It’s time to get ready for the five-step revenue recognition standard.   

Since the beginning of time, or at least that’s the way it feels, construction contractors have recognized revenue from long-term contracts using the cost-to-cost percentage-of-completion method. Under this method, judgment and subjectivity were pretty much nonexistent. There were rules, and we followed them. 

Gone are the days of relative simplicity. Industry-specific revenue recognition methods and guidance are a thing of the past with the introduction and impending implementation of Financial Accounting Standards Board (FASB) ASC 606, which introduces a five-step model. The purpose of ASC 606 and the five-step model is to provide financial statement users with the ability to compare revenue across industries. Most contractors, as private companies, will be required to implement the new standard effective for their reporting periods beginning after Dec. 15, 2018 (calendar year 2019). 

Five-Step Revenue Recognition Standard

If you haven’t already started the implementation process, make room in your accounting toolbox and start now. Below are some of the things contractors should know about the five-step model:

Step 1: Identify the Contract

  • Contracts can be written or oral but must be identifiable and have commercial substance.
  • Contracts entered into around the same time with the same customer may need to be combined.
  • Termination clauses that are unilateral without significant penalties may jeopardize the existence of a contract.
  • Approved (written, oral or implied) change orders or contract modifications must be analyzed to determine whether they are a separate contract or not.

Step 2: Identify the Performance Obligation

  • A performance obligation is a distinct good or service that a contract provides.
  • Determination of whether a good or service is distinct will require judgment and, most likely, be the most challenging step of the five-step model.
  • Multiple performance obligations should be treated as separate contracts. This is even if all of them fall under one contract, unless a distinct good or services are immaterial within the context of the contract.
  • Service warranties may need to be separated into performance obligations.
  • Due to the high level of integration that is typically involved in construction contracts, contractors may ultimately reach the conclusion that, in many cases, these contracts contain a single performance obligation. However, the analysis must still be performed to support the conclusion.

Step 3: Determine the Transaction Price

  • It is more than the amount of the basic contract price.
  • Variable considerations – such as contract options, unapproved/unpriced change orders, performance bonuses, and damages/penalties – will need to be estimated (either by using the expected value or most likely amount method) by the contractor and also included in the transaction price.
  • The likelihood and the magnitude of reversal of revenue due to subsequent change in the estimate must be considered and applied at the contract level.
  • Contractors will need to assess the timing of customer payments in relation to the transfer of goods or services. If significant (greater than one year), that could indicate that a significant financing component needs to be factored in.

Step 4: Allocate the Transaction Price

  • No allocation will be necessary if only one performance obligation is identified in Step 2 of the model.
  • If multiple performance obligations in Step 2 are identified, the transaction price determined in Step 3 will need to be allocated based on the relative standalone selling price of the goods or services being transferred.

Step 5: Recognize Revenue

  • While ASC 606 does not use the term “percentage-of-completion,” revenue will continue to be recognized over time for long-term contracts using a single method to measure progress for each performance obligation within a contract.
  • Input (costs incurred, labor hours) or output (units produced, milestones reached) methods can be used.
  • Cost-to-cost method under ASC 606 can create the need for additional judgment related to the accounting for un-installed materials and the recognition of contract costs such as warranties, mobilization costs, etc.

Other Considerations for Contractors

  • Warranties – Warranties that the customer has the option to purchase separately may give rise to a separate performance obligation, which could possibly require separate accounting.
  • Contract costs – Contractors will no longer be able to defer costs if the performance obligation qualifies for over-time recognition unless such costs qualify for capitalization based on either being costs to obtain or costs to fulfill the contract. Costs incurred satisfying a performance obligation are charged to expense as incurred.
  • Set-up and mobilization costs – Direct costs such as set-up and mobilization costs are typically incurred at a contract’s inception to enable a company to fulfill its obligations under the contract. Contractors should consider whether the costs are costs to fulfill a contract that qualify for capitalization.

Presentation and Disclosure

  • Quantitative and qualitative information about revenues, remaining performance obligations (backlog-like disclosure), and activities affecting contract balances will be disclosed.
  • Users of the financial statements will need to be able to understand the judgments made in applying ASC 606.
  • Disaggregation of revenues for presentation and disclosure purposes will need to be determined. Common revenue categories are:
    • Residential and commercial contracts
    • Revenue from public and private sources
    • Geographic region
    • Contract duration
  • Revenue recognition policies by revenue category will also be required.
  • Contract balances should be presented as either a contract asset or a contract liability determined at the contract level.

Don’t be fooled into thinking that the new standard will not affect you as a contractor. While little change is expected in the amount of revenue recognized under long-term contracts, the process of recognition, as you can see above, has changed considerably. The shift from a rules-based to a principles-based paradigm is the new normal in the world of Generally Accepted Accounting Principles. Implementation of the new standard will require considerable effort, time, judgment and analysis. It is upon us, so let the construction of your adoption plan begin.