Revenue Recognition Changes Affecting Gov't Contractors

A Global Reach with a Local Perspective

2011
Rocket City
Gov Con
Conference
September 22, 2011

www.decosimo.com

FASB Proposals Affecting Gov‟t Contractors
ROBERT BELCHER, CPA
KEN CONNER, CPA

Agenda
 Overview and scope of the exposure draft

 Core principles and implementation guidance

 Recap of some key changes affecting government
contractors

 Preparing for the adoption of the new revenue
recognition standard

FASB/IASB PROJECTS AND TARGET DATE
2011/2012
2012
Project 3Q 4Q 1H
Balance Sheet - Offsetting F
Consolidation: Policy & Procedures E
Consolidation: Investment Companies E
Revenue Recognition E
Accounting for Financial Instruments E
Leases E
Insurance Contracts E
Emissions Trading Schemes L
Financial Instruments with Characteristics of Equity L
Financial Statement Presentation L
Reporting Discontinued Operations L

F - Final document
E - Exposure draft

FASB-ONLY PROJECTS

Expected Date
2011
Project 3Q 4Q
Disclosure about an Employer's Participation in a
Multi-Employer Plan F
Goodwill Impairment Assessment F
Codification Technical Corrections E
Investment Properties E
Disclosure about Risks and Uncertainties and the
Liquidation Basis of Accounting E
Disclosure Framework D
Disclosure of Certain Loss Contingencies
F - Final document
E - Exposure draft
D – Discussion paper

Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying
Amounts

When Will the Amendments Be Effective?

 For public entities, the amendments in this Update are effective for fiscal years,
and interim periods within those years, beginning after December 15, 2010.
Early adoption is not permitted.
 For nonpublic entities, the amendments are effective for fiscal years, and interim
periods within those years, beginning after December 15, 2011. Nonpublic
entities may early adopt the amendments using the effective date for public
entities.
 Upon adoption of the amendments, an entity with reporting units that have
carrying amounts that are zero or negative is required to assess whether it is
more likely than not that the reporting units’ goodwill is impaired. If the entity
determines that it is more likely than not that the goodwill of one or more of its
reporting units is impaired, the entity should perform Step 2 of the goodwill
impairment test for those reporting unit(s). Any resulting goodwill impairment
should be recorded as a cumulative-effect adjustment to beginning retained
earnings in the period of adoption. Any goodwill impairments occurring after the
initial adoption of the amendments should be included in earnings as required
by Section 350-20-35.

FASB Going Concern Project
 The going concern assumption is fundamental to accrual accounting.
 To assume that an entity will continue in business is to say that the entity
expects to realize its assets at the recorded amounts and to extinguish its
liabilities in the normal course of business. If the going concern assumption
fails, then the amount and classification of assets and liabilities in the
balance sheet may need to be adjusted, with consequences to revenues,
expenses, and equity.
 Among other things, the going concern assumption justifies the current and
non-current classification within the balance sheet, the allocation of costs
over periods benefited, historical cost accounting, and most aspects of the
revenue recognition and matching principles.
 Continuation of an entity as a going concern is assumed in financial
reporting in the absence of significant information to the contrary. Therefore,
going concern is an accounting assumption.
 In other words, the financial statements (which are the assertions and
responsibility of management) should convey this going concern
assumption (or lack thereof).

 During 2007, 2008 and 2009 (no figures for 2010 as of the date this
presentation was prepared), over 3,000 public companies (or about
20% of U.S. public companies) had going concern paragraphs in
their audit report during each year.

 Some people say, “going concern opinions,” but that is not true
because having that paragraph in an audit report does not affect the
opinion on the financial statements. It is an “explanatory
paragraph,” so it should be called, “a paragraph in the report” rather
than a “going concern opinion.”

 It’s not a death sentence. All 3,000 of these companies did not go
out of business since they were classified as a going concern.

 The Financial Accounting Standards Board (FASB) has proposed
changes that would provide guidance on the preparation of financial
statements as a going concern and on management's responsibility to
evaluate a reporting entity's ability to continue as a going concern. It
also would require certain disclosures when the financial statements
are not prepared on a going concern basis, as well as provide guidance
on the adoption and application of the liquidation basis of accounting.
 The FASB proposal states that accounting guidance about the going
concern assumption should be directed specifically to management of a
reporting entity because management is responsible for preparing an
entity's financial statements and evaluating its ability to continue as a
going concern.
 As an auditor, we are evaluating management's assertion about the
entity's ability to continue as a going concern. The consideration of an
entity's ability to continue as a going concern is required in every audit
performed under GAAS, and is an especially important consideration in
the current state of the economy.

TIME HORIZON

 AU §341 states that there is "a responsibility to evaluate whether
there is substantial doubt about the entity's ability to continue as a
going concern for a reasonable period of time, not to exceed one
year beyond the date of the financial statements being audited."
 International Accounting Standard (IAS 1), Presentation of Financial
Statements, requires that an entity consider "all available
information about the future, which is at least, but is not limited to 12
months from the end of the reporting period" when assessing
whether the going concern assumption is appropriate.
 The FASB decided to use the time horizon in IAS 1 because it
avoids the inherent problems that a bright-line time horizon would
create for events or conditions occurring just beyond the one-year
time horizon that are significant and most likely would have to be
disclosed.

Consolidation issues
 Both the FASB and the IASB agreed that the
contractual ability to direct the activities of an entity
arises from having:
 More than half of the voting rights in an entity
controlled by voting rights
 Contractual rights within other contractual
arrangements that relate to the substantive activities
of the entity
 A combination of contractual rights within other
contractual arrangements and holding voting rights in
the entity.

Consolidation issues
 The FASB tentatively decided not to amend its current
consolidation guidance to include the concept of “effective
control,” which is when a reporting entity can have control over
an entity by holding less than half of the entity‟s voting rights.
The assessment of whether a reporting entity has ”effective
control” would have required a reporting entity to analyze:
 The reporting entity's voting or other rights relative to the size
and dispersion of holdings of other vote holders, together with
voting patterns at previous shareholder meetings
 Indicators of power that provide evidence of having the ability to
direct.
 Potential Voting Rights (Options and Convertible Instruments)


2011
Rocket City
Gov Con
Conference

September 22, 2011

www.decosimo.com

Revenue Recognition
Robert Belcher, CPA
Principal

Exposure draft overview
 June 2010 FASB and IASB each issued exposure drafts
entitled “Revenue from Contracts with Customers”
 Benefits:
 Removes inconsistencies in existing standards
 Provides a more robust framework
 Improves comparability across companies, industries and
capital markets
 Simplifies the preparation of financial statements by
reducing the number of requirements
 Applies to ALL entities except for rate-regulated entities
 Comment period June 24 – October 22, 2010, almost
1,000 letters received

Exposure draft status
 Redeliberations were substantially completed at the
July 21, 2011 meeting
 IASB and FASB announced they will re-expose
proposals in Q3 2011 for a 120 day comment period
 Effective date – likely not earlier than annual periods
beginning on or after January 1, 2015; early adoption
probably not permitted

Five Distinct Revenue Recognition Steps
Core principle: Recognize revenue to depict the transfer of
goods or services in an amount that reflects the
consideration that an entity receives, or expects to
receive, in exchange for those goods or services.

Applying core principle:
Step #1 - Identify the contract(s) with the customer
Step #2 - Identify separate performance obligations “SPOs”
Step #3 - Determine the transaction price
Step #4 - Allocate transaction price to the SPOs
Step #5 - Recognize the allocated revenue when SPO
satisfied

Step #1 – Identify the contract(s) with the
customer
Key provision: An entity should apply the proposed
guidance to each contract identified.

Government contractors will need to consider:
 Contract existence i.e. right to receive consideration
and obligations to transfer goods/services
 Combine two or more contracts if certain criteria
met
 Determine if contract modification results in SPO

Contract modifications i.e. change orders
Contract modifications are any change in the scope or
price of a contract.
Treatment of contract modifications:
 Account for as separate contract if modification
results in the addition of a SPO at a price that is
commensurate with that additional performance
obligation.
OR
 Combine the modification with the contract and
reevaluate the performance obligation and reallocate
the transaction price to each SPO.

Step #2 – Identify SPOs
Key provision: Evaluate the terms of the contract and
your customary business practice to identify all
promised goods and services and determine
whether to account for each as a SPO.

 A performance obligation is a promise whether
explicit or implicit in a contract to transfer a good or
service to the customer. You will need to consider
your customary business practices.

Economic units of measure
 Previously the economic unit of measure was the
entire contract but now is the SPOs.
 Likely impact on government contractors is that
more economic units of measure will be identified
(i.e. design phase, construction phase, warranty).
 Identifying SPOs and allocating the transaction price
will require judgment and therefore experienced
personnel familiar with the new standard will be
needed.
 Revenue recognition is tied to satisfaction of SPOs
which may not be directly related to cost incurred;
cost capitalization rules will have an impact.

Separate vs. bundle SPOs
 If more than one good or service is provided, you
will need to make a determination whether to bundle
or separate the performance obligation.
 Account for each promised good or service as a
separate performance obligation only if it is
distinct.
 If not distinct, combine good or service with other
promised goods or services until you identify a
bundle of goods or services that is distinct.
 In some cases, that would result in accounting for
all the goods or services promised in the contract
as a single performance obligation.

Distinct performance obligations
Distinct if either:
1. You regularly sell the good or service separately, or
2. The customer can use the good or service either on its
own or together with resources that are readily available
to the customer.

Exception: If you transfer goods or services at the same time, it
is not necessary to apply the proposed requirements to
each performance obligation separately if accounting for
those obligations together would result in the same
amount and timing of revenue recognition as if they were
accounted for separately.

Step #3 – Determine the transaction price
Key provision: The transaction price is the amount of
consideration an entity expects to receive in
exchange for transferring goods or services to a
customer.

To meet that objective, estimate the transaction price
using one of the following methods depending on
which is most predictive of the amount of entitled
consideration:
 The probability-weighted amount; or
 The most likely amount.
This amount would then be allocated to the SPOs.

Step #4 – Allocate the transaction price
 Key provision: Allocate the transaction price to all
SPOs in proportion to the standalone selling price of
the good or service underlying each performance
obligation at contract inception.

 The best evidence of a standalone selling price
would be the observable price of a good or service
when you sell it separately.

Step #5 – Recognize revenue when
performance obligation satisfied
 Key provision: Recognize revenue when a
performance obligation is satisfied.
 In order to transfer a good or service, the customer
must obtain control.
 Indications the customer has taken control:
 Customer has unconditional obligation to pay
 Customer has legal title
 Customer has physical possession; exceptions
allowed for consignments and bill and holds.
 Design or function is customer specific
 Risk of ownership has passed to customer

Two options for revenue recognition: point in time
or over time

 Identify each performance obligation within a contract
and determine if performance obligation is satisfied:
 At a point in time, or
 Recognize revenue when control of asset is transferred
to customer.
 Over time i.e. continuous transfer.
 Recognize revenue as performance obligation is
satisfied.

Over time i.e. continuous transfer
Recognize a performance obligation over time if:
 Your performance creates or enhances an asset that the
customer controls as the asset is being created, or
 Your performance does not create an asset with an
alternative use to you and at least one of the following:
 Customer receives a benefit as you perform each task;
 Another entity would not need to re-perform the tasks
performed to date if that other entity were to fulfill the
remaining obligation to the customer, or
 You have a right to payment for performance to date
even if the customer could cancel the contract for
convenience.

Over time revenue recognition methods
1. Output method – Recognize on basis of units produced
or delivered, contract milestones or surveys of goods or
services transferred to date relative to the total.
2. Input method – Recognize on basis of efforts expended
to date (cost of resources consumed, labor hours
expended, machine hours used) relative to total efforts
to be expended.
3. Passage of time method – Recognize revenue on a
straight-line basis over the expected duration of the
contract if services are transferred evenly over time
(licenses).

Recap of key concepts
 Fewer contracts may qualify for over time i.e.
continuous transfer revenue recognition. Need to review
contract terms closely.
 You need to meet over time i.e. continuous transfer
requirements to be able to recognize revenue on an
incomplete asset.
 Determine if you must account for change orders as
separate contracts or modifications to existing contracts
(and potentially new SPO).
 The total transaction price is allocated to SPOs based on
relative standalone selling prices.

Recap of key concepts
 Contract cost have been divorced/separated from
contract revenues therefore the new standard will
address accounting for cost capitalization.
 If cost capitalization rules were not added, many
government contractors might incur negative margins in
the early stages of contracts if performance obligation
not yet met.
 Changes to estimated future COST are not recognized
immediately unless you expect a loss on the specific
SPO.

Other significant items in exposure draft
 Warranties

 Account for a product warranty that related to quality
assurance by accruing warranty cost of the time
revenue is recognized rather than by deferring
revenue.
 A warranty is a SPO if:
 Customer has option to purchase the warranty separately
from the vendor, or
 Warranty provides a service to customer in addition to
assurance that the vendor’s past performance occurred as
specified in the contract.

WHAT YOU NEED TO DO
 Apply the proposed standard to your specific
customer contracts to determine the impact.
 It will be challenging to truly know the impact of this
proposed guidance without applying it directly to your
contracts and working through each of the principles.
 Are your current internal controls and operating
systems sufficient?
 Budget and plan for training for your staff
 Remember retroactive application
 Will the new standard impact debt covenants?
 Discuss with your tax preparer.

RESOURCES
 FASB Proposed Accounting Standards Update –
Revenue Recognition (Topic 605)
 FASB In Focus –short 2-page summary of proposal
 FASB website – technical plan and project updates
tab
 AICPA Accounting and Auditing Brief June 16, 2011 -
good information on redeliberation impact on
exposure draft
 Revenue Recognition Guide – Chapter 13 Future
Expectations – Short 13-page summary of exposure
draft however redeliberation impact is not
incorporated

Example – Long-term contract
 An entity enters into a contract to construct a facility or
produce a product for a customer
 Requires engineering (design), procurement and
production activities
 Design is specific to the customer’s requirements and
they are involved in specifying major elements
 The entity procures materials and equipment as they
are needed during production
 Customer obtains control of materials and equipment as
they are installed
 Production is expected to take 3 years

How would the entity recognize revenue?

(Under current GAAP, combine all activities and apply
percentage of completion or completed contract.)

Design services:
Distinct? Yes, contractor regularly sells design services
separately.

When do you recognize? Over time as service is
performed - The vendor’s performance does not create
an asset with an alternative use to the vendor AND the
vendor has a right to payment for performance to date
even if the customer could cancel the contract for
convenience.

Procurement service:
Distinct? No, construction company doesn’t regularly
provide procurement services. Procurement is an activity
that is necessary for the entity to obtain control of the
promised materials and equipment.

When do you recognize? N/A

Construction:
Distinct? Divide into separate performance obligations if
the pattern of transfer of the good or service is different
from the pattern of transfer of other promised goods or
services in the contract, and the good or service has a
distinct function.

When do you recognize? Recognize revenue for each
performance obligation over time or with the passage of
time when it is satisfied.


2011
Rocket City
Gov Con
Conference

September 22, 2011

www.decosimo.com

Leases – The Winding Road Ahead
A Review of Current and Proposed Lease Treatment

KEN CONNER, CPA
Principal

Objectives
 Review of current GAAP related to leases
 Case study on Capital versus Operating Leases
 Current Exposure Draft for Leases –
 What is the objective
 What are they proposing
 How will it work
 Examples of calculations

Leases – Current GAAP
 Capital leases meet one or more of the following
criteria:
 1) The lease conveys ownership to the lessee at the
end of the lease term.
 2) The lessee has an option to purchase the asset at
a bargain price at the end of the lease term.
 3) The term of the lease is 75% or more of the
economic life of the asset.
 4) The present value of the rents, using the lessee's
implicit or incremental borrowing rate, is 90% or more
of the fair market value of the asset.
 Operating leases - All other leases

Leases – Current GAAP
 Lessee’s incremental borrowing rate - The rate that,
at the inception of the lease, the lessee would have
incurred to borrow over a similar term the funds
necessary to purchase the leased asset.
 Interest rate implicit in the lease - The discount rate that, when
applied to (i) the minimum lease payments, excluding that portion of the
payments representing executory costs to be paid by the lessor, together with
any profit thereon, and (ii) the unguaranteed residual value accruing to the
benefit of the lessor, causes the aggregate present value at the beginning of the
lease term to be equal to the fair value of the leased property to the lessor at the
inception of the lease, minus any investment tax credit retained by the lessor
and expected to be realized by him.

Capital or Operating – what is important?
 When does the reader of the financial statements
really care about lease obligations of any type? What
is material?
 15 year building lease that qualifies as operating
 Five year equipment lease that has a NPV of 75%, 80%,
89%
 How is a three year lease obligation different from a
three year note payable?

Why are FASB and IASB Looking at Lease
Accounting
 Leasing is an important source of finance.
 Provides users of financial statements with a
complete and understandable picture of an entity‟s
leasing activities.
 The models also lead to a lack of comparability and
undue complexity because of the sharp „bright-line‟
distinction between capital leases and operating
leases.
 A new approach to lease accounting that would
ensure that assets and liabilities arising under
leases are recognized in the statement of financial
position.

From FASB Exposure Draft Leases - August 17, 2010

General rules

 The right-to-use model, what today we
would term a Capital Lease, – any lease
greater than a year
 Use of the old “Operating lease model”–
all other leases

Lessee Accounting - General
“A lessee would recognize an asset (the right-of-use
asset) representing its right to use an underlying
asset during the lease term, and a liability to make
lease payments. The lessee would amortize the right-
of-use asset over the expected lease term or the
useful life of the underlying asset if shorter. The
lessee would incur interest expense on the liability
to make lease payments.”

• SOURCE: Exposure Draft and FASB LEASE UPDATES
APRIL 2011

Does not apply to -
 Short term leases – defined by FASB at its meeting of June 23,
2011 as, “A lease that, at the date of commencement of the
lease, has a maximum possible term, including any options to
renew, of 12 months or less.” (Emphasis added)
 An entity can elect to treat short term leases on a right-to-use
basis on a case-by-case basis
 “Leases” covered elsewhere in GAAP
 Leases with the right to explore for oil and minerals
 Leases for intangibles
 Leases for biological assets (i.e. timber or agricultural products)

 SOURCE: Exposure Draft, minutes of June 23, 2011 FASB meeting

What would it do?
 (a) A lessee would recognize an asset representing its right to
use the leased („underlying‟) asset for the lease term (the „right-
of-use‟ asset) and a liability to make lease payments.
 (b) A lessor would recognize an asset representing its right to
receive lease payments and, depending on its exposure to risks
or benefits associated with the underlying asset, would either:
 (i) recognize a lease liability while continuing to recognize the
underlying asset (a performance obligation approach); or
 (ii) derecognize the rights in the underlying asset that it transfers
to the lessee and continue to recognize a residual asset
representing its rights to the underlying asset at the end of the
lease term (a derecognition approach).

 SOURCE: Exposure Draft and FASB LEASE UPDATES APRIL 2011

Key Components to Measurement
 Assets and liabilities recognized by lessees and lessors would
be measured on a basis that:
 (a) assumes the initial term of the lease and options to renew if
there is an economic incentive to extend the lease term. (Origin
Exposure Draft included option to renew, “that is more likely than not to occur”, taking into
account the effect of any options to extend or terminate the lease).
 (b) included fixed lease payments, variable payments that are
effectively fixed payment and variable payments tied to a rate or
index. (Original Exposure Draft included contingent payment based on an expected outcome
technique to reflect the lease payments, including contingent rentals and expected payments under
term option penalties and residual value guarantees, specified by the lease).
 (c) is updated when changes in facts or circumstances indicate
that there would be a significant change in those assets or
liabilities since the previous reporting period.
• SOURCE: Exposure Draft and FASB LEASE
UPDATES APRIL 2011

Key Components to Measurement
 Other measurement notes
 Don’t change the interest rate on the original measurement
unless there has been a significant change
 Election of option to renew
 Renegotiation of key lease terms
 The lessee should allocate payments as follows:
 If the purchase price of each component is observable, the
lessee would allocate the payments on the basis of the
relative purchase prices of individual components;
 If the purchase price of one or more, but not all, of the
components is observable, the lessee would allocate the
payments on the basis of a residual method; or
 If there are no observable purchase prices, the lessee
would account for all the payments required by the
contract as a lease.

Example A
 Terms of the Lease –
 Five year triple net operating lease at $48,000 in year
one due on the first day of the month
 Lease payments escalate at 3% per year with no
contingent payments
 Incremental borrowing rate is 7%

Example A
 Record lease value –
 Lease Rights $218,042
 Lease Obligation $218,042
 Entry to record payment in month two –
 Lease Obligation $2,752
 Interest Expense $1,248
 Cash $4,000
 Entry to record „use‟ of lease property
 Lease Amortization - $3,634
 Accumulated Amortization $3,634

Renewal Options
 ED: longest possible term that is more likely than not
to occur
 Changes:
 Options to extend or terminate when there is a
significant economic incentive to extend, or not to
terminate the lease
 Reassess only when there is a significant change in
relevant factors

• SOURCE: FASB LEASE UPDATES APRIL 2011

Transition
 There is no grandfather clause.
 Speculation is that there will be a long lead time to
the effective date- (i.e. 2015).
 Interest rate determined at the date of application.
 Any prepaid or deferred rent at the date of
application included in the amortization of lease
rights.
 Capital leases with no economic incentives to renew
will use the carrying value established under capital
lease treatment.

Consequences
 How will lenders view the change in the short term?
In the long term?
 Raises EBITDA, by adding an interest component
previously imbedded in operating leases
 Raises „debt‟ obligation and debt to equity ratio
 If we know what the numbers are, do the bankers
and lawyers know what the documents say?
 Will it make as much sense to use debt as leases in
the future?

Consequences
 Lowers debt service coverage – increases „debt‟
payments and money available for debt service by
same amount, raising the denominator by a greater
percentage
Existing - Old New Lease Revised Debt
Rule Amounts Service
Available for Debt
Service $4,000,000 $500,000 $4,500,000
Debt Service
Requirement $2,000,000 $500,000 $2,500,000
Debt Coverage
Ratio 2.00 1.80

What is next -
 FASB – intends to release another exposure draft for
public comment before the end of 2011
 Implementation – pending final

Reference Sources
 Lease Update – Most current (September 16, 2011)
 http://www.fasb.org/cs/ContentServer?c=FASBConten
t_C&pagename=FASB%2FFASBContent_C%2FProje
ctUpdatePage&cid=900000011123#decisions
 Original Exposure Draft
 http://www.fasb.org/cs/BlobServer?blobcol=urldata&bl
obtable=MungoBlobs&blobkey=id&blobwhere=11758
21125393&blobheader=application%2Fpdf

Annual Tax Seminar
 Save the Date!
Decosimo‟s Tax Seminar
Nov. 15th
Receive up to 8 hours of CPE
 Find more information online at:
http://decosimo.com/2011taxseminar
 Or See a Decosimo Representative

Connect with me

H. Kennedy (Ken) Conner, CPA
Principal – North Alabama
Development
423.756.7100
kenconner@decosimo.com

On LinkedIn:
http://www.linkedin.com/in/kenconner

Disclaimer:
The contents of this presentation are for informational purposes only. The information is not intended to be a substitute for
professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you
may have regarding your financial goals or specific situations.

CONTACT ROBERT BELCHER

Robert Belcher, CPA
Assurance Principal
robertbelcher@decosimo.com
423-756-7100

DISCLAIMER: The contents and opinions contained in this presentation are for informational purposes
only. The information is not intended to be a substitute for professional accounting counsel. Always seek
the advice of your accountant or other financial planner with any questions you may have regarding your
financial goals.

Revenue Recognition Changes Affecting Gov't Contractors

Recommended

Recommended

More Related Content

What's hot

What's hot (18)

Viewers also liked

Viewers also liked (20)

Similar to Revenue Recognition Changes Affecting Gov't Contractors

Similar to Revenue Recognition Changes Affecting Gov't Contractors (20)

More from DecosimoCPAs

More from DecosimoCPAs (20)

Recently uploaded

Recently uploaded (20)

Revenue Recognition Changes Affecting Gov't Contractors