In May 2014 the Financial Accounting Standards Board (FASB) issued Accounting Standards Codification Topic (ASC) 606, which fundamentally changes the way companies across most industries will be required to recognize revenue under U.S. generally accepted accounting principles (GAAP), specifically with regard to contracts with customers. Leases, financial instruments, insurance contracts, and nonmonetary exchanges are not impacted. Construction contractors in particular will find that the standards require some major rethinking by their accounting functions and the significant application of judgment.
Public companies will need to comply with the new standard starting with annual reporting periods beginning after Dec. 15, 2016, and nonpublic companies will need to comply starting with annual reporting periods beginning after Dec. 15, 2017. Nonpublic companies may choose to adopt the new standard early, but no earlier than the date for public company compliance.
While these deadlines may seem like a long way off, adopting the new standard is a significant undertaking whose impact will extend far beyond your finance and accounting teams. You may wish to change operating practices or parts of your contracts to more clearly and accurately align with the terminology and concepts in the new standard. You’ll also need to decide which transition method makes the most sense for your organization: the full retrospective or modified retrospective.
At the highest level, the new standard requires companies to recognize revenue:
- When promised goods or services are transferred to customers
- In the amount of consideration to which the company expects to be entitled
To do this, companies will follow a five-step process outlined by the FASB:
Let’s look at each of these steps and how they pertain to contractors in closer detail.
Step 1: Identify the contract
Though this step may seem obvious, it bears stating that a contract is an agreement that creates enforceable rights and obligations. A contract must meet the following criteria:
- It contains approval and commitment of the involved parties.
- It identifies the rights and payment terms.
- It has commercial substance.
- Collectability is probable at the time of inception.
Step 2: Identify performance obligations
Once you’ve identified the contract, you’ll need to identify the distinct performance obligations contained within it. A performance obligation is a promise in a contract to transfer a good or service to the customer. This may be a single good or service (or a bundle of goods or services) that is distinct, or it may be a series of distinct goods or services that are homogeneous and have the same pattern of transfer to the customer over time; thus, they are accounted for as a single performance obligation.
A good or service is considered distinct if:
- It benefits the customer on its own.
- It isn’t used as an input to produce a combined output.
- It doesn’t significantly modify or customize another good or service in the contract.
- It isn’t highly dependent or interrelated with other goods or services in the contract.
For example, say a company is contracted to rebuild a warehouse. The contractor will perform demolition, pour the new foundation and floor, erect the framing, install plumbing and electrical systems, put up drywall, and perform the finishing work. In this case the individual tasks are interrelated services — a series of inputs that results in one combined output (the rebuilt warehouse). Although the customer could likely benefit individually from many of these separate activities, the individual activities are not considered distinct within the context of the entire contract. This means there is one distinct performance obligation in the contract that encompasses all of the highly interrelated activities.
Step 3: Determine transaction price
The transaction price is the amount of consideration to which a company expects to be entitled in exchange for transferring goods or services. Determining the transaction price can become complicated when you consider variable consideration — such as performance bonuses, unpriced or unsigned change orders, claims, and liquidated damages — and noncash consideration.
Companies must estimate the amount of variable consideration to include in a contract’s transaction price by one of two methods:
- The single most likely amount
- The probability-weighted expected value
When determining the transaction price that includes an element of variable consideration, you’ll need to consider it in terms of its constraint: the extent to which it is probable no significant revenue reversal will occur. Make your estimate of variable consideration first, then evaluate the constraint when determining how much of the variable consideration to include in the transaction price.
Take, for example, a contractor engaged in a $10-million fixed-price contract to construct an office building. The contract includes a $500,000 performance bonus if the work is completed by Jan. 1, 2018. To recognize the revenue correctly, the company must analyze the likelihood that it will receive the bonus. This is, of course, a complicated determination, but the contractor in this case weighs the many relevant factors and determines there is an 80% chance of the work being completed by Jan. 1, 2018. Since there are only two possible outcomes (the transaction price will be either $10 million or $10.5 million), the performance bonus is an example of variable consideration that has a binary result, and the first method — choosing the most likely amount of the transaction — is more appropriate. As a result, the contractor records the transaction price as $10.5 million.
Step 4: Allocate transaction price
In this step the total transaction price is allocated to each of the distinct performance obligations in the contract (if there is more than one). The allocation is done on a relative stand-alone selling-price basis. If an entity doesn’t sell a particular performance obligation on a stand-alone basis, it will have to estimate the stand-alone selling price. There are three methods for estimating the stand-alone selling price for each obligation:
- Top-down approach. Make a market assessment of each individual performance obligation, taking into consideration what other competitors in the same market sell similar goods or services for.
- Bottom-up approach. Estimate the expected cost of each performance obligation plus a reasonable margin.
- Residual approach. Generally, this will only be used if stand-alone selling prices are highly variable and the company has not yet established stand-alone selling prices (or has no history of selling the good or service on a stand-alone basis).
Say, for example, that a contractor agrees to demolish an old sidewalk and lay a new one in the front parking area of a customer’s building and to construct a new (unconnected) patio area and pavilion behind the building. The contractor determines that there are two separate performance obligations in the contract: first, the replacement of the sidewalk; second, the new patio and pavilion. Based on the terms of the contract, the contractor determines that the transaction price is $30,000 and then applies the top-down approach to allocate the transaction price to the distinct performance obligations. Assuming the contractor determined the market value to replace the sidewalk to be $22,000 and the market value to construct a new patio area and pavilion behind the building to be $11,000, the transaction price allocated to each performance obligation would be as follows:
- $20,000 to replace the sidewalk. To calculate this amount, we’d divide $22,000 (the stand-alone market value for the sidewalk) by $33,000 (the total of the two stand-alone market values of the two performance obligations in the contract), then multiply by $30,000 (the total transaction price).
- $10,000 to construct the new patio and pavilion. To calculate this amount, we’d divide $11,000 (the stand-alone market value for the patio and pavilion) by $33,000 (the total of the two stand-alone market values of the two performance obligations in the contract), then multiply by $30,000(the total transaction price).
Step 5: Recognize the revenue
Once you’ve identified the contract and the individual performance obligations, determined the transaction price, and allocated the transaction price to the individual performance obligations, you’re ready to recognize the revenue when or as the performance obligations are satisfied.
Revenue will be recognized by one of two methods: either at a single point in time or over time. Revenue should be recognized at a point in time unless one of the following criteria, which would require revenue to be recognized over time, is met:
- The customer simultaneously receives and consumes the benefit as the work is performed (such as a general contractor — the customer in this case — using a subcontractor’s labor on a project).
- The work creates or enhances an asset that the customer controls as the asset is created or enhanced. (For example, if a contractor is constructing a building on land owned by a project owner, the land is being enhanced as the building being built.)
- The work creates an asset without an alternative use, and an enforceable right to payment exists for performance to date (such as the installation of wiring in a building that is owned by the customer and to which the contractor has lien rights).
A contractor recognizing revenue over time also needs to determine a measurement of progress towards satisfaction of the performance obligations over time. This can be accomplished by either the output method or the input method. Under the output method, progress is measured by the result of the work performed. This might be based on the number of units produced, an appraisal of the completed portion, a survey of the performance, or milestones that have been reached. The input method, on the other hand, measures progress by resources consumed, such as labor hours expended, costs incurred, or time elapsed. To be reasonable, these inputs must be proportional to the contractor’s progress towards fulfillment of its performance obligation. It would not, for example, be appropriate to measure progress by including the costs incurred for uninstalled materials purchased at the outset of a project (see the section on uninstalled materials, below, for more detail) or the costs resulting from inefficiencies and rework that were not considered when pricing the contract.
Let’s return to our first example, the contractor engaged to rebuild a warehouse. As we determined earlier, only one distinct performance obligation exists: the rebuilt warehouse. The transaction price is $20 million, and the estimated cost to the contractor is $16 million. Work is underway, and as of Dec. 31, 2018, the contractor has incurred $4 million of the expected costs. Since the contractor does not have control of the land or the warehouse, it makes sense for the contractor to recognize the revenue over time. The contractor identifies the input method as the most appropriate way to measure its progress of satisfying the performance obligation. Since the $4 million of costs incurred marks 25% of the total expected costs ($16 million), the contractor recognizes the same proportion of the transaction price as revenue, $5 million (25% of the $20 million). In this simple example, this calculation is similar to existing GAAP’s guidelines on the percentage of completion.
Note that there are several measures by which the contractor could have chosen to measure progress, and costs incurred won’t be the best choice in every scenario (for example, in some projects, hours expended may be a more accurate estimate than the ultimate costs expended, where costs may be difficult to estimate based upon fluctuating material prices or where the installation service is more critical than the procurement of stock components and materials). While the result in this example closely mirrors the old percentage of completion method of accounting under ASC 605-35 (formerly Statement of Position 81-1), it’s important for all contractors to go through the five-step process outlined above and not assume a similar conclusion without going through the process as there are differences that can arise.
Special considerations
Change orders
One area of particular note to contractors concerns change orders, which qualify as contract modifications (approved changes in either the scope of a contract, the price of a contract, or both). Contractors must treat change orders (contract modifications) in one of three ways, depending on the circumstances:
- Create a new and separate contract for the additional work. This is the prescribed approach when new, distinct goods or services are added to the scope of the work and the price of the contract increases by an amount based on their stand-alone selling price.
- Terminate the existing contract and replace it with a new one. This prospective adjustment approach should be used when the additional goods or services are distinct from those already transferred at the time of the modification but the contract consideration has not been increased based on the amount of their stand-alone selling price.
- Continue the existing contract. Use this cumulative catch-up adjustment approach when the new goods or services are not distinct but rather part of the existing performance obligation that is partially satisfied at the time of the modification.
To illustrate, let’s return to the example of the contractor rebuilding the warehouse. The contract is worth $20 million, but now let’s say the cost to the contractor is $10 million (instead of the $16 million used in the earlier example). The customer requests an unpriced change order involving $2 million in additional expected costs. There is still just one distinct performance obligation, since the change requested does not create a distinct additional good or service. The contractor has a history of executing change orders with this customer, which generally result in cost recovery at minimum. As of Dec. 31, 2018, the contractor has incurred $4 million in costs. To calculate how much revenue should be recorded for year-end 2018 using the same input method we did before, we add the $2 million in new costs to the existing $10 million in expected costs for a total of $12 million. We adjust the revenue by adding the $2 million in expected new revenue to the $20 million in the original contract for a total of $22 million. Next, we divide $4 million (the current amount of costs accumulated to date) by $12 million (the total costs expected to be accumulated) and find that the new adjusted percentage of completion is 33%. As a result, the contractor can recognize 33% of the total revenue ($22 million), which gives us roughly $7.33 million in revenue that should currently be recognized. Note that the approved change order is subject to variable consideration guidance. In this case the contractor believes that recovery of costs associated with the change order is probable — but the contractor applied the constraint to prevent recognizing margin on the change order because collection of a margin was not yet deemed probable. (See step three for more on variable consideration.)
Retainage
Retainage is generally not considered a financing component in the determination of a contract’s transaction price since its use reflects a protection for the customer in the event a contractor should fail to satisfy its performance obligations. Therefore, contractors may not consider retainage a receivable, since receivables are defined as rights to consideration that are unconditional and only require the passage of time for collection. This change in classification may affect financial metrics and ratios used in covenant calculations or other contractual agreements.
Uninstalled materials
Costs that are not proportional to progress toward satisfying a performance obligation require that the input method calculation be adjusted. If certain conditions are met at contract inception, a contractor could determine that the best depiction of performance would be to adjust the input method to exclude the uninstalled materials from measurement of progress toward the satisfaction of the performance obligation. In such a situations, the contractor would recognize revenue equal to the sum of:
- Purchased but uninstalled materials (exclusive of any profit margin); and
- Proportion of progress towards satisfying the performance obligation multiplied by the transaction price (exclusive of the total estimated cost of all anticipated costs that aren’t indicative of progress towards satisfaction of a performance obligation) .
Say a contractor is engaged in a $13-million fixed-price contract to construct a building, which includes the installation of elevators. As in the example of the warehouse, there is still only one distinct performance obligation: the construction of the building. The estimated cost to the contractor is $10 million, including $1 million for the elevators and related equipment. As of Dec. 31, 2018, the contractor has incurred $4 million in costs, including the elevators, which have been purchased and delivered on-site but have yet to be installed. To calculate how much revenue the contractor should recognize, we’d adjust the cost-to-cost input method by subtracting the $1 million for the uninstalled elevators from the $4 million in total costs incurred to date and from the $10 million in total estimated costs, then divide the two to determine progress toward completion, which is 33.3% ($3 million divided by $9 million). We’d also subtract the $1 million for the elevators from the $13-million transaction price before multiplying it by our progress (33.3%) and then add the $1 million for the elevators back in, resulting in a current total of $5 million in revenue to be recognized. (If the $1 million for the elevators was included in the calculation of progress towards satisfaction of the performance obligation, the measurement of progress would have been overestimated and $5.2 million of revenue would have been recognized.)
Loss contingencies and warranties
The accounting for loss contracts was excluded from the scope of the new revenue recognition guidance, and the existing requirements in this area continue to apply; that is, the entire anticipated loss should be recognized as soon as it becomes evident.
Warranties may fall into several categories. If the contractor provides the customer with the option of purchasing the warranty separately, the warranty should be treated as a distinct performance obligation, and a portion of the transaction price would be allocated to it. Likewise, if the warranty provides additional services (such as a certain number of years of maintenance), that service component qualifies as a distinct performance obligation, and a portion of the transaction price would be allocated to it. But if the warranty is solely an assurance-type warranty (that is, a warranty against latent defects), there is no distinct performance obligation, so any inherent warranty embedded in the contract would be reflected in the performance obligation for the respective good or service and would not be considered a separate performance obligation. This will likely result in less diversity in the treatment of warranties across entities, since it will result in a more consistent use of a cost accrual approach to such warranties within contract costs.
Mobilization
Many contractors incur costs to mobilize equipment and labor to and from a job site. In many circumstances, contractors are able to bill for this in advance based on the schedule of values included in the signed contract. Under the new revenue recognition guidance — since the mobilization costs do not add to the satisfaction of a performance obligation under the contract — they are not included in the estimated costs or the contract costs incurred for purposes of measuring satisfaction of the performance obligations (which in turn drives revenue recognition). Instead, mobilization costs are generally considered contract fulfillment costs that are capitalized on the balance sheet and amortized over the expected duration of the contract. This differs from current practice, in which these mobilization costs have often been included in the estimated costs and in the cost accumulation for each project, then used to determine the percentage of completion and, as a result, recognition of revenue.
Precontract costs
The incremental costs of obtaining a contract — costs that the entity would not have incurred if the contract had not been obtained — are recognized as an asset if they are expected to be recovered. These costs are then amortized on a basis consistent with the transfer of the goods or services to which the capitalized amounts relate, and the unamortized costs are evaluated for impairment. As a practical expedient, such costs may be expensed as incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less.
Transitioning and disclosures
Businesses will need to determine whether a full retrospective transition or a modified retrospective transition makes the most sense for their particular circumstances. In the full retrospective, for which optional practical expedients exist, all reporting periods presented are reported under the new standard and the entity is required to disclose any prior-period information that has been adjusted. Under the modified retrospective approach, only the initial period of adoption needs to be reported under the new revenue model; other periods would remain presented under existing GAAP. Entities that choose the modified retrospective approach are required to make a cumulative effect adjustment and disclose the effects of adopting the new standards on each financial statement line item as of the beginning of the period of adoption.
Other required disclosures, regardless of whether you choose the full or modified retrospective approach, include:
- Disaggregated revenue information by customer type, geographic region, product line, etc.
- Contract balances information, including significant changes in contract assets and liabilities
- Timing of future revenue recognition, including the amount of transaction price allocated to unsatisfied performance allocations
