The new revenue recognition standard has been issued, and as the Financial Accounting Standards Board (FASB) finalizes implementation guidance, your company should prepare for the effect the standard will have on accounting and reporting revenue under construction contracts.
Construction companies face unique considerations with the FASB's Accounting Standard Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). One of those considerations is adopting a new vocabulary for various terms that have a deep-rooted understanding in the industry, terms such as percentage of completion and change orders. New terms such as performance obligations, contract modifications, distinct, bundle, series, constraint and integration service will need to be learned and understood in order to apply the new standard correctly. Readying for the standard, which is effective for non-public entities for annual periods beginning after December 15, 2018, will require a full-team effort. Certain changes are complex, and your organization should use the time to adjust its processes and approach to contracts in order to meet the new requirements.
The new guidance defines a contract as an agreement between two or more parties, implied or written, that creates enforceable rights and performance obligations. Subsequent modifications to a contract generally will be considered part of the original contract unless the modification is determined to be a new contract. Typical contract modifications for the construction industry include change orders, field directives, liquidated damages, equitable adjustments, claims and follow-on contracts as well as others.
Modifications constitute a new contract when the modification adds promised goods or services that are distinct from the original contract and are priced as if they were being sold separately.
Unlike current U.S. generally accepted accounting principles (GAAP) where combining two or more contracts that meet specified criteria is optional, the new standard requires entities to combine two or more contracts for financial reporting if one of the following is met:
- The contracts are negotiated as a package with a single commercial objective
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract
- The goods or services promised are a single performance obligation
Identifying Performance Obligations
Performance obligations in the new standard resemble deliverables in current revenue recognition accounting. They consist of promises within a contract to transfer a good or service to a customer. Typical construction contracts contain a number of promises/deliverables, which creates the possibility of multiple performance obligations.A promise, or a group of promises, becomes a separate performance obligation when it is distinct from the other goods or services being provided in a contract. A promised good or service is considered distinct if the good or service has utility to the customer (i.e., the customer can benefit from the good or service) and the promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. Promised goods and services that do not meet the definition of distinct must be combined with other goods and services promised in the contract until a bundle of goods and services is identified that meets the definition of distinct.
The bundle concept should result in identification of a single performance obligation and revenue recognition measured at the contract level for a majority of construction contracts. However, each contract must be evaluated. For example, contracts that promise delivery of goods and services (e.g. design/build; engineering, procurement and construction (EPC); contracts with operation and maintenance) are more likely to have multiple performance obligations that are distinct from one another.
A series of distinct goods or services in a contract that are substantially the same can be accounted for as a single performance obligation. The series concept does not exist in current U.S. GAAP. To qualify as a series, each distinct good or service must be a performance obligation satisfied over time and the same method must be used to measure progress toward satisfaction of each performance obligation (e.g. cost-to-cost, units/quantities installed, labor dollars/hours incurred, etc.). Entities must use the series concept where applicable.
Your organization should monitor the FASB's activity with revenue recognition closely. The FASB is working on several elements to clarify performance obligations under the new standard. If the proposed changes are approved, more construction contracts could be accounted for as a single performance obligation.
Variable consideration is a concept that will affect substantially all types and forms of construction contracts. Common examples of when construction entities will encounter variable consideration include unapproved change orders, unpriced change orders, performance bonus/penalty, schedule bonus/penalty, safety bonus/penalty, shared savings, unit pricing, discounts, refunds/rebates and economic price adjustments.
Entities will need to estimate the amount of variable consideration to include in the contract value using either the expected value or most likely amount method, depending on which method better predicts the amount of variable consideration that will be realized. The expected value method is a probability-weighted amount that results from considering a range of possible outcomes and is most appropriate when each point in the range has the potential to be the end result (sliding scale). The most likely amount method is the single most likely amount in a range of possible outcomes and is most appropriate when only two possible outcomes exist (binary - yes/no).
When estimating the amount of variable consideration to include in the contract value, entities must assess whether it is probable that a significant reversal of the amount of cumulative revenue recognized will occur and appropriately constrain their estimate of variable consideration. The constraint concept for estimating variable consideration is designed to eliminate significant reversals of revenue and does not require that there is no subsequent adjustment of any kind. Entities have an opportunity to review accounting policies and procedures in this area and determine if they will remain conservative in their recognition of variable consideration that has been required to date by pre-existing GAAP, or if they will choose to be more liberal with the recognition policies permitted under the new standard.
Uninstalled Material Considerations
The new standard redefines the nature of uninstalled materials an entity must consider when measuring progress under the cost-to-cost method and revises the way revenue is measured throughout the term of a contract when uninstalled materials are present. The following are characteristics of uninstalled materials:
- The good is indistinct from the contract
- The customer is expected to obtain significant control of the good before receiving services related to the good
- The cost of the transferred good is significant relative to the total expected costs to satisfy the performance obligations
- The entity procures the good from a third party and is not significantly involved in designing and manufacturing the good
Entities will need to allocate a portion of the transaction price equal to the cost of qualifying uninstalled materials at the outset of the contract. As uninstalled materials are installed and control is transferred to the customer, the cost is recognized as a cost of performance and revenue is recognized in an amount equal to material costs recognized, also known as the zero profit method. Remaining revenue, excluding the amount allocated to the uninstalled materials, is recognized as performance on the contract and is satisfied based on the cost-to-cost method using all other direct and indirect costs. As a result, 100 percent of the gross profit is recognized as the other costs related to the performance obligation are incurred.
Readying for the New Standard
Your organization should be working now to get up-to-date with the requirements of the revenue recognition standard. Internal controls will be critical for compliance. Your organization should work now to ensure there are processes in place to gather the necessary information.
Revenue recognition changes will also affect multiple areas of your operations, so be sure to include project managers and project engineers in the revenue recognition planning process. They'll need to be aware of the estimating and judgment elements involved in the pricing and contract arrangements.
For more information about how revenue recognition affects your organization, please contact your local MHM service professional.
Published on September 27, 2015