Is construction accounting headed for a troublesome shake-up? A proposed new rule aimed at aligning financial reporting by construction firms with other industries could bring sweeping changes to long-held, generally accepted accounting principles. Critics warn the new rule could significantly raise administrative costs, open the door to financial manipulation and dampen surety credit.

The Financial Accounting Standards Board (FASB), which is the designated private-sector organization in the U.S. that establishes financial accounting and reporting standards, and the International Accounting Standards Board have released a draft standard to create a single revenue-recognition standard across multiple industries, including construction.

“The idea is to provide better information to users of the financials,” says Prasadh Cadambi, a practice fellow working on the standard at FASB. “We want to create a single model, rather than multiple models for the same economics.”

The draft standard, which was released in June, is open for public comment until Oct. 22. Directions for submitting comments appear at www.fasb.org.

Some observers suggest the recently announced departure of FASB Chairman Robert Herz, who will leave his post on Oct. 1., could cause a delay in the adoption of any new standard. Still, even critics admit that new rules are on the horizon.

“It is very likely a new revenue standard will be put in place, and revenue recognition for construction will change,” says Jerry Henderson, a partner with accountant BKD and member of the Construction Financial Management Association, Princeton, N.J. “There is still open dialogue on this, so what the final standard would be is hard to say.”

“It is very likely that a new revenue standard will be put in place and revenue recognition for construction will change.”

— JERRY Henderson, partner, BKD

Critics warn that this one-size-fits-all approach will erode accounting principles that are specifically tailored to the construction industry. For decades, contractors have used a percentage-of-completion method for revenue recognition. Based on the percentage of completion, proportionate revenue and earnings can be determined.

Under the proposed rule, contractors would be required to recognize revenue using a series of performance obligations. For example, the contractor might classify utility work as one obligation and structural work as a separate obligation. The net effect is that a project covered under a single contract today could be split into multiple performance obligations, essentially acting as individual contracts on a job.

Henderson says that by breaking up performance obligations, FASB is introducing considerable subjectivity into the process. For example, if two companies were each hired to build an identical freestanding store for a national retailer, one company might decide the job should be broken into two parts, while the other company might see it in six parts.

Differing Judgements

The new latitude granted to contractors in how they recognize revenue could lead to chaos—and deception. For example, a contractor could choose to put 40% of the revenue in the first obligation, while another might decide to put 20% percent in the same obligation.

“What this does is open the door for significant manipulation that doesn’t exist in the revenue model today,” Henderson says, adding that contractors could intentionally accelerate profitability to improve a company’s financial statements.

With such a subjective range of choices, the new process could have a dampening effect on surety credit, says Darrin Weber, president of IMA of Texas, a Dallas-based risk consultant and surety bond broker. “Surety companies will be more suspect of the numbers because more judgment is in play,” he adds. “If there’s more suspicion, less consistent numbers or less credible numbers, the sureties are likely to move much slower and ask more questions.”

Although the new standard would be required for reporting, many contractors could continue to follow the existing percentage-of-completion method. While accountants could learn the new standard 

...critics say getting management and other staff to adopt the new performance obligation method is unlikely. As a result, a company could be forced to keep multiple sets of books.

“Percentage of completion is logical,” says Steve Lords, chief financial officer of contractor Martin Harris, Las Vegas, and a member of the FASB Private Company Reporting Committee. “It makes sense to contractors.”

If the change were adopted, Lords says, “our company would continue to keep books during the year on percent- complete accounting, then have to pay some horrendous fee of something like $50,000 to have it converted at the end of the year.” Further, companies could incur added administrative costs, such as hiring additional accounting staff. Lords says new software would be needed, too. “If you make this kind of change, the software out there wouldn’t be able to do it,” he adds.

Pressures After Scandal

The draft standard is the latest step by FASB to overhaul financial reporting standards. In the wake of financial scandals involving companies such as Enron and Tyco, some observers say the Security and Exchange Commission has pressured FASB to “keep a clean house, or we’ll clean it for you.”

In defense of FASB’s proposed changes, Cadambi notes that providing a model that is reflected across multiple industries would be particularly helpful for investors. “An investor in multiple companies would want a consistent [reporting] model across all industries,” he says. “If someone is following a technology stock or a product stock or a construction stock, everyone would know that the same standard is being followed.”

Under the proposed changes, each performance obligation would be treated as an economic unit of measure, meaning some obligations on the same project could carry losses while others might show a profit. There would be other big changes. For example, some performance obligations might not qualify for percentage-of-completion accounting. Today, percentage-of-completion accounting applies to the entire contract.

One of the most interesting—or scary—aspects of the proposed rule is that change orders might be considered new performance obligations.

In a highly fragmented industry that predominantly comprises small businesses, the benefit would be limited, says Lords. “There are very few public companies in this industry,” he says. “This is a big change for an industry [in which] the vast majority of companies are private.”