The ASC 606 transition for construction contractors: Determining the transaction price – Significant financing component

Construction contractors with contracts exceeding one year should consider whether the pricing of the contract contains an element of financing. The new accounting standard requires a contractor considers whether the pricing of the contract contains an element of financing when, at contract inception, the period between when the contractor transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or more. An element of financing could be provided to the customer or the customer could provide financing to the contractor as determined by the timing of when consideration is received in comparison to the transfer of the promised goods or services.

To reduce the burden of this requirement, the FASB included a practical expedient in the standard that allows a contractor to ignore a significant financing component when the period between a customer’s payment and a contractor’s transfer of the goods or services is expected to be one year or less at contract inception. In most circumstances, costs and earnings in excess of billings (underbillings) and billings in excess of costs and earnings (overbillings) on uncompleted contracts are resolved within one year and would not constitute a significant financing component.

For all other longer-term contracts, a significant financing component can be explicitly stated in the contract or implied by the payment terms agreed to by the parties. When a significant financing component has been identified, a contractor would adjust the transaction price by discounting the amount of promised consideration and recognizing interest income (when customer payments are deferred) or interest expense (when customer payments are accelerated) based on prevailing interest rates in the relevant market. A contractor uses the same discount rate that it would use if it were to enter into a separate financing transaction with a customer. The discount rate should reflect the credit characteristics of the borrower regardless of a rate explicitly stated in the contract when it does not correspond with market terms.

The new accounting standard provides for certain situations which would not indicate a financing component:

• A customer paid for goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer.