After years of deliberation, the new revenue recognition standard is finally here. The standard has been met with much criticism, concern, and confusion within the construction industry. The interpretations and speculations have been widespread, but in the end, the construction industry impact isn’t as significant as many first feared. However, there are nuances within the new standard that will ultimately have an impact on our industry.
A simple Google search will result in hundreds of well-written articles by highly reputable firms documenting the changes. Rather than rewriting some of this content, we’ve opted to compile a list of the most common questions we’ve been receiving related to Accounting Standards Codification (ASC) Topic 606. If you would like to discuss the details that may or may not pertain to you, please don’t hesitate to reach out.
What is the purpose of the new standard and when is it effective?
In 2002, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) began discussions about a converged revenue recognition standard. The standard would replace volumes of industry-specific revenue recognition literature with one pronouncement that encompasses all industries. It took almost 12 years, but in May 2014, the FASB issued the first of several updates, Accounting Standards Update (ASU) No. 2014-09 Revenue from Contracts with Customers, and it will replace our long-coveted Statement of Position 81-1 Accounting for Performance of Construction-Type and Certain Production-Type Contracts (ASC 605-35).
Historically generally accepted accounting principles related to revenue recognition have been “rule” based. ASC 606 is a principle-based standard that provides construction financial managers with some subjectivity when assessing the standard. This is a bit of a paradigm shift in the FASB’s approach to standard setting.
ASC 606 is effective for non-public companies for fiscal years beginning after December 15, 2018. Thus, for calendar year companies this new guidance will need to be implemented January 1, 2019.
What are the main provisions of the new standard?
ASC 606 introduces a five-step approach to revenue recognition:
- Identify the contract
- Identify the performance obligations within the contract
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue as performance obligations are satisfied
While the five-step approach provides the construction industry with a similar approach to revenue recognition as that of legacy US GAAP, there are nuances to consider within each step above that could alter the way revenue is recognized.
What exactly constitutes a “Performance Obligation”?
At contract inception, you will need to assess the goods or services promised to your customer and identify the separate performance obligations within the contract that are “distinct”. To be distinct, a customer can benefit from the good or service on its own (or together with other readily available resources), and significant integration services are not provided. Given the integrative nature of construction, for a majority of contractors, a contract will constitute one performance obligation. A common example of a construction contract that may contain multiple performance obligations are “Design/Build” contracts where the contractor enters into the design phase as a separate promise before procuring the construction portion of the contract. Another example is contracts with maintenance agreements commencing subsequent to the completion of the contract. In these instances, the contractor may have to account for the design and maintenance components as individual performance obligations.
What are the main differences between ASC 605-35 and ASC 606?
The following five concepts are some of the more common differences we’re experiencing when considering ASC 606.
Combining of Contracts
The combining of contracts entered into at or near the same time will be required if any of the following criteria are met:
- The contracts are negotiated together with a single commercial objective.
- Pricing interdependencies exist between the contracts.
- The goods or services promised in the contracts represent a single performance obligation
Accounting for Change Orders and Contract Modifications
As customary within the construction industry, most projects will encounter change orders throughout the construction process. Under legacy US GAAP, most contractors would simply account for the changes prospectively by adjusting the existing contract on the work in progress schedule. Under ASC 606, an entity shall account for a contract modification as a separate contract if both of the following conditions are present:
- The scope of the contract increases because of the addition of the promised goods or services that are distinct (i.e. a contractor that is awarded the “build” component as a change order to the initial design contract)
- The modification is priced at the entity’s standalone selling prices for the additional promised goods or services.
There are several areas of consideration related to variable consideration. Unpriced change orders, liquidated damages, contract contingencies, and performance bonuses are some of the common areas that should be considered when evaluating variable consideration within a contract. ASC 606 allows for the inclusion of variable consideration within the transaction price, but only to the extent that it is “probable” that a significant reversal of cumulative revenue recognized will not occur. When assessing probability, utilize a threshold of 70%-80%. Contractors must constrain the value of variable consideration included in contracts using one of two methods of valuation:
- The Expected Value Method – The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts.
- The Most Likely Amount – The most likely amount is the single most likely outcome in a range of possible outcomes. This method is typically utilized if only two possible outcomes exist.
In practice, many contractors already include unapproved and unpriced change orders in contract values if it is highly certain that the pending change order will be approved. Under ASC 606, contractors will need to develop an accounting policy for constraining the contract for amounts that are less than probable.
Contract Costs and Uninstalled Materials
Most contractors will utilize the input method of recognizing revenue which is most similar to the percentage of completion method under legacy GAAP. In doing so, ASC 606 only allows for the inclusion of costs that contribute to the entity’s progress in satisfying the performance obligation. Wasted materials and inefficient labor, as an example, would not be included in the entity’s progress toward completion. Similarly, pre-contract costs, such as bond and insurance costs, should be capitalized and amortized over the life of the contract.
As discussed above, when utilizing the input method of recognizing revenue, ASC 606 allows only for costs that contribute toward completion. Thus, uninstalled materials that the entity does not design or manufacture would not be included in the revenue recognition calculation. Rather, ASC 606 generally allows for the recognition of revenue equal to the cost incurred of uninstalled materials. However, removing the uninstalled materials from the contract and total estimated costs on a work in progress schedule in order to recognize revenue equal to the cost complicates the work in progress schedule, so a practical alternative might be to capitalize the materials into inventory until they are installed.
Are there any differences in the balance sheet presentation?
ASC 606 introduces new terms to be utilized on the balance sheet. Among these new terms are “Contract Assets” and “Contract Liabilities”. Contract assets represent assets related to the contract, (i.e. costs and estimated earnings in excess of billings, unbilled receivables, etc.), and Contract liabilities represent liabilities associated with the contract (i.e. billings in excess of costs and estimated earnings). The guidance does allow for the utilization of the traditional names, but the entity would have to disclose what is included within these line items on the balance sheet.
Furthermore, ASC 606 defines a receivable as amounts due contingent only upon the passage of time. Thus, retentions receivable would not qualify as a “receivable”. An entity could choose to include retentions within the contract assets line or as a separate line on the balance sheet, but could not include the retentions within the contract receivable line on the balance sheet.
What do we need to include in our footnote disclosures?
The disclosure requirements within ASC 606 are robust. Among other information, an entity needs to disclose the following:
- Nature of performance obligations
- How performance obligations are satisfied and the remaining duration
- Unearned revenue (i.e. backlog)
- Opening and closing balances of receivables and contract assets (liabilities)
- Methodology of revenue recognition (i.e. input method)
- Methodology used for variable consideration and amounts constrained in contracts
- Change in retained earnings due to the adoption of ASC 606
- Other significant judgements
ASC 606 was effective for 2018 for most publicly traded companies. In reviewing some of the published financial statements for publicly traded construction companies, we noted significant increases in the revenue recognition disclosures.
How do I implement the new standard?
ASC 606 allows for a full retrospective approach or a modified retrospective approach in implementation. Under the full retrospective approach, an entity would apply the standard to the earliest year presented. Thus, if your financial statements are comparative, restatement of the prior year financial statements to account for the changes within the standard would be required. Under the modified retrospective approach, the entity would recognize a cumulative effect to beginning retained earnings at the date of initial application. Certain practical expedients are provided for initial implementation.
The ultimate impact of the standard is going to be dependent upon each entity and the nature of their contracts. At a minimum, construction financial managers should assess the impact of the standard, including all of the above topics. Creating accounting policies to identify and assess these changes will be crucial in ensuring proper compliance. We recommend communicating with your stakeholders as to some of the expected changes within your financial statements. Discuss the proforma impact with your construction focused CPA now to avoid any surprises later.
As always, if you have questions about ASC 606, or would simply like a second set of eyes at your particular situation, please don’t hesitate to reach out. Be sure to ask about our ASC 606 checklist.