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Attention construction industry: 5 new steps that could impact revenue recognition

11-25-2019

by Benjamin R. Bostic

In an ongoing effort to remove inconsistencies in how companies report revenue on their financial statements, the new, revenue-recognition accounting standard requires construction companies to take a closer look at how they recognize contract revenue – and in some cases significantly change back-office procedures.

The standard, developed jointly by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), focuses on accounting for revenue and ultimately, cash flows “to which an entity expects to be entitled in exchange for transferring goods or services to customers”. The objective of the standard is to eliminate differences in revenue recognition within same industries and within those industries, company-by-company. The construction industry will be impacted significantly.

For private companies, ASC 606, Revenue From Contracts With Customers is effective for annual reporting periods beginning after December 15, 2018.

Under legacy GAAP, revenue was recognized when it was realized or realizable and earned. ASC 606, however, recognizes revenue by applying the following five steps:

Step 1: Identify the contract(s) with a customer

Step 2: Identify the performance obligation(s) in the contract (defined as a good or service — or bundle of goods or services — that is distinct)

Step 3: Determine the transaction price

Step 4: Allocate the transaction price to the performance obligations in the contract

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation

 

Additional considerations when implementing ASC 606

Combining Contracts

Legacy GAAP allowed the combining of contracts under certain conditions. Under ASC 606, contracts will be combined when approved around the same time with the same customer; and if they have a single, commercial objective; pricing interdependencies; or the transfer of goods or services constitutes one performance obligation.

For instance, a design-build, construction firm may be required to combine separate design and construction-services contracts depending on facts and circumstances.

Contract Modifications
Contract modifications, including change orders, need to be evaluated individually to determine whether a contract modification constitutes one of the following:

  1. A separate contract
  2. Termination of the existing contract and creation of a new contract
  3. Part of the current contract
  4. A combination of the above

Legacy GAAP treated most contract modifications as part of the current contract.

Determining Transaction Price When Multiple Performance Obligations Exist
Most contracts contain only one performance obligation due to the interconnectivity of goods and services provided. If a contract contains multiple performance obligations, the contractor needs to track each obligation separately based upon each obligation’s stand-alone selling price.

For example, the contract for building a new hospital may also include constructing a parking garage. While part of the same project, the garage is usable on its own. If the contractor determines multiple, performance obligations exist, the contractor should consider separate recordkeeping to track the progress of each obligation. The hospital might sell for $100 million, while the garage could sell for $20 million. If the total, contract price is $110 million, the contractor must allocate the contract price using the performance obligations’ stand-alone, transaction prices.

Accounting for Incentives, Rebates, Bonuses and Penalties
Incentives; rebates; performance bonuses; penalties; and other common, contract variables can affect a contract price. Under legacy GAAP, these variables were recognized when triggering conditions occurred. Now, contractors must factor the likelihood of receiving variable consideration into a transaction price.

Waste and inefficiencies
Revenue recognition calculations now exclude significant inefficiencies, such as re-work or wasted materials. For example, a contractor spends $400,000 toward a $1 million contract, but $200,000 of the amount spent is waste. Under the old standard, the contractor could include the entire $400,000 in the job cost. Under ASU 606, the waste costs are not considered part of the goods and services provided to the client and do not count toward progress in meeting the performance obligation. Because ASU 606 calls for segregation of waste costs, revenue recognition may be delayed.

Uninstalled materials
Recognize procurement of materials and equipment that are significant to the total cost of the contract at zero-margin.

For example, under legacy GAAP, if an electrical contractor purchased a generator that totaled 40% of a contract cost, that contractor could recognize 40% of the contract’s revenue. Under ASC 606, the contractor recognizes revenue equal to cost of the generator. Remaining revenue is recognized over the contract’s term.

Amortizing
Some costs provide little value to the customer – such as trailers rented for the construction site or commissions paid to consultants. For projects exceeding one year in length, these incremental and contract-fulfilment costs no longer count in lump sums toward project completion but are amortized over the term of a contract.

Bottom line

Contractors need to work with their accountants to determine the effects that ASC 606 will have on their companies’ financial-reporting processes and to develop policies and procedures to recognize revenue from contracts with customers according to the new guidance.

Contractors also need to talk with their bonding companies and financial institutions to familiarize them with the anticipated financial-reporting implications of ASC 606.

Contact the financial professionals of Boyer & Ritter to discuss the impact of ASC-606 and the guidance needed to comply with its provisions.

 

 

Benjamin R. Bostic, CPA, is a manager at Boyer & Ritter with experience providing tax and accounting services for individuals, closely-held business and construction industry clients. Reach Ben at 717-264-7456 or bbostic@cpabr.com

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