The Power of Illusion

ASC 606.  While I think it can be a very useful tool in some situations, like with condominium and homeowner associations, I am not convinced that it will help a reader, an investor, anywhere else.  That is because it is almost uniformly built on the concept of management choice – which sadly can lead to poor decisions that ultimately hurt investors.

In a perfect world, I think the concept of ASC 606 is inspiring.  Finally, a reader can see what has been committed to and what prices will end up being paid.  What a great way to predict a company’s ability to generate future cash flows.  But that isn’t what is going to happen. I have seen enough at my end of the spectrum to know that anytime subjective measures are involved, those impacted want the measures skewed in their direction.  And something like ASC 606, which almost completely makes determining revenues subjective, simply is going to take this to a new level.

This reminds me of an attest engagement on a contractor.  The contractor stated that they had a maintenance contract which runs for 12 months with options to extend an additional 12 months and 6 months.  No problem.  We though.  We asked for the contract, the controller hemmed and hawed.  Why?  She put the information into the disclosure so there must be a basis for its inclusion.

Apparently not.  It seems that the customer is not so thrilled and has expressed that they won’t extend the contract.  But there is a catch.

The customer is also the ultimate customer on several other contracts.  It seems that the customer accounts for about 60% of the revenues for this company and when this contract goes, there is about a 99.8% chance that the other contracts are not renewed and new contracts won’t be awarded.

This all came to a head when we questioned the fade, or loss of gross profit, over contracts.  Long-term contracts are handled on the guesstimate method.  We use the “objective” measure of actual cost incurred in relationship to the guess of total estimated costs.  The total estimated cost is management’s choice, its illusion, which drives not only gross profit recognized but also the percentage of completion.

We identified a problem.  The fade, or the loss of gross profit over time, on contracts was starting to become noticeable.  The graph shows what we noticed:

fade analysis

The gross profit percentage ends up remarkably lower over time.  There is really only one reason for this, the inability to estimate accurately.  Notice that all fade is in excess of 5 basis points, the smallest fade being 7 points on project ABC.  If this were a $10,000 project, that wouldn’t be a big issue but it is their second largest contract.  And worse, you can see that on one job they estimated an increase in gross profit in year two only to have it plunge to a net contract loss of 5%.

GP Fade

I know I know, the point.

The problem is that they estimated their new contract, the one likely not to get extended at 45% gross profit.  The trend though, is clear: Gross profit fades lower consistently over time.  The trend indicates to us that the project will end up at 30% overall.  The project AAA is recorded at 5% complete which means the company has recorded over $100K of gross profit.  The trend says that, at best, they have earned $67K.

But wait, there’s more.

Since the original estimated cost in year one is too low, this changes the percentage of completion.  Not a lot, but enough.  The true fade, after revising the percentage of completion is

true fade.png

Huge.  So huge, in fact, that it can’t be ignored.  It totals out to about $375K of gross profit incorrectly recognized in earlier years.

Of course, our concern is not really those older contracts, it is the new one, the one which is likely not to be extended.  It is our concern that current gross profit is overstated by about $50K AND it is likely that this contract won’t be reupped and that there will be no future contracts with this customer.

With the loss of this customer, revenues will drop 50%.  Given the fade problem from poor estimates, the company has not had the gross profit it envisioned on these projects which has forced it to borrow heavily to meet its operating needs during the end phase of these projects.  The borrowing, by the way, is from both the bank and the new projects with higher initial gross profit that will ultimately fade away.

Since we are independent CPA’s attesting to the financial statements, we are held to the standard that we think the company in question can continue as a going concern for at least one year from the date of our report.  We ran several different scenarios, none of which succeed in changing the trajectory.

I would like to say there was a happy ending.  I guess in a way there was.  Management, the sole owner, decided to terminate our engagement.  The next year, the owner filed for bankruptcy.  The bank never got is independent accountants’ report by the way.  They didn’t call the loan and ended up with over a $500K loss due to the reorganization.

It is tempting to believe that management wants accuracy and objectivity in its reports.  But as with estimated costs to complete, ASC 606 is open to management’s very subjective and capitalistic approach.  Management is responsible for

  • determining what makes up a contract with a customer
  • selecting at least one (and possibly only one) performance obligation
  • Allocating the contract price over the performance obligations
  • Determining when the performance obligation is complete so that the price can be recognized

These all have similar requirements – management’s ability to use good judgment.  And much like with contract estimates under old GAAP, it will be well-nigh impossible for an independent CPA to challenge management’s assertions, until it is too late.

 

Impact of New Accounting Standards on Condo Associations Chapter 1.

During our weekly meetings, we identified the upcoming changes to revenue recognition codified in ASC 606 could likely be a significant disruption for community associations and how they report activity.  Currently, condominiums and HOA’s follow the guidance provided in ASC 972-605 for reporting revenues.  Beginning in 2020, this industry specific guidance goes away and associations will need to follow ASC 606 Revenues from Contracts with Customers.

The first thing to understand is that ASC 606 will apply to associations.  Associations enter into contract agreements with their unit owners which state that unit owners will agree to provide resources to pay for the expenses incurred for the common good.  Since it is an agreement between the parties it is considered a contract.  Since you have identified the existence of a “Contract”, the next big question is, “Now what?”

First, it depends on whether you identify a single contract or n number of contracts where n represents the number of units in your association.  Our take on it right now is that there is a single contract between the association and its unit owners.  We believe this is conceptually correct as the unit owners, as a group, vote to ratify the budget.  Plus we believe it fits since the association has a single contractual purpose which is to maintain the common elements.  But you can see that, right off the bat, there is a basis for a disagreement.

We believe the next step would be to record the following transaction once the budget is approved and ratified:

Owner Contract Asset                   $XXX,XXX
Unearned Contract Revenue                         $XXX,XXX

This identifies that the association expects to receive, as payments from the unit owners as the party to the contract, a certain amount to address the expenditures to maintain the common elements.

I can see the confused looks.  It’s ok, we understand.  Think about it this way:

Your association has a fiscal year which begins January 1 and ends December 31.  In November the board passes a budget for $250,000 in assessments.  The owners meet and ratify the budget on December 1.  Because the association passes the budget for the annual cycle, it is creating the claim for the contract which begins January 1.  Since it won’t begin to perform work until January 1 the association would not recognize the revenues until that date.  Never-the-less, because the final step of the contract, its ratification, happened in December, we believe it is appropriate to record the transaction as stated above on the date of ratification, even though it is clearly not effective until January 1.

On a practical basis, what this means is that your management company should be changing its account structure and its memorized transactions – ASSUMING you want your manager to report the association’s accounting information in accordance with GAAP.  If you want to follow some other accounting principle, well this blog is not for you.

What does this mean to you as a board? That the issuance of a paper statement, a coupon book, a web portal, no longer dictates when something is revenue.  All these items do is determine the timing of when payments are received.  What you will be most focused on, as a board, is this series of transactions

Owner Receivable                       $XXX
Owner Contract Asset                         $XXX

Followed by this when payment is received:

Operating Bank Account         $XXX
Owner Receivable                             $XXX

We will delve more into this over the next 10 days, but the key takeaway today is that your association will still invoice unit owners when you want payment and the money will still be deposited to your bank.  How and when it is recognized as revenues will be independent of the billing.

Obviously, even at this point you can see where there could be lots of opportunity for confusion.  We have always been taught that it is revenue when invoiced.  While I can prove that this is hardly ever the case, it is what has been treated as truth for as long as I can remember.  And moving away from this will require boards and management to think long and hard about the process.

Next up: Performance Obligations for associations – No more “Net Income” on your Management Reports.

Have a great weekend.  If you have questions or would like to participate in a discussion about how ASC 606 will impact community associations, feel free to email me for an invitation to our next webinar on the subject.

 

Debit This, Credit That, isn’t that Accounting?

Sometimes all you can do is simply stare at a speaker and wonder what is going through his mind.  “Accounting says you have to debit receivables and credit revenues.”

Um, no.

Accounting makes no such claim.  Effective accountants (and auditors) know that often earning revenues is divorced from demands for payment.  Demanding payment is a contract right – your attorney might require a retainer, your roofer wants a deposit, you want to be paid for the feet of pipe laid; but none of these are revenues. Yet.

Accounting is about reporting the economic substance of a transaction.  Accounting has to look for features which support the premise that the efforts necessary have been expended and accepted by the buyer in order to record revenue.  It doesn’t have to be hard, but it does have to be consistently applied.

Take for example, that piping contractor.  Let’s say he has a contract to

  • Dig a 1,000 foot ditch for $20/foot
  • Lay 1,000 of 24″ concrete pipe at $18/foot
  • Backfill and compact the trench for a lump sum of $8,000

The contract requires that the contractor submit a schedule of values (work completed) in order to be paid.

On the first billing, the contractor submits the schedule for the 1,000 feet of ditch dug for $20,000.  The effective accountant does not immediately do this for the invoice:

  • Accounts Receivable       $20,000
  •     Contract Revenues                         $20,000

That is because the rules for recognizing revenues is not based upon something as arbitrary as a schedule of values.  The smart accountant understands that the true measure of the revenue for a contractor is based upon an analysis of costs expended to actual anticipated costs.  So the accountant creates a little spreadsheet:

Anticipated Period Actual
Contract Revenue Costs Gross Profit Costs % Complete Revenue Billings Over/Under CIE BIE
ABCD     46,000   35,000          11,000   6,500 18.57%       8,543   20,000          11,457     –   11,457

The Company incurred only $6,500 of costs in the period.  This represents less than 20% of the total anticipated costs for the project.  The reality is, the contractor front-loaded the bid.  This is perfectly acceptable – provided the owner accepts the schedule of values and is a great way to get project funds in early.  But, GAAP says to recognize the contract’s revenue based on the relationship between actual costs incurred and the estimated total costs to complete.

In this case, only 18.6% of the project costs were incurred so really only 18.56% of the contracts revenues are earned.  The remainder is considered unearned revenues or, in construction accounting parlance, Billings in Excess of Costs and Gross Profits.  The accounting principle is called the percentage of completion method of accounting for long-term construction contracts.  The rule says that the form – the schedule of values – is not the appropriate measurement for recording revenues: The comparison of actual to anticipated costs is the appropriate basis for recording revenues.  Economic substance over the form.  $8,500 not $20,000 for revenues.

Accounting is more than debits and credits.  That is, assuming you need to know what is actually happening economically in an enterprise.  Most non-employee investors in a business should be thinking about the true substance of transactions and how they impact today’s profits and tomorrow’s cash flows.  Revenues and profits generate true cash flow, not the other way around.  The effective accountant knows this is far more important than debits and credits.

 

How Small Business Can Apply GAAP Successfully

There are two big GAAP changes coming up that could have a major impact on small business if decision makers do not start thinking about the issues.  These are changes to lease accounting and the new revenue recognition standards.  The lease accounting is probably the more challenging of the two, as I will hopefully explain below.

New Lease Standards

The new lease standards will challenge every small business who needs access to capital and where the money people want GAAP financial statements.  So, if you are even thinking of going public or taking on substantial bank debt, you need to think about implementing the new lease standards.

The new lease standards now require you to record an asset and a liability as though you bought the asset on a contract.  You then amortize (depreciate) the new asset over the lease term.  This is substantially different from old GAAP which handled leases off balance sheet – meaning payments were treated as an expense in the period incurred.  The commitment for the lease was then reported in the disclosures.

Obviously, the kicker here is that you will now have additional debt on your books which did not exist before.  And like all debt, the current portion, that amount due in the next twelve months, is considered a current liability.  So businesses with tight current ratios (say 1.1:1.0) and an affirmative covenant to maintain a current ratio of 1.0:1.0 may find themselves out of compliance.  Noncompliance is a default condition.

So, if you are thinking about leasing equipment you may want to reconsider this approach IF GAAP statements are a business requirement.

Recognizing Revenue from Service Contracts

This is a major rewrite for GAAP but is probably will not have a huge impact on most small businesses.  Yes, conceptually the issue exists, but most small businesses do not have agreements with customers which extend for long periods of time.  But, where your business does have an ongoing customer relationship where money is changed hands intermittently and service is on-going, then you will want to start looking at this ASC.

The biggest change is realizing that billing a customer no longer drives revenue.  For QuickBooks users, this could cause problems.  As an example, lets say your business enters into a maintenance contract which runs for twelve months.  You agree that the client gets up to 20 hours of on-call service plus a 5 hour preventative maintenance visit monthly.  The on-call hours do not roll-over and you charge $100 per hour for any hours over 20.

Historically, you know that your clients use about 300 hours additional during the year and you anticipate that this new client will be the same.  The new ASC, ASC 606, would require you to anticipate this when you recognize revenues.

What is happening is that we are separating out the revenues from what customers are going to pay.  This separation is a good thing, even though it may not seem like it.  But anyone who has ever worked with contractors and percentage of completion will understand this concept.  Billings are the offset to the accounts receivable and costs and gross profit on contracts is the offset to revenues.  The separation will make almost all businesses with contractual relationships with customers record revenues similar to contractors.

This is because we are moving into a transfer of control (knowledge, ability, compute cycles, etc.) instead of transfers of products.  Stores will likely continue their accounting the way they used to; unless they have after-sale service offerings.  Then, this will become a little more complex but still somewhat like what you are already doing.  But you need to start analyzing your processes now to see what can remain the same and what you need to change – assuming GAAP is required.

If you have questions or would like to discuss how the new accounting standards might impact your business, make sure you talk with your CPA.  Or, if you would like some help understanding what is about to happen, feel free to contact me with your questions.  We are here to help.

Have a great day.