Who is complaining about POC accounting?
One of the frequent criticisms the revenue recognition project has received in the past few years is that the proposed new standard would change revenue recognition in areas that do not seem to pose any problems today. One example of that is the construction industry, where the proposed new standard has the potential to change revenue recognition significantly. Interestingly, in all of my time working on this project, the only criticism I heard about percentage-of-completion (POC) accounting came from board members who described how a construction contract can be presented as profitable as long as there is still one dollar of profit expected on the contract. But once that one dollar of profit disappeared, the contract was written down for a sizable and unexpected loss, as if the contract had just fallen off of a cliff. The concern was that there was very little information about how poorly the contract was performing until it was too late.
Although we heard this criticism often from some board members, this was not a common complaint from any other sources. I thought it was particularly noteworthy that we never heard such complaints from people actually working in the construction industry or analysts and investors in that industry. I’m not saying that some wouldn’t have agreed with this concern, but we so rarely heard complaints from preparers and users in that industry that I often wondered why this concern consumed so much of our staff time and seemed to motivate so much of the model we were creating.
To look into this a little bit more, I decided this morning to read through a few of the comment letters that have responded to the recent FASB/IASB exposure draft. The comment deadline is Oct. 22, so we can expect to see many more letters submitted in the next few weeks. But let me post a few excerpts from submitted letters that address concerns from the construction industry.
One letter is from Michael F. Greer, Vice-president of Surety and Fidelity of Penn National Insurance. Penn National provides surety bonds for construction companies, so they have extensive experience reviewing financial reports of construction companies and assessing the risk that a company will fulfill its contracts. Here’s some of what Mr. Greer has to say:
In our opinion, the new methods proposed are so unworkable, that it would be our company’s position that we would not accept a financial statement on this new method. So in order to obtain surety credit a contractor would have to have the CPA still provide us with a Percent complete basis statement, which may or may not be in accordance with GAAP under the new methods. The contractor’s Bank would more than likely require a GAAP basis statement. So in effect, the contractor will now have to pay for two sets of financial statements rather than one.
I understand that the goal of this effort was to create one unified method of accounting across various industries and countries. While that might be helpful to some industries, I suggest that a better alternative is that each Industry has a unified method of accounting. There needs to be recognition that there are major differences from one industry to the next. It does not make sense for every industry to have to be the same.
Most importantly however needs to be the recognition that the purpose of financial statements is to provide the users of the statements with information on which they can make decisions. If knowledge is lost just for the sake of having one set of rules, that would be a mistake and no one would be better off.
As you can see, Penn National Insurance company voices a strong opinion against modifying the requirements of POC accounting for the construction industry. He follows these statements up by asking the boards to scope construction contracts out of the proposed new standard.
Another letter, this one from David H. Rhodes and Steve Pate from Insco Insurance Services (also a provider of surety bonds to the construction industry), the authors highlight the longstanding and proven practices of POC accounting in SOP 81-1:
SOP 81-1 has provided a consistent standard of reporting revenue and income for construction contracts for almost three decades. It is a well established industry standard, and the percentage of completion method is imbedded [sic] in our company’s analytical approach, underwriting training, and information systems. We feel that the new standards proposed by the Board will lead to less consistency in revenue recognition under construction contracts, and could increase the opportunity for profits reported to be “managed” by selection of differing revenue recognition methods for different construction contracts underway for the same contractor.
Again we see a strong opinion that nothing is wrong with POC accounting. There are probably 10+ other letters (out of 35 so far submitted) from construction companies, many of the form letters expressing the same concerns. All of these make me wonder whether the proposed new standard should just leave well enough alone or whether the Boards and staff have been successful in educating construction industry constituents about how little would actually change under their proposed standard.
One final letter, this one from Allan Korsakov of Baker Concrete Construction, Inc. In his letter, he forcefully argues:
In my reading of the Exposure Draft, the Boards came across are [sic] being rather dismissive of industry by industry nuances. Perhaps not enough consideration has been given to the validity of the “one-size-fits-all” approach. If one takes all the animals in the zoo and dresses them up in the same school uniform, they may all be animals, may all be in the same zoo and, so dressed, may all superficially bear a little more resemblance to one another, but they all remain uniquely different animals. We have to be careful to avoid mandating one size which fits none. We are not oblivious to the dangers of granting exceptions to individual industries. But from a practical point of view, we really don’t care how every other industry managers their business. Construction is a universal activity with many similarities in many different countries, but I would maintain that the construction industry is uniquely different from most other industries. The management of construction companies, their financial preparers, the users or [sic] their financial statements and even the accountants that audit them are all specialists in their field. The same is true from the perspective of many other industries as well. From a practical point of view, none of us really need to know how the other industries manage their affairs.
A few paragraphs later in the same letter, after describing in detail some of the complexities that are unique to the construction industry, Mr. Korsakov continues:
Given this greater level of complexity, we respectfully disagree that the stated goals of the Boards are best served by the cursory dismissal of the concerns expressed in the Construction Financial Management Association comment letter dated June 19, 2010. A few needed tweaks notwithstanding, SOP 81-1 works pretty darn well thank you very much.
So, who is complaining about POC accounting, and are the complaints important enough to warrant the significant changes that many in the construction industry expect from the newly proposed revenue standard?