This Practical tip highlights the U.S. GAAP disclosure requirements and considerations relating to changes in contract estimates when using the percentage-of-completion method of accounting.
Companies entering into long-term construction contracts, especially in the aerospace & defense and engineering & construction industries, frequently apply the percentage-of-completion method of accounting under the contract accounting guidance.1 To apply this method of accounting, a company must have the ability to make reasonably dependable estimates of contract revenues and costs, and the extent of progress toward completion.
Contract revenues and costs are estimated in a variety of ways, but a company's estimating process should provide reasonable assurance of its ability to produce reasonably dependable estimates. Estimating is an essential part of contract accounting and revisions to those estimates are necessary as work progresses.
ASC 250, Accounting for Changes and Error Corrections, requires the following disclosures in a company's financial statement footnotes when the effect of revising an estimate is material:
This Practical tip focuses on the U.S. GAAP disclosure requirements and considerations relating to changes in contract estimates when using the percentage-of-completion method of accounting.
The frequency of SEC comments on this topic, predominantly to registrants in the aerospace & defense and engineering & construction industries, continues to increase. The application of percentage-of-completion accounting requires significant estimates, and the changes in these estimates directly affect contract profit margins. The SEC’s comments emphasize the need to provide accurate, transparent, and plain English disclosures of significant changes in the estimates of contract revenues and costs under the requirements of ASC 605-35, Revenue Recognition: Construction-Type and Production-Type Contracts, ASC 275, Risks and Uncertainties, and ASC 250. Over the past several months, many large contractors have enhanced their disclosures to address this trend.
The SEC has commented that the requirement to disclose the impact of significant changes in estimates is not limited to a qualitative discussion or disclosure of only significant adjustments on specific contracts. The SEC has indicated in its comment letters that it would expect, if material, registrants to disclose the impact on income of significant changes in estimates for all contracts in the aggregate. In a number of cases, the SEC has requested registrants to disclose the total amount of gross favorable and gross unfavorable adjustments.
The SEC has requested the following types of disclosures:
Financial statement footnotes
As noted above, companies are required to disclose in annual and quarterly filings material changes in estimates and the related impacts on income and earnings per share. When material, the SEC expects, at a minimum, disclosure of the aggregate net impact of changes in contract estimates on income and earnings per share for each period presented. Companies should also consider disclosure of the aggregate gross favorable and gross unfavorable profit adjustments if such disclosure would be meaningful to an investor. In addition to quantitative disclosures, a qualitative description of the circumstances leading to the adjustments should be provided.
It is important for companies to maintain sufficient and clear documentation to support revisions to estimates and the timing of such revisions. A revision to an estimate should be based on events, facts, or circumstances that occurred during the period in which the estimate was revised.
Companies also should be mindful of changes in estimates subsequent to the balance sheet date but prior to the issuance of the financial statements. These changes should be considered similar to any other change in estimate under the subsequent events guidance in ASC 855, Subsequent Events, and the guidance in ASC 605-35-25-85 on information obtained after the balance sheet date.
Management Discussion & Analysis (MD&A)
The SEC has also requested expanded disclosure of the impact of changes in contract estimates in MD&A pursuant to Regulation S-K Item 303, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Financial Reporting Codification 501.14, Critical Accounting Estimates. For example, the SEC has requested:
Consistent with the requirements for other aspects of MD&A, the SEC expects a discussion of any trends (both past and future) in the profit adjustments arising from revising contract estimates. The SEC has also indicated that disaggregation of these profit adjustments by segment might be necessary, if material.
PwC clients that have questions about this Practical tip should contact their engagement partner. Engagement teams that have questions should contact a member of the Revenue team (1-973-236-7804) or a member of the SEC Services team in the National Professional Services Group.
1 ASC 605-35, Revenue Recognition: Construction-Type and Production-Type Contracts