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2. Tax and revenue recognition update CFMA Central VA Chapter November 13, 2014 Presented By: Kevin Branner, CPA, Principal Chris Frye, CPA, Manager Construction Industry Services Team Yount, Hyde & Barbour, P.C.

3. Kevin Branner, CPA, Principal is the Leader of Yount, Hyde & Barbour’s Construction Industry Services Team. He has been with the firm for 23 years, where he began his career after receiving a bachelor’s degree from Randolph-Macon College. Kevin is the immediate past president of the Central VA chapter of Construction Financial Management Association, as well as past president of the Construction Industry CPAs/Consultants Association. He is also active in the following construction trade associations: ABC, AGC, ASA, and NAHB.

4. Chris Frye, CPA, is a Manager in YHB’s Construction Industry Service Team. Chris joined Yount, Hyde and Barbour, P.C. in 2004 after graduating from Virginia Tech. During his time with the firm, he has focused his efforts on providing audit, review, compilation and tax services to clients in a variety of industries, including construction and real estate. Chris also specializes in assisting clients with strategic performance management, including the implementation of dashboards and overall process improvements. He is also active in the following construction trade associations: ABC, AGC, ASA, and NAHB.

5. disclaimer Any tax advice contained in this presentation is not intended or written to be used, and cannot be used for the purpose of avoiding penalties imposed by the IRS or any other state or local jurisdiction. This presentation is for educational purposes and should not be construed as tax or legal advice.

6. summary Revenue Recognition Standard Affordable Care Act Update Tax Update (or lack thereof) Questions

7. Revenue Recognition under the new Guidance

8. Revenue Recognition – The Future has Arrived FASB Accounting Standard Update No. 2014-09 Revenue from Contracts with Customers (Topic 606) • Standard applies to all transactions which relate to and include: • Contract • Customer • Terminology has changed – first step is to gain understanding of the new language of revenue recognition

9. Revenue Recognition – The Future has Arrived New Terminology Performance obligation Transfer of “control” Contract asset Variable consideration Constraint Distinct Transaction price Onerous contract

10. Taking your Crutch Away • Industry guidance from SOP 81-1 will no longer be relevant. • Decisions relative to revenue and, to some degree, costs will be guided by the principles of ASU 2014-09. • The FASB expects industry practice guidance to be developed but it will not be under the authority of the FASB. • AICPA has formed multiple industry groups to address and modify current audit and accounting guides – these will not be GAAP unless designated by FASB. • Engineering and Construction Task Force • Possible additional guidance resulting from FASB/IASB deliberations with Revenue Recognition Transition Resource Group

11. Much of the Future Will Not Change Most construction contracts will have revenue recognized at the contract level Percentage of completion will be the method used Cost to cost is an acceptable input method for determining the percent complete Loss accrual in current practice will not change

12. Core Principle An entity should recognize revenue to depict the transfer of promised goods, or services, to customers in an amount that reflects the consideration to which the entity expects to be entitled, in exchange for those goods or services.

13. Five-Step Process

14. Core Principle and Five-Step Process Basic Observations • On the surface the five step process does not seem overly complex and arguably, it appears to include much of what is currently done to determine revenue recognition. • However, each of the five steps will require significant judgments by management and auditor in applying the underlying principles included in the new guidance. • The transfer of “control” to the customer becomes the driving issue in evaluating the appropriateness of revenue recognition under the new guidance. • Currently, the evaluation of “risk and reward” often drives the determination of revenue recognition. While it remains an important consideration, it is no longer determinant under the new guidance.

15. Step 1 - Identify the Contract with the Customer Issue 1. Change Orders (including unpriced change orders) • Current Standards – • Change orders are accounted for as a modification of the original contract. Current standards provide 3 different methods to time measurement and recognition. • Change orders with agreement on scope but no agreement on price are accounted for under claim recognition guidance. • New standard guidance is “Contract Modification” • Determination of whether the change order is a new contract, a new performance obligation that is distinct, or a change in the original agreement [JUDGEMENT] • The conclusion regarding the above will change timing of recognition, presentation, and possibly disclosures • May require evaluation under new “Variable Consideration” standard [JUDGEMENT]

16. Contract Modification • A contract modification exists when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract. • Examples of potential contract modifications – • Approved change orders • Unapproved change orders • Field directives • Liquidated damages • Equitable adjustments • Claims • Follow-on contracts

17. Contract Modification – Separate Contract • There are two paths to consider when evaluating the accounting related to a modification. • An entity shall account for a contract modification as a separate contract if both of the following conditions are present: • The scope of the contract increases because it results in the addition of promised goods or services that are distinct, [JUDGEMENT]and • The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods and services and any appropriate adjustment to that price to reflect the circumstances of the particular contract. (The construction industry lacks observable standalone pricing data.) [JUDGEMENT] • This standard may require certain change orders to be accounted for as if they are a separate contract. • Software may need revision so it facilitates combining of jobs for certain reports that are treated separately for revenue recognition • Sureties will want to see the combined effect of all contracts under a single surety bond

18. Contract Modification – Separate Contract • How will this standard impact recognition & reporting? • The separate contract from the contract modification will require consideration whether it contains more than one performance obligation that is distinct • The separate contract will require separate accounting tracking of costs, billings, and revenue recognition • The separate contract will be reported separate from the original contract on the contract schedule • If the job is bonded, the surety will have to combine the contracts to monitor their exposure • It is likely that tax reporting will not qualify for separate reporting and book/tax timing differences can arise.

19. Contract Modification – Existing Contract • If a contract modification is not accounted for as a separate contract, an entity shall account for the promised goods or services not yet transferred at the date of contract modification in whichever of the following ways is applicable: • An entity shall account for the contract modification as if it were a termination of the existing contract and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. [JUDGEMENT] • Rare for the construction industry • An entity shall account for the contract modification as if it were part of the existing contract if the remaining goods or services are not distinct, and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. • Catch-up accounting for the revised contract and percent complete

20. Step 1 - Identify the Contract with the Customer Issue 2. Claims • Current standards • Four conditions precedent to recognize claim revenue • Not carried into the new standard • Pre-resolution revenue recognition limited to costs incurred • New standard - guidance is “Contract Modification” • Determination of whether the claim is a new contract, a new performance obligation that is distinct, or a change in the original agreement. [JUDGEMENT] • The conclusion regarding the above will change timing of recognition, presentation, and possibly disclosures. • May require evaluation under new “Variable Consideration” standard • May require evaluation under new “Financing” standard • Margin can be recognized if estimated recovery exceeds costs

21. Step 1 - Identify the Contract with the Customer Issue 3. Combining Contracts • Current standards • Allows combining contracts but rules based criteria are very difficult to satisfy. • New standard • Two or more contracts entered into at or near the same time with the same customer (including contracts with parties related to the customer) are combined and accounted for as one contract if one or more of the following conditions are met: • The contracts are negotiated as a package with a single commercial objective • The amount of consideration to be paid in one contract depends on the price or performance of the other contract • The goods or services promised are a single performance obligation

22. Step 1 - Identify the Contract with the Customer Issue 3. Combining Contracts • Combining standard conditions changed from “may” to “will” which will require more activity in assessing whether combining is appropriate • Guidance creates more opportunity to measure multiple contracts in a single step. • Goes against surety separate risk on single projects but this third-party risk is not part of the criteria for combining. • Will require evaluation including proper treatment when multiple contracts with a single customer exist. • Note that the decision to combine contracts occurs before the evaluation of performance obligations. • Note that these standards are similar but not identical for tax qualifications for combining contracts which will lead to more book/tax timing differences

23. Step 2 - Identifying Performance Obligations • Current practice evaluates “profit centers” which typically are the entire contract. • A performance obligation is a promise in a contract with a customer to transfer to the customer either: • A good or service (or bundle of goods or services) that is distinct. • This is the standard that permits multiple performance obligations to be bundled and reported on a total contract basis – same as current practice. • A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. • Generally explicit but may also include promises that are implied by an entity’s customary business practices, published policies or specific statements, if at the time of entering into the contract those promises create a valid expectation of the customer that the entity will transfer a good or service to the customer.

24. Distinct • A promised good or service is considered distinct if both of these conditions are met: • The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct). • [JUDGEMENT] This assessment requires the contractor and its auditor to understand the customer’s business and capacities • The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the good or service is distinct within the context of the contract). [JUDGEMENT]

25. Distinct • Determining whether the good or service is “distinct within the context of the contract” is a critical aspect of identifying the performance obligations. Factors that indicate that an entity’s promise to transfer a good or service to a customer is separately identifiable include but are not limited to: • The entity does not provide a significant service of integrating the goods or services into the bundle of goods or services that the customer has contracted for. • Most construction contracts will include an integration of a bundle of services. • The good or service does not significantly modify or customize another good or service promised in the contract. • Most construction contracts will include modification or customizing. • The good or service is not highly dependent on, or highly interrelated with, other goods or services promised in the contract. • Most construction contracts will be dependent and interrelated with other goods or services.

26. Distinct • If a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. • In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation. • The construction industry will likely adopt a practice that the presumption is that the goods or services are not distinct and are therefore combined and the contract is reported as a single performance obligation — unless there is evidence to the contrary. • Each contract will be required to be evaluated.

27. Possible contracts with multiple PO • Contracts that provide both services and product • Design/Build contract • EPC contracts • IDIQ contracts • Contracts with separate deliverables • Add-on change orders

28. Step 3 - Determining the Transaction Price • The transaction price is the amount of consideration that an entity expects to be entitled to in exchange for transferring promised goods or services to a customer. Issues that impact the determination of the transaction price include: • Variable consideration • Constraining estimates of variable consideration • The existence of a significant financing component in the contract • Non-cash consideration • Consideration payable to a customer • Materials provided by the customer

29. Variable Consideration • Often, part of the contractual consideration related to a good or service is variable in nature or contingent on future events. (not an all inclusive list): • Unapproved change orders • Unpriced change orders • Performance bonuses — signing bonus, early completion, savings sharing, etc. • Project performance terms • Unit pricing • Economic price adjustments • Latent defects • Claims • Discounts • Refunds/Rebates • Royalties

30. Variable Consideration • An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled: • Expected value – the expected value is the sum of probability weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics. [JUDGEMENT] • Most likely amount – the most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of an amount of variable consideration if the contract has only two possible outcomes. [JUDGEMENT]

31. Step 4 - Allocate the Transaction Price • The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer. • To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation in the contract on a relative stand-alone selling price basis. • Relative selling price is best evidenced by the observable price of a good or service when sold separately in similar circumstances and to similar customers. • If a stand-alone selling price is not directly observable, an entity shall estimate the standalone selling price. [JUDGEMENT]

32. Step 5 - Recognize Revenue as Performance Obligation is Satisfied • An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. [JUDGEMENT] • Control of an asset refers to the customer’s ability to direct the use of and obtain substantially all of the remaining benefits from the asset. Indicators that a customer has obtained control are as follows: • The entity has a right to payment for the asset. • The entity transferred legal title to the asset. • The entity transferred physical possession of the asset. • The customer has the significant risk and reward of ownership. • The customer has accepted the asset.

33. Performance Obligation Satisfied Over Time • An entity transfers control of a good or service over time and satisfies a performance obligation and recognizes revenue over time if one of the following criteria are met: • The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. • The entity’s performance creates or enhances an asset (WIP) that the customer controls as the asset is created or enhanced. • The entity’s performance does not create an asset with an alternative use to the entity and the entity has a right to payment for performance completed to date.

34. Measurement of PO Satisfied Over Time • Similar to current practice – Percentage of Completion • Output measurement • Units of delivery or production • Milestones • Generally create audit challenges • Input measurement • Cost to cost • Labor – cost or hours • Measurement should be reflective of transfer of control of the asset to the customer. • Zero margin in early stages of completion is acceptable

35. Change to PCM Model • Current standards • Method A • Revenue, costs and gross profit recognized based on percent complete • Method B • Gross profit recognized based on percent complete. Revenue equals costs incurred plus gross profit recognized • New standard • Revenue for performance obligations satisfied over time is recognized on percent complete • Costs are recognized as incurred • Gross profit is the difference and may not be equal to estimated gross profit times the percent complete

36. Changes in Cost to Cost Timing Uninstalled costs • Current standards – • Uninstalled materials that are not modified for the specifications of the contract are excluded from costs incurred in the PCM calculation. Effectively, revenue is recognized equal to the cost of the uninstalled materials. • New standard • If including the cost of uninstalled materials are significant in relation to total contract costs – [JUDGEMENT] • Excluded from cost to cost PCM measurement • Revenue recognized equal to costs incurred (zero profit method) at the time control is transferred to the customer

37. Changes in Cost to Cost Timing Exclude costs that do not contribute to performance • When a cost incurred does not contribute to an entities progress in satisfying the performance obligation [JUDGEMENT] • Wasted materials • Significant inefficiencies in the entities performance that were not reflected in the contract price • Owner provided materials • Excluded costs are treated a period costs • Will these be reflected in the contract schedule?

38. Disclosures • Disclosures • The objective of the disclosure requirements (Topic 606) is for an entity to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. • The disclosure requirements found in the new revenue recognition guidance are significantly in excess of what is currently required under U.S. GAAP.

39. Disclosures • Disclosures • An entity shall disclose qualitative and quantitative information about all of the following: • Its contracts with customers • The significant judgments, and changes in the judgments made in applying the guidance in Topic 606 to those contracts • Any assets recognized from the costs to obtain or fulfill a contract with a customer

40. Disclosures • Disclosures • Contracts with customers • Disaggregation of revenue • Contract balances • Performance obligations • Transaction price allocated to the remaining performance obligations • Significant judgments in the application of the guidance in Topic 606 • Determining the transaction price and the amounts allocated to performance obligations • Practical expedients adopted

41. Preparing for the Change: Next Steps

42. Next Steps • Effective Date of Adoption (Public Entity) • For a public entity, the amendments in Topic 606 are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. • Early application is not permitted.

43. Next Steps • Effective Date of Adoption (Nonpublic entities) • The amendments in Topic 606 are effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. • A nonpublic entity may elect to apply the guidance in Topic 606 earlier, however, only as of the following: • An annual reporting period beginning after December 15, 2016, including interim periods within that reporting period (public company effective date) • An annual reporting period beginning after December 15, 2016 and interim periods with annual periods beginning after December 15, 2017 • An annual reporting period beginning after December 15, 2017, including interim periods within that reporting period

44. Next Steps • Transition • The FASB has allowed two methods for transition: • Retrospectively to each prior reporting period presented. • Practical expedients provided • Retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial adoption. Certain disclosures are required: • The amount by which each financial statement line item is affected in the current reporting period by the application of Topic 606 as compared to the guidance that was in effect before the change. • An explanation of the reasons for significant changes.

45. Next Steps • Transition and Implementation • What do sureties expect? • What do bankers expect? • What do investors expect? • What are your peers likely to do?

46. Next Steps • The impact from the adoption of the new revenue recognition standard will likely be complex and far-reaching and involve many different functions within an organization. • Information systems may require adjustment. • Standard contracts and other sales agreements should be evaluated in light of the changes. • Sales incentives/commissions should be considered. • Internal control processes may need updating. • Executive compensation arrangements • Debt covenants • Tax Implications • Software enhancements to support

47. Next Steps • Transition and Implementation • Start early. With the long “on-ramp” that FASB has allowed for, it is easy for entities to get lulled into a false sense of security. Large public companies with three-year P&L presentations face the most time pressure. • Consider the use of an implementation team (financial and operations) approach working with auditors and/or professional advisors. • Watch for further education opportunities from the FASB Revenue Recognition Implementation Group. • Watch for guidance from AICPA • Follow CFMA publications, conferences and webinars

48. Affordable care Act update Effective dates. Am I an applicable large employer? What are my responsibilities? Reporting requirements. What should I do now?

49. ACA Effective Dates Employer mandate and potential shared responsibility payment is effective in either 2015 or 2016. 2015 if 100 or more full-time equivalent employees. 2016 if 50-99 full-time equivalent employees. No responsibility if less than 50 full-time equivalent employees.

50. Am I an applicable large employer? Calculation must be done based on prior calendar year to determine if the 100 or 50 FTE threshold is exceeded. A full-time employee is any employee who averages 30 or more hours per week or who works 130 or more hours in a month. Must also determine full-time equivalent portion of part-time work force. In initial year, FTE’s can be determined based on any six consecutive month period from the prior year. Seasonal employee (less than 120 days) exception. Cannot use subsidiaries or create new entities to fall under the threshold. IRS “controlled-group” rules apply.