Engineering & Construction

Engineering & Construction

Construction Accounting
The application of revenue recognition models in the engineering and construction industry

May 2010

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

Executive summary
Companies in the Engineering and Construction industry have a number of different alternatives when applying the current construction contract standard. Those options include selecting a method to calculate percentage of completion (input or output methods) and selecting a method of recognizing revenue, costs of revenue and gross profit (Revenue or Gross Profit method). ASC Topic 605-35-25 (formerly Statement of Position 81-1, Accounting for Performance of ConstructionType and Certain Production-Type Contracts indicates that total estimated gross profit on a contract, or the difference between total estimated contract revenue and total estimated contract cost, must be determined before the income earned on the contract for a period can be determined. The portion of total revenue, costs of revenue and gross profit to date is determined by the measurement of progress toward completion using either an input method (e.g., cost-to-cost, labor hours, labor dollars, machine hours, material quantities) or an output method (e.g., physical progress, units produced, units delivered, contract milestones). Once this "percent-complete" is derived, there are two different approaches for determining revenue, costs of revenue and gross profit; these two methods broadly are referred to as "Alternative A" and "Alternative B." Within the Engineering and Construction industry, these two methods commonly are referred to as the "Revenue method" and the "Gross Profit method." The use of either an input method or an output method to calculate percentage of completion, and the use of either the Revenue method or Gross Profit method to determine the amount of revenue, costs of revenue and gross profit to recognize is a matter of judgment; no one method is preferred. It is acceptable, for example, that certain contracts employ input methods, while others employ output methods for calculating percentage of completion. It is also acceptable that some contracts employ the Revenue method, while others employ the Gross Profit method for recognition purposes. Companies should undertake a thoughtful process, in a well controlled environment, when determining which methods to apply. Company controls must also ensure that selected policies are consistently applied. This paper primarily focuses on the technical guidance, policy elections and accounting for those companies that use a method of calculating percentage of completion other than cost-to-cost (e.g., physical progress).

Revenue method (Alternative A)

Under the Revenue method, revenue, costs of revenue and gross profit are determined as follows: a. Revenue to date is computed by multiplying total estimated contract revenue by the percentage of completion. 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. Downward revisions of percent-complete may cause a reduction of revenue in the period such revisions are made. b. Cost of revenue to date is computed by multiplying total estimated contract cost by the percentage of completion on the contract. 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. The difference between total cost incurred to date and cost of revenue to date (if any) is reported on the balance sheet. 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). If total contract costs exceed total contract revenue, the expected loss should be recognized as an expense as soon as the loss becomes probable. c. Gross profit on a contract for a period is the excess of revenue over the cost of revenue.

Gross Profit method (Alternative B)

Under the Gross Profit method, revenue, costs of revenue and gross profit are determined as follows: a. Revenue is the amount of gross profit earned on a contract for a period plus the costs incurred on the contract during the period. Downward revisions of percent-complete may cause a reduction of revenue in the period such revisions are made. b. Cost of revenue is the cost incurred on a contract during the period, 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. If total contract costs exceed total contract revenue, the expected loss should be recognized as an expense as soon as the loss becomes probable. c. Gross profit earned on a contract is computed by multiplying the total estimated gross profit on the contract by the percentage of completion. 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.

Advantages and Disadvantages - Revenue method

The primary benefit of the Revenue method, and the reason why this method is favored among many companies in the Engineering and Construction industry, is because this method best reflects the "matching concept." That is, the measurement of extent of progress towards completion is applied equally against both contract revenues and contract costs. Accordingly, any difference between actual contract costs incurred and the calculated cost of revenue is accounted for as "work-in-process" on the balance sheet. Many entities prefer this for contracts that have an element of learning curve (i.e., costs incurred early in the contract that benefit the totality of the contract). In situations where there are no changes in estimates during the performance of the contract, this method produces a consistent gross profit percentage from period to period. The primary disadvantage, however, 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.

Advantages and Disadvantages - 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.g., direct materials, labor, and subcontractors) should be the cost of revenue reported during the period. That is, because such incurred costs can be objectively determined and do not depend upon estimates, no amounts should be recognized on the balance sheet. Entities that favor this approach, therefore, believe that recognizing a consistent gross profit percentage may be inconsistent with the true economics of the contract as it is being performed. The primary disadvantage, however, is that gross profit percentages will vary from period to period, unless the cost-to-cost method is used to measure the progress towards completion (see Appendix A).

Industry perspectives
As both the Revenue and Gross Profit methods are acceptable alternatives, there is no one preferred approach within the Engineering and Construction industry. Likewise, as the use of either an input or output method to derive the extent of progress towards completion is acceptable, 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. For example, using publically available information for selected large-cap construction companies, approximately 70% of these companies primarily use the cost-to-cost method. When using cost-to-cost to determine percent-complete, there is no difference in the recognition of revenue, costs of revenue and gross profit between the Revenue method and Gross Profit method (see Appendix A). While some companies in the Engineering and Construction industry do use output measures to derive the extent of progress towards completion, this approach is more often seen in production-type contracts used in the Aerospace and Defense industry. In the performance of production-type contracts within the Aerospace and Defense industry, 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). Some companies believe costs incurred prior to the effect of the learning curve benefit the entirety of the contract and, therefore, believe matching revenues with costs is most reflective of the underlying economics of the transaction. For this reason, some contractors in this industry prefer the use of an output measure to derive percent-complete and the Revenue method to recognize revenue, costs of revenue and gross profit.

Insight* Under the Revenue method, costs deferred as an asset on the balance sheet are subject to impairment testing in accordance with existing asset impairment standards. Any impairment charge generally would be recorded in cost of sales and appropriately disclosed.

Selecting a policy
When selecting a policy to determine percent-complete or a policy for recognizing revenue, costs of revenue and gross profit (i.e., Revenue method or Gross Profit method), 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. No one method is preferred and there are a number of potential alternatives to consider. Accordingly, it is possible that an entity could develop more than one policy for assessing percent-complete and recognizing revenue, costs of revenue and gross profit. For example, an entity may use, for a grouping of similar contracts, physical progress to calculate percent-complete and apply the Revenue method for recognition purposes. Conversely, for a different group of contracts, an entity might use physical progress to calculate percent-complete and apply the Gross Profit method for recognition purposes. It is critical that an entity ensures that groups of contracts with similar characteristics employ consistent methods. For example, a company may enter into a contract to drill 20 wells in an area in which no drilling previously occurred. Accordingly, the company expects actual drilling costs per well to decline over the life of the contract due to a normal learning curve (i.e., costs incurred early in the contract benefit the totality of the contract). 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. If the Company then entered into a new contract to drill 50 wells in an adjacent location, the company may expect the actual costs per well to be constant (i.e., no learning curve because the previous experience is included in the cost model). 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. So, 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. From there, companies should analyze those contracts to determine characteristics of the groupings to which the policy will be applied. Examples of such characteristics might include labor intensive contracts and contracts with learning curve. Finally, 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.g., input or output) and the method used to recognize revenue, costs of revenue and gross profit (e.g., Revenue method or Gross Profit method). Making these accounting policy elections is a process that likely would extend far beyond the traditional accounting function. Leveraging input from operational planning, engineers and financial professionals is critical to ensuring that all of the relevant characteristics are considered when grouping similar contracts. The policy decision process should be subject to the Company's normal internal control procedures.

Preferability
Once a company selects its accounting policies, they must be applied consistently when accounting for similar events and transactions. An entity that wishes to change an accounting policy must justify that the allowable alternative accounting principle is preferable. As described in ASC 250-10-45-12, "a method of accounting that was previously adopted for a type of transaction or event that is being terminated or that was a single, 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, costs of revenue and gross profit, it must be applied consistently to similar contracts, unless a company can justify a change on the basis of preferability.

Insight* Either the Revenue method or Gross Profit method is acceptable so long as the policy chose is applied on a consistent basis. We believe that the assessment of consistency must be performed on a contract-bycontract basis. That is, an entity should ensure that similar contracts employ consistent methods. It is acceptable, for example, that certain contracts employ the Revenue method, while others employ the Gross Profit method. Further, it would not be appropriate to change methods while a contract is in-process.

Appendix A
Example 1: A construction company enters into a contract with a customer to build 20 wells over the next five years. Because of learning curve efficiencies, the actual cost of production decreases over the contract. The company uses physical progress to measure percentage-of-completion. Calculate the income statement and balance sheet at the end of Year 1 under alternatives A (Revenue method) and B (Gross Profit method). 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, there is no change in the company's estimated cost of the contract at completion.

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, while margin dollars are consistent between the Revenue method and Gross Profit method, margin percentages are not. Assuming there is no change in estimates, margin percentages under the Revenue method will remain at 20% period to period, while margin percentages under the Gross Profit method will vary period to period.

Example 2: Assume the same fact pattern as Example 1, except that the company uses the cost-to-cost input method to determine percentage-of-completion. Compute revenue, 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 % ($9.5m / $47.5m) Work in process ($38m-$38m) 23.75% $47.5 million $38 million $ 9.5 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 % (9.5m / $47.5m) Work in process ($38m-$38m) 23.75% $47.5 million $38 million $ 9.5 million 20% $ 0 million

Insight* This example demonstrates that when using the cost-to-cost input method, there is no difference in the amount of revenues, cost of revenues or margin (percentage or dollars) recognized between the Revenue method and Gross Profit method.

Where can I get more information?

PwC US Engineerinig & construction industry website http://www.pwc.com/us/en/industrial-products/engineering products/engineering-construction.jhtml Visit our website to download our thought leadership publications for the engineering and construction industry, free of charge. Also, learn more about the E&C issues that our global network of functional and industry professionals specialize in to help address client needs. Upcoming PwC industry sponsorship CFMA 2010 Conference The Construction Financial Management Associations (CFMA) annual conference and exhibition serves as a premier source of information concerning all aspects of construction financial management. PwC is a proud to sponsor the 2010 CFMA conference, which will be held on June 26-30 26 in Kona, Hawaii. In addition to leading ading a panel discussion that will focus on surety industry trends, concerns, and issues, we will be hosting a client dinner on the evening of June 29, , 2010, 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. Hope to see you there! Corruption orruption prevention in the E&C industry

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Engineering and construction industry contacts H. Kent Goetjen

US Engineering and Construction Leader Phone: 1-860-241-7009 Email: h.kent.goetjen@us.pwc.com

Joseph P. Dunleavy
Partner - Assurance Houston, Texas Phone: 1-713-356-4034 Email: joseph.p.dunleavy@us.pwc.com

Daniel Zwarn
Partner - National Office Phone: 1-973-236-4571 Email: dan.zwarn@us.pwc.com

Michael Matthews
Director - Advisory Houston, Texas Phone: 1-713-356-4615 Email: michael.f.matthews@us.pwc.com

Michael Sobolewski
Senior Manager - National Office Phone: 1-973-236-4975 Email: michael.sobolewski@us.pwc.com

Michael Collier
Halliburton Global Engagement Partner US Energy M&A Leader Houston, Texas Phone: 1-713-356-8133 Email: michael.collier@us.pwc.com

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Information contained in this document comes primarily from ASC Topic 605-35-25 and the AICPA Audit and Accounting Guide for Construction Contractors