Implementing the new revenue recognition standard will be complicated for all entities, even when the changes do not present a dramatic change from how entities recognize revenue today, such as the case with the construction industry.
The Financial Accounting Standards Board (FASB) is working to simplify the changeover from the current standard to the new guidance. In the nearly two years since the release of Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), the FASB has made several modifications to the standard to assist with implementation.
The revenue recognition standard will require a five-step model for recognizing revenue from contracts that includes: identifying the contract(s) with a customer; identifying the performance obligations in the contract; determining the transaction price; allocating the transaction price to the performance obligations in the contract and recognizing revenue when or as the entity satisfies a performance obligation. Construction entities should be examining how the five-step model will affect their current reporting while also taking into consideration the recently updated guidance in order to meet the revenue recognition implementation timeline. The following are three areas of the guidance that may require a closer look. For a broader overview of the changes coming your way, please see Top Revenue Recognition Considerations for the Construction Industry.
Changes to Determining Performance Obligations
One of the post-issuance changes affects performance obligations, a step of the revenue recognition standard that will number among the more significant changes from current practice for construction entities. The release of ASU 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing should help make the preparation for the new standard easier.
Identifying performance obligations within a contract occurs in step 2 of the new revenue recognition model. Entities examine the promises to deliver goods or services and determine whether they are separate performance obligations. Promises are considered separate performance obligations if they are for either a distinct good or service (or bundle of goods or services) or a series of distinct goods or services that are substantially the same. Construction contracts such as design/build, engineering, procurement and construction and operation and maintenance will likely contain multiple performance obligations under this new standard.
Revised guidance in ASU 2016-10 clarifies how to evaluate promises. The ASU emphasizes that entities need to evaluate whether the promise is to provide the goods or services individually or if the promise is to provide goods or services that have a combined output. Also included are updated examples and factors entities should consider when determining whether a good or service is separately identifiable to assist in making the determination. The accounting standard update allows entities to forgo the performance obligation assessment if the good or service is immaterial to the contract.
Accounting for Variable Consideration
Another significant change for construction entities from the old model to the new model involves how entities account for variable consideration in the contract price, such as liquidated damages and contract penalty/incentive provisions. Construction contracts often include penalty/incentive provisions that are based on whether a project takes longer than expected or finishes ahead of schedule. These elements must be considered when determining the transaction price. Liquidated damages often affect the ultimate amount of consideration that will be received in exchange for the service being provided and must also be considered when determining the transaction price. If a contractor has a history of incurring contract penalty/incentive provisions or incurring liquidated damages, it may be difficult to justify that such historical experience will not affect the determination of the contract price at the inception of the contract.
When variable consideration provisions exist in contracts, a contractor must estimate the amount of variable consideration to include in the contract price using either the expected value or the most likely amount method. Estimates of variable consideration are required to be reassessed each reporting period, as the assumptions that make up the estimates may change.
Essentially, what the changes mean is that the price agreed upon in the signed contract and as adjusted by subsequent change orders may no longer be an appropriate measure of the transaction price for accounting purposes. Contract penalty/incentive provisions and liquidated damages, as well as others, are examples of variable consideration in the contract price that will have an impact on determination of the ultimate transaction price for accounting purposes.
The new standard requires entities provide qualitative and quantitative disclosures about their contracts that include disaggregation of revenue by category, the transaction price allocated to remaining performance obligations, the pattern of transfer used to recognize revenue and typical payments terms as well as other potential disclosures. Entities must also provide disclosures about any significant judgments used to determine the satisfaction of performance obligations and information about assets recognized from the costs to fulfill the contract.
During its deliberations about the standard, the FASB has considered whether to add a practical expedient for disclosures related to the remaining performance obligations in the contract. The FASB is also looking into whether to add a disclosurepractical expedient for disclosures of variableconsideration that is not included in determining the transaction price. Nodecision has been reached yet, but construction entities should monitor thesituation closely.
The FASB's Joint Transition Resource Group continues to meet as it works through questions related to implementing the new revenue recognition standard. These meetings may result in the identification of additional improvements to Topic 606. We will keep you up-to-date on those changes. For more information, please contact your local MHM professional.
Published on May 17, 2016
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