How the New Revenue Recognition Standard Will Impact the Construction Industry
The revenue recognition methodology for the construction industry will change with the adoption of Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606). Topic 606 is effective for public companies for periods beginning after Dec. 15, 2017 and for most non-public companies for periods beginning after Dec. 15, 2018. Early adoption is permitted.
Understanding the New Standard
The FASB’s goals with the new revenue standard include removing inconsistencies and weaknesses in today’s model, improving comparability of revenue recognition practices across entities and industries, and providing more useful information to users of financial statements through improved disclosure requirements.
The core principle of Topic 606 is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In order to achieve the core principle of Topic 606, an entity should perform the following five-step analysis:
Step 1: Identify the contract(s) with the customer
A contract with a customer can be written, oral, or implied, and must satisfy all of the following conditions to be considered a contract under the new standard:
- Be approved
- Identify the rights of each party
- Identity the payment terms
- Have commercial substance
Step 2: Identify the performance obligations in the contract
A performance obligation is defined as a promise in a contract to transfer goods or services. A promised good or service must be distinct to be accounted for as a separate performance obligation when there are multiple promises in a contract. A good or service is distinct if the customer can benefit from the good or service either on its own or together with other resources readily available to the customer and the entity’s obligation to transfer the good or service is separately identifiable in the contract.
Step 3: Determine the transaction price
The transaction price is the amount of consideration to which an entity expects to be entitled to in exchange for transferring promised goods or services to a customer, excluding the amount collected on behalf of third parties, such as sales tax. Transaction price can be fixed or variable or a combination of both.
Step 4: Allocate the transaction price to the performance obligations
The transaction price is to be allocated to various performance obligations based on standalone selling prices. If relative standalone selling price does not exist, then the entity can use adjusted market approach, expected cost plus gross margin approach, or residual approach to allocate transaction price to various performance obligations in the contract.
Step 5: Recognize the revenue
Revenue is recognized when performance obligations are satisfied by transferring control of a promised good or service to a customer. Control either transfers at a specific point in time or over time.
Applications of New Revenue Recognition Standard on Construction Companies
Multiple Performance Obligations
If there are multiple deliverables in the contract, then the company has to evaluate if deliverables are distinct from each other and in the overall context of the contract. If they are distinct, then the company should treat them as separate performance obligations and recognize revenue at each performance obligation level.
Series of Performance Obligations
A company is to treat a contract as a series of performance obligations if the contract is for multiple units and each unit is distinct from the other one. The company will then recognize revenue at each unit based on percent complete of each respective unit. If the units are not distinct, then the entire contract will be treated as a single performance obligation.
Under the new revenue recognition standard, a company has to combine contracts if the contracts are entered into at or near the same time with the same customer and one or more of the following conditions are met:
- The contracts are negotiated as a package deal with a single commercial objective
- The amount of consideration in one contract depends on the price or performance of the other contract
- The goods or services promised in the contracts are a single performance obligation
The company is to recognize revenue at each performance obligation level, but then combine the contracts and present them as one with net overbilling/underbilling for the combined contract.
The company needs to transfer uninstalled materials from inventory to job cost when they are delivered to a job site and recognize revenue up to the extent of cost. The company will defer the profit on these uninstalled materials until installation occurs. Revenue and profit from the remaining contract will be recognized based on percent complete, excluding the uninstalled materials.
Variable consideration include claims, change orders, incentives, penalties, shared savings, price concessions, liquidating damages, unit price contracts with variable units, etc. The company needs to estimate an amount for variable consideration and add it to the contract price at the start of project if the variable consideration is not constrained and no significant revenue reversal is expected. The company can use expected value method or most likely amount method to determine the estimated amount for variable consideration.
Waste and Inefficiencies
Costs related to rework or wasted materials need to be excluded when calculating percent complete, as these costs do not represent the transfer of goods or services to the customer. Waste and inefficiencies occur when a cost incurred does not contribute to progress on the project.
Cost of Obtaining and Fulfilling a Contract
Incremental costs of obtaining a contract need to be deferred and amortized over the life of the contract, and the amortization method should be consistent with how revenue is being recognized on the project. The company may elect a practical expedient to immediately expense the cost if the amortization period is one year or less. The cost incurred in fulfilling a contract should be accounted for in a similar fashion, except there is no practical expedient available for the cost incurred in fulfilling a contract. An example of a cost incurred to obtain a contract is a sales commission. An example of a cost incurred to fulfill a contract is mobilization cost.
The company needs to account for a warranty as a separate performance obligation and allocate a portion of the transaction price to the warranty if at least one of the following is true:
- Customer has the option to purchase a warranty separately
- Warranty period is over a year
- Warranty provides a separate service other than assurance of a product’s compliance with agreed upon specifications
Construction companies will need to disclose the adoption of Topic 606 and calculate its impact on their financial statements by using one of the following two methods:
Full Retrospective Method
Under the full retrospective method, the construction company will need to implement the standard for all years presented in financial statements in the year of adoption. If the construction company adopts Topic 606 in 2019 and presents comparative financial statements, then both 2018 and 2019 financial results will be presented under Topic 606, which may require revisions to 2018 financial statements, including the disclosure of the adjustments.
Modified Retrospective Method
Under the modified retrospective method, the construction company is only required to apply the new revenue standard to the financial statements for the year in which Topic 606 is adopted. This will require an adjustment to retained earnings as of the beginning of the current year to recognize the cumulative impact of the new revenue standard. In the year of adoption, the company must disclose the amount by which each financial statement line item is affected in the current year by the application of the new revenue standard as compared to the guidance that was previously in effect before the change and an explanation for the reasons for significant changes.
Based on recent public construction company 10-Q filings, the new revenue recognition standard may have a material impact on the financial statements of a construction company. That being said, all entities – including construction companies – will need to adopt the new standard and go through the process of analyzing and documenting the five steps noted above.
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