Construction Revenue Recognition Changes
Private companies are required to adopt FASB ASC 606 – Revenue from Contracts with Customers effective for years beginning after December 15, 2018. The new standard is over 700 pages long and will require considerable resources to implement properly.
According to a survey conducted by Deloitte & Touche LLP, 47% of private company financial professionals said their organizations had not started the implementation of the new standards or were only in the early stages.
Each company will be required to analyze their contracts and the new standard’s impact on an individual basis. The first step to this process is understanding the new rules and developing a framework to assess the Company’s current contracts. The goal of this article is to provide some guidance to management of these construction firms as they go through this process.
Step 1: Identify the contract with the customer
The most important aspect of Step 1 is to understand that the revenue recognition guidance only applies to contracts with customers that meet certain criteria. If the criteria are not met, it is questionable whether the contract creates enforceable rights and obligations and thus allows for the recognition of revenue.
A practical consideration relates to identifying change orders and how they impact the overall contract. 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. 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. While the change order needs to be agreed to by each party in order to be a valid contract, the exact price does not need to be known at the time. If the price has not yet been agreed to but the scope of work has, the contractor should use its best estimate of the price expected to be received.
Another potential issue related to identification of contracts is Contractors should combine two or more contracts that are entered into at or near the same time with the same customer (or related parties of the customer). They should also account for them as a single contract if the consideration to be paid in one contract depends on the price or performance of the other contract, and the goods and services promised are considered a single performance obligation. Otherwise, contracts should be accounted for on a standalone basis.
Step 2: Identify the separate performance obligations in the contract
The process of identifying performance obligations will vary among different types of contractors. It is possible to conclude that all goods and services in a contract are part of one performance obligation. Before reaching that conclusion, however, the individual goods and services in the contract need to be evaluated to determine whether the contract contains multiple performance obligations.
For example, a construction contractor may enter into a single contract to provide engineering, procurement, and construction (EPC) services. Under the contract, the contractor plans out the design, procures the materials needed for the job, and builds the structure. The contractor needs to consider carefully the nature of the services and how they relate to each other to determine whether each service is distinct. Many construction contracts will involve only one performance obligation, such as a contractor building a new convenience store or a new bridge, installing all of the electrical system in a new building, or replacing the HVAC system in a home. However, some contracts may include a maintenance agreement, such as replacing the HVAC system in a home and providing annual maintenance services for the next five years, which adds another performance obligation. All contracts should be carefully considered to determine whether multiple performance obligations exist.
For some contractors their accounting for warranties may be different under the new guidance. A typical product warranty gives the customer assurance that a good or service meets the contract specifications for the good or service. When a customer has the option of purchasing a warranty and chooses to do so, or when a customer does not have the option of purchasing a separate warranty but the warranty provides an additional service, the new standard requires accounting for that warranty as a separate performance obligation.
Step 3: Determine the transaction price
Under current guidance, this process is fairly simple, as the transaction price is typically explicitly stated in the contract. However, the new guidance introduces the concept of variable consideration and its impact on revenue recognition. Variable consideration includes discounts, rebates, incentives for completing a contract early or on time, penalties for not completing a contract on time, price concessions, and other contingencies. The amount of variable consideration should be estimated and included in the transaction price, but only to the extent that it is probable that the estimate would not result in the reversal of a significant amount of the cumulative revenue recognized for the contract when the uncertainty related to the variable consideration is resolved.
In addition, nonrefundable fees can be a component of the transaction price charged by contractors at the beginning of a contract. If a nonrefundable upfront fee relates to a performance obligation satisfied over time, the fee revenue should be recognized over time as the performance obligation is satisfied; not when the fee is received. For example, the contract may require the customer to pay a nonrefundable fee before the contractor relocates all of the necessary equipment to the job site. That relocation is not considered a separate performance obligation but is part of performing the construction project. Therefore, the nonrefundable fee should be recognized over the period the construction services are performed.
Step 4: Allocate the transaction price to the separate performance obligations
The transaction price is typically allocated to each performance obligation on the basis of the relative standalone selling prices of each good or service in the contract. To accomplish this, the standalone selling price of each performance obligation must be determined and then all the standalone selling prices should be aggregated. The ratio of the amount of each good's or service's standalone selling price to the aggregate is then calculated, and the total transaction price is multiplied by each ratio to allocate the transaction price to each performance obligation. This allocation includes considering whether any discount or variable consideration amount applies to one or some of the performance obligations, rather than to all performance obligations in the contract.
Step 5: Recognize revenue when (or as) each performance obligation is satisfied
This step will be done in a similar manner as it is under current guidance, such as by applying costs incurred to total estimated costs to complete. However, potentially the most significant change for contractors with the new guidance related to the actual recognition of revenue relates to uninstalled materials. Under current guidance, the costs of materials that are not unique to the project, that have been purchased or accumulated at the job site, and have not been installed (referred to as uninstalled materials), are to be excluded from costs incurred for the purpose of measuring the percentage of completion.
The new standard requires adjusting inputs to exclude the effect of any inputs that do not depict the performance in transferring control of the goods or services to the customer. Inputs also need to be adjusted when a cost incurred is not proportionate to the progress. In these cases, it may be necessary to adjust the input method to recognize revenue only to the extent of that cost incurred; that is, do not recognize any gross profit on that cost.
Keiter's Construction Industry Team is committed to helping our clients and other contractors with this implementation phase and in understanding the financial statement and analysis impacts of the new standard.This article is meant to be a brief summary of the new rules. There are many intricacies that will likely arise for each contractor based on the specific terms of their contracts. The most significant changes are around accounting for variable consideration, warranty obligations, and uninstalled materials at job sites. However, while the rest of the rules may result in a similar outcome as the current guidance, the implementation and application of the new rules will follow a different policy. Keiter recommends that construction financial professionals start evaluating the impact of these new rules sooner rather than later, as the reporting impacts will need to be reflected beginning January 1, 2019. Contact your Keiter representative or our Real Estate and Construction Team with any specific questions.
PPC – Construction Contractors 311 Revenue from Contracts with Customers
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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.