By Keiter CPAs
Revenue from Contracts with Customers – Other Accounting Items
Article 1 in a 3 part series
Adopting the new revenue recognition standard, FASB ASC 606 – Revenue from Contracts with Customers, may pose numerous challenges for engineering and construction contractors. To assist you in understanding and adopting the new standard, Keiter will take a deeper dive into the key areas relevant to engineering and construction businesses through a series of three articles.
It is important to have a thorough understanding of the five-step process for determining how and when to recognize revenue. A reference to this five-step process can be found in a previous article, “New Revenue Recognition Standard: Construction Industry Impact”. In addition to understanding the five-step model, engineering and construction contractors should also consider other accounting impacts, such as combining contracts, contract modifications, and variable consideration, among others.
Under previous guidance of FASB ASC 605, the combining of contracts, or segmenting an individual contract, was optional as long as the criteria was applied consistently to contracts in similar situations and with similar characteristics. However, FASB ASC 606 requires contracts to be combined and accounted for as a single contract when certain criteria are met. The criteria include combining the contracts if (1) two or more contracts are entered into at or near the same time with the same customer; or (2) if the consideration to be paid in one of the contracts is dependent upon the price or performance of the other contract(s); or (3) the goods and services that are promised in the contracts are considered a single performance obligation. If these criteria are not met, the contracts should be accounted for on a standalone basis.
Also under FASB ASC 606, the term segmenting contracts is no longer used. Revenue is now recognized at the performance obligation level instead of at the contract level, unless the contract is in itself a single performance obligation.
Under FASB ASC 606, accounting for revenue from contract modifications has changed. Whether goods and services are distinct, not distinct, or a combination thereof will determine the approach for accounting for contract modification revenue.
- If the change adds goods and services that are distinct from those provided before the modification, the change is accounted for as a new contract that replaces the original contract. The sum of the original consideration not yet recognized plus additional consideration from the modification is allocated to the remaining performance obligations. (Thomson Reuters/PPC)
- If the change adds goods and services that are not distinct from those provided before the modification, the change is accounted for as if it were part of the original contract. The transaction price is updated for the modification, along with re-measuring progress to completion, and a revenue adjustment is made on a cumulative catch-up basis to increase or decrease the amount of revenues recognized to date. (Thomson Reuters/PPC)
- If the changes adds some goods and services that are distinct and some that are not, the change is accounted for as a mix of new and modified contracts based on the guidance above. (Thomson Reuters/PPC)
- It is worth noting that modifications to the scope of the contract and/or pricing typically are not recognized until all parties in the contract have approved the change. The exception is that if all terms, except the price, have been agreed upon by the contractually obligated parties then the transaction price should be estimated by the contractor as variable consideration to the extent it is probable that the final agreed upon price will not require a significant reversal.
As discussed in Step 3 of the aforementioned five-step revenue recognition process, an estimate of the variable consideration is now included in determining the transaction price. In determining this transaction price, there are two straight forward ways outlined by the guidance – expected value method or most likely amount method:
- The expected value method is to be used if there are numerous possible outcomes in relation to the amount of the variable consideration. As the name suggests, the expected value method applies a probability to each of the possible outcomes to determine the amount.
- The most likely amount method is to be used when there are only two possible outcomes. This method uses judgment to determine the most likely outcome. However, there is a gray area, in which using the most likely amount method is allowable in a situation with more than two possible outcomes. For example, a contractor may receive a bonus of 3,000 dollars for finishing a month early, 1,000 dollars for finishing a week early, or no bonus if finishing at the deadline. The most likely amount method is allowable, if it is determined to be the best method in this situation.
It is important to keep these accounting items in mind when implementing the new revenue recognition standard. For more information on all of the significant changes to the revenue recognition process, please contact your Keiter representative or a member of Keiter’s Construction Industry Team | Email | Call: 804.747.0000
Engineering and Construction Revenue Recognition Impact Series:
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About the Author
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.