FASB ASC 606, Revenue from Contracts with Customers (referred to as “new standard” or ASC 606 throughout), eliminated all industry specific guidance and replaced it with a uniform five-step process for recognizing revenue.
We have identified 10 areas of the new standard that, we believe, will have a significant impact on the construction industry. While this list is not all-inclusive, it should help you begin to identify areas to consider as part of the new revenue recognition standard.
1. Have you determined Adoption Timing and Approach? For non-public companies, the effective date for calendar year-end companies is January 1, 2019. As part of the adoption process, companies will need to consider between the two adoption approaches available: the full retrospective approach or the modified retrospective approach.
Under the full retrospective approach, all periods presented would be required to be shown under the new standard. Under the modified retrospective approach, only the initial period of adoption would be reported under the new standard; and cumulative effect adjustment to beginning retained earnings would be made for the adoption of the new standard.
2. How many Performance Obligations do you have? Under the new standard, determining how many performance obligations exist in a contract will require significant judgment. A single contract might contain one or multiple performance obligations. While the industry expectation is that, typically, one performance obligation will exist for many construction-type contracts (specifically as it relates to a facility or capital assets), this is by no means a one size fits all determination. A major factor in determining whether one or multiple performance obligations exist will depend on the level of integration involved. Once the number of performance obligations is determined, companies should remain consistent with similar-type contracts. If you identify more than one performance obligation in a contract, you will be required to allocate the transaction price to the separate performance obligations in the contract based on the stand-alone selling prices.
An often-cited example that would require a determination analysis is a contract involving construction and maintenance activities. Often, the maintenance activities do not involve any degree of integration with the construction component. Therefore, they are often considered separate performance obligations.
3. Do you have Variable Consideration Components? Variable consideration is an important element in determining the transaction price. Types of variable consideration often seen in the construction industry include the following: performance bonuses, penalties, claims, unapproved/unpriced change orders, liquidated damages, unit pricing, back charges, refunds, rebates, and discounts. Variable consideration requires companies to refrain from recognizing revenue until it is probable that a significant reversal of revenue recognition will not occur. While the new standard does not provide a percentage for the term “probable”, the industry often quotes 70-75% as being the threshold of probability for inclusion.
Having these types of variable consideration components will require historical, current, and forecasted information to determine when these types of variable consideration should be included in the revenue recognition process.
4. How will you Recognize Revenue? Revenue is recognized either at a specific point in time (similar to current guidance over completed contract method), or over time (similar to current guidance over the percentage-of-completion method). While the default under the new standard is that revenue would be recognized at a specific point in time, revenue can be recognized over time if one of the following criteria under FASB ASC 606 is met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
- The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or
- The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date at all times during the term of the contract.
Note: While many contractors assume the cost-to-cost input method, (percentage-of-completion method) will continue to be utilized, it’s important to recognize that an analysis should be performed to determine if this method of revenue recognition is most relevant in depicting the transfer of goods or services to the customer.
We recommend companies evaluate their fact-pattern for transferring the goods or services to the customer and document why they chose a particular revenue recognition method.
5. Do you have Master Service Arrangements? The construction industry has extensively considered the issue of Master Service Arrangements, largely as they relate to whether or not a contract exists. Often, Master Service Arrangements only provide basic terms and conditions and may require submitting a purchase order detailing the specific goods and services provided. These purchase orders will often include specifics related to the enforceable rights and obligations criteria. As revenue cannot be recognized until each of the criteria under ASC 606 have been met, determining when the contract exists will be critical.
6. Do you have Combining Contract Requirements?
Under FASB ASC 606, contracts are required to be combined when contracts are entered with the same customer (or related party) at or near the same time, and the following criteria are met:
- Contracts are negotiated as a package with a single commercial objective;
- The amount of consideration payable under one contract depends on the price or performance under the other contract; or
- The goods or services promised in the contracts represent a single performance obligation.
One common example pertaining to the combining contracts requirement focuses on contracts entered into with the same customer at or near the same time for engineering services and construction services.
While facts and circumstances will differ depending on the situation, the general observation is that if the engineering and construction services are for the design and building of a single capital asset, these contracts will likely require combination. Under the combining contract requirement, revenue will be recognized over the life of the entire contract, and there will be no need to identify separate performance obligations.
7. Do you have Wasted Materials, Inefficiencies, or Uninstalled Materials?
The construction industry has paid significant attention to the issue of wasted materials and inefficiencies when using the cost-to-cost method for measuring progress toward satisfaction of performance obligations. Under the new standard, wasted materials and inefficiencies should be excluded when measuring the extent of progress towards completion.
Further, if significant uninstalled materials exist on a reporting period date, FASB ASC 606 requires uninstalled materials that are not specifically produced or fabricated for the project to be excluded from costs incurred when measuring the extent of progress toward completion.
8. Do you have Significant Pre-Contract (such as mobilization, bonding, or insurance) costs?
ASC 340-40, Other Assets and Deferred Costs – Contracts with Customers, was amended to provide guidance related to costs incurred in obtaining and fulfilling a contract. Under the amended guidance, incremental costs, or costs which would not have been incurred if a contract was not obtained (such as sales commissions), must be capitalized if expected to be recovered (this can be through margin inherent in the contract or via reimbursement).
In order for the costs to be capitalized, the following criteria under FASB ASC 606 must be met:
- Costs must relate directly to a contract;
- Costs relate to future performance; and
- Costs are expected to be recovered
If it is determined that pre-contract costs represent costs to fulfill the contract and meet the requirements noted above to be capitalized, the costs will be capitalized as an asset and amortized using a method consistent with how progress is measured on the applicable construction project.
9. What Information should you be gathering for Disclosure Requirements?
Financial statement disclosure requirements have been significantly expanded. Companies should begin to gather detailed information surrounding the following items:
- Disaggregation of revenue (such as residential and commercial contracts, revenue from public sources, private sources, geographic region, etc.);
- Information regarding performance obligations and when the entity normally fulfills its performance obligations, including any significant payment terms, the nature of the services, and any obligations for returns, refunds, warranties, etc.;
- Description of the method used to recognize revenue and how it is applied to recognize over time (input or output method used to measure revenue);
- Contract balances;
- Significant judgments;
- Costs to obtain or fulfill a contract;
- Remaining unsatisfied performance obligations (i.e. backlog information).
There will also be some changes to the face of the financial statements, specifically surrounding the presentation of: unbilled receivables, retainage, costs and estimated gross profit in excess of contract billings and billings in excess of costs and estimated gross profit on contracts in progress. As mentioned under item 8 above, contractors may need to recognize a “Contract Asset” if goods and services are delivered to a customer before control is transferred and must recognize a “Contract Liability” if the customer pays consideration prior to the goods and services being delivered.
10. What are the Tax Implications?
While FASB ASC 606 will an impact on revenue recognition for book purposes, it’s important to note that tax law has not made any such changes. As a result, companies will likely have more book/tax differences, and C-Corporations will need to make additional considerations regarding deferred tax assets and liabilities.
Further, all companies will need to consider tracking for:
- separate performance obligations - under the new standard, the book method may result in multiple performance obligations, however under tax, the unit of account remains the contract; and
- variable consideration - under the new standard, the book method may result in accounting for variable consideration earlier than tax would allow (under tax it is not recognized until earned). As such, companies will need to devise a tracking method for differences resulting from adoption of the new standard for book purposes and the implications those will have on the differing treatment under tax.
If you have any questions or comments concerning these topics, or any other issue, please do not hesitate to contact your Bonadio engagement team. We look forward to answering your questions.
Amanda Smith is a Principal based out of our Rochester, NY office.