Each year, the AICPA issues an audit risk alert for the real estate and construction industry that tells financial statement auditors about a variety of challenges and opportunities that might impact their audits. Not only is this a great tool for auditors, but management at real estate and construction firms may also find the topics of interest. Here are the top items covered in the alert that companies will likely be addressing in the near future.
Revenue recognition
Maybe the hottest topic in the construction financial reporting realm right now is revenue recognition. Although the new accounting standard won’t be effective for non-public companies until 2018, or later — based on the recent FASB vote to propose a one-year deferral — it’s important to start planning for its effects now.As the name indicates, adopting the new standard may result in changes to how revenue is recognized, and most companies will have significant new disclosure requirements. Specific areas that may result in changes to how revenue is recognized include contract modifications, separate performance obligations, and variable contract prices.
Not sure where to start? First, determine how the new standard will affect your business activities and contracts. Second, set a goal for implementation, considering the length of your typical contracts. It’s important to note that the standard must be applied retrospectively for all contracts in process at the beginning of the year when the standard goes into effect. Finally, determine if changes to project management, job costing, and accounting software are necessary. Some companies have even considered modifying their standard contract terms based on the resulting accounting treatment.
Other accounting changes (and leases!)
The alert covers six additional new accounting pronouncements that could impact real estate and construction companies; each has a fairly narrow focus: service concession arrangements sometimes found in “P3” contracts, investments in qualified affordable housing projects, mortgage restructuring by creditors, discontinued operations, development stage entities, and collateralized financing entities. However, there’s a pending accounting change that will have a much more significant and widespread effect, which is the long-running leases project.We know—these much-talked about lease changes have been on their way for years. We have reason to believe, however, that a proposed change to lease accounting will be issued sometime in 2015 and would affect both lessees and lessors.
Under the proposed changes, lessees would account for essentially all leases in the way capital leases are currently treated, eliminating the distinction between operating and capital leases. This is a significant change and will likely have a significant impact on the industry. For lessors, however, the leases would either be accounted for like current sales-type or direct-financing leases or like current operating leases. Therefore, they likely won’t be impacted as severely. Under the proposed changes, lessees would account for essentially all leases in the way capital leases are currently treated, eliminating the distinction between operating and capital leases. This is a significant change and will likely have a significant impact on the industry. For lessors, however, the leases would either be accounted for like current sales-type or direct-financing leases or like current operating leases. Therefore, they likely won’t be impacted as severely.
Leases in effect as of the date of transition would have to be accounted for based on the new standard in order to provide comparable statements. An effective date for the proposed change hasn’t been established but it is expected to be in 2018, or later for non-public entities.
Economic factors to consider
For the construction industry, the alert cites decreased margins as the number one economic risk. “As a result of recent economic difficulties,” reads the alert, “new work is being obtained at margins only beginning to mirror pre-recession levels. As backlogs of pre-recession jobs dry up, contractors will be running much leaner with respect to both revenues and margin.”Interestingly, this is somewhat inconsistent with what we’re seeing with our clients. Volumes and profits are already increasing significantly. As companies are suddenly getting an influx of new work, the challenge becomes finding skilled people to perform that work. Some companies take on work they don’t have the ability to perform, which is a significant risk. It’s also important to exercise diligent supervision over subcontractors, meaning that even though a contractor may be staffed appropriately, a subcontractor may not—opening up the contractor to undue risk.
For the real estate industry, the alert warns of risks related to debt, specifically debt modifications and covenant issues. While we’ve certainly seen an improvement in the overall real estate market, there remain some troubled assets out there. In addition to distressed debt situations, debt modifications may also arise out of an improved financial standing and negotiating position with lenders. There are various financial reporting ramifications to watch out for if this arises (as well as a tax impact, but that’s a topic for a different article).
For more information on these or other challenges facing the real estate and construction industry, please give us a call. We’re happy to help.
