connotes segregation based on fairness in quantifying the performance obligations relating to the current and subsequent accounting periods. “Revenue is a crucial number to users of the financial statements in assessing a company’s performance and prospects” (IFRS 2013a). Practical issues in developing new standards for revenue recognition The proposals in Exposure Draft are only tentative. These decisions may undergo changes based on discussions at various levels, including communication channels. Accounting standard updates are issued when they become final after a written ballot. This is to ensure that all the stakeholders such as auditors, regulators and users are given an opportunity to express their points of view based on industry specific issues or other practical considerations involved in implementation. Therefore, delay in this process is inherent due to various factors. The FASB/IASB Board has received a large number of comments from various industries including construction industry. The review of these comments is an important responsibility of the board before it issues the final standard on revenue recognition. Revenue recognition is a corner-stone of modern accounting. The institutions take into account all the suggestions and comments for finalization of the new standard. Therefore, the delay involved in issuing final standard is justifiable. This will also avoid complications in implementation. Accounting under new standards The accounting standard is likely to introduce significant changes in accounting of constructions contracts spanning over more than one accounting period. Revenue recognition assumes greater significance in accounting of construction contracts and their reporting in financial statements. This will require changes in the accounting practices currently adopted by companies. According to the Exposure Draft on revenue recognition under new IFRS, conditions to be stipulated in respect of revenue recognition in the case of construction industries vary significantly with the current standard. This will also enhance comparability of the financial performances of the companies in the industry since the financial statements reflect the correct position of the financial performance of companies. Rubin Brown states “There are five key steps to applying the proposed revenue recognition standards.” These are mainly relating to linking contract with the customer, clarity in performance obligations, bases for determining contract price, allocation or apportionment of price and revenue recognition. This is to resolve uncertainties in estimations for establishing percentage of performance during the accounting period. Conclusion For companies which are fully prepared to implement the changes as required under the new standard, transition from the current practices will be smooth and the financial reporting will be made easy. A separate report will be submitted after IASB publishes the long awaited new standards on revenue recognition in due course of time. The financial statements are the main documents for investors to analyze the performance of companies for taking investment decisions. The other stakeholders like employees, suppliers, bankers and tax authorities depend on financial statements of companies for taking various decisions. Various stakeholders expect that the new standard will plug several loopholes in the accounting of construction contracts spanning over several accounting periods and make the financial statements more reliable. Apart from making the financial statements more reliable, the new accounting standard is expected to improve comparability of performances by various companies in the industry. Since the new standard places emphasis on revenue recognition and matching principle of accounting, transparency in accounting and financial reporting will improve considerably which is very important in the backdrop of globalization drive in various countries. References Ernst & Young, 2011. Revised revenue recognition proposals – implications for the real estate and construction industries. ey.com/IFRS, December 2011. http://www.ey.com/Publication/vwLUAssets/IFRS_Developments_for_Real_Estate_Dec11/$FILE/IFRS_Developments_for_Real_Estate_Dec11.pdf FASB, 2011. Summary of Board Decisions. http://www.fasb.org/jsp/FASB/FASBContent_C/ActionAlertPage&cid=1176159037307 IFRS, 2013. FASB and IASB to form joint transition resource group for revenue recognition. 26 July 2013. http://www.ifrs.org/Alerts/ProjectUpdate/Pages/IASB-and-FASB-to-form-joint-transition-resource-group-for-revenue-recognition-July-2013.aspx IFRS, 2013a. Revenue Recognition. http://www.ifrs.org/current-projects/iasb-projects/revenue-recognition/Pages/revenue-recognition.aspx Rubin Brown, 2013. Focus on Construction: Revised Exposure Draft On Revenue Recognition. http://www.rubinbrown.com/resource-center/223-construction/1909-focus-on-construction-revised-exposure-draft-on-revenue-recognition Appendix Annexure - I Revenue Recognition: Summary of Board Decisions The disclosure requirements proposed by the FASB and the IASB for amendment to Topic 270 on interim reporting and IAS 34, Interim Financial Reporting An entity that prepares interim financial statements should disclose in its interim financial statements the following information (if material): 1. A disaggregation of revenue   2. A tabular reconciliation of the movements in the aggregate balance of contract assets and contract liabilities for the current reporting period   3. A maturity analysis of remaining performance obligations   4. Information on onerous performance obligations and a tabular reconciliation of the movements in the corresponding onerous liability for the current reporting period   5. A tabular reconciliation of the movements of the assets recognized from the costs to obtain or fulfil a contract with a customer” (FASB, 2011) Read More