By Steven Bailey, Business Assurance Director
The new revenue recognition standard became effective for nonpublic entities on January 1, 2019, yet many companies still find themselves struggling with how to apply it. The standard was issued by the Financial Accounting Standards Board (FASB) and can be found within Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers. The struggle is understandable as ASC 606 is considered by many to be one of the most far-reaching pronouncements issued by the FASB in recent memory, and the five-step process prescribed by the new standard for use in evaluating customer contracts is a completely different lens through which management must become accustomed to viewing revenue recognition.
Construction contractors are particularly impacted by this new standard as companies in this industry frequently execute contracts that may span multiple years, include multiple goods and services to be delivered that have been bundled into one contract, and often can include provisions that impact the amount of consideration ultimately received. Further, it is not uncommon for the scope of a contract to evolve over time based on the changing needs and wants of the customer, often significantly. In this article, we present five common issues in adopting ASC 606 that we have encountered in assisting our clients through implementation of the new standard.
Common Issue #1: One performance obligation or multiple?
Construction contracts may include provisions for multiple goods and services to be delivered over the course of the contract. These deliverables need to be evaluated by management to determine whether they should be accounted for as separate performance obligations or as a single unit. A deliverable becomes a separate performance obligation when it is considered to be “distinct” from other goods and services promised in the contract. To be considered distinct, the additional goods and services must have utility to the customer on a standalone basis (that is, they can benefit from the additional goods and services on their own) and the goods and services must be separately identifiable from other promises in the contract. This evaluation can require significant management judgment, and certain contractors will likely be impacted more than others.
For example, contracts including goods and services, such as design / build or engineering, procurement and construction may be more likely to have multiple performance obligations that are distinct from one another.
Common Issue #2: Series of distinct goods and services?
It is not uncommon for contracts to provide for the construction of a series of otherwise distinct goods and services that are substantially the same. If the performance obligations included in the series meet the criteria set forth by ASC 606, they would be accounted for as a single performance obligation. To qualify as a series, each distinct good or service must:
- a. Be a performance obligation satisfied over time; and
- b. Use the same measure of progress toward satisfaction of each performance obligation (e.g., cost-to-cost)
For example, assume a contractor has secured a contract with a university to construct four dormitory buildings to house students. The plans for each building are nearly identical, allowing the construction process to be highly standardized. This scenario would likely meet the criteria set forth above and would be accounted for as one performance obligation, as opposed to four.
Common Issue #3: Change order or a separate performance obligation?
Similar to evaluating promises in the original contract, management must evaluate the nature of contract modifications (e.g., change orders) to determine whether they should be accounted for as a modification to the existing contract or as a separate performance obligation altogether, again requiring significant judgment. Consider a contractor who was awarded a contract to construct a shell building for a developer. During construction, a tenant is identified, and a change order is executed for the tenant build out. Is this change order a new performance obligation or a modification to the original contract? Significant judgment is required by management to determine the treatment, and documentation of such reasoning is crucial.
Common Issue #4: Variable consideration
As an incentive for the contractor to complete a construction project timely and at a high level of quality, it is not uncommon for contracts to include provisions that may contingently increase the amount of revenue ultimately realized on the project. Examples of these items include early completion bonuses, safety bonuses or shared savings clauses. Under ASC 606, these items constitute variable consideration and would need to be estimated and included in the contract price to the extent their realization is highly probable (i.e., there would not be a future reversal of this revenue). The same evaluation would hold true for provisions that could ultimately decrease the amount of revenue recognized on a contract, such as liquidated damages should a contractor deliver a project late. ASC prescribes two methods for estimating variable consideration – the expected value or the most likely amount method – depending on which method better predicts the amount of variable consideration that will be realized.
Common Issue #5: Uninstalled materials
Under ASC 606, special care must be taken by contractors in determining whether to include the cost of uninstalled materials in the calculation of the percentage of completion on a contract (assuming use of an input method to measure progress) as the existence of these costs may not paint the true picture of progress on the contract. Management must evaluate whether to exclude these costs from the measurement of progress if, for example:
- a. Cost incurred does not contribute to progress in satisfying the performance obligation (e.g., wasted or defective materials)
- b. Cost incurred is not proportionate to progress in satisfying the performance obligation (e.g., materials purchased and delivered to the jobsite but not installed)
The bottom line
The application of ASC 606 requires significant management judgment and could have significant impacts on revenue recognition for construction contractors. Companies who are proactive with an implementation plan and involve their CPA in the process are seeing a much less painful transition to ensure compliance with the new standard.
Steven Bailey, CPA, CFE, is a Director in Moore Colson’s Business Assurance Practice. With over 14 years of experience, Steven leads audit and assurance engagements primarily within the construction, transportation, software, technology, and healthcare industries.