Has your company implemented the new revenue recognition standard? If not, it's important to begin the implementation process as soon as possible.
Private companies are required to adopt the new revenue recognition standard (FASB ASC 606, Revenue from Contracts with Customers) in 2020. The construction industry traditionally followed a rules-based standard that was industry-specific. Depending on how long you have been in the industry, these were historically referred to as SOP 81-1 or ASC 605-35. The new standard is principles-based - not industry-specific - and will require more judgment when evaluating contracts and recognizing revenue.
Below are 10 key considerations for construction contractors to evaluate as they adopt the standard:
1. Combining contracts - Contracts are required to be combined if they were entered into at or near the same time and one or more of the following conditions exists:
- The contracts were negotiated as a package with a single commercial objective.
- The amount of consideration to be paid in one contract depends on the price or performance of the other contracts.
- The goods or services are promised as a single performance obligation.
For example, if a contractor enters into a contract at a loss in order to obtain an additional contract, these contracts may be required to be combined into one contract. First, we must address whether or not these contracts were entered into at or near the same time. The definition of "at or near the same time" is not concrete and will require judgment, but the longer the time period between the contracts, the more likely there have been changes to the economics of the contracts.
If contracts are combined, only one over- or under-billed balance will be reported on the balance sheet on the combined contract. For example, if two contracts were combined and one had a $200,000 over-billing and the other had a $100,000 under-billing, the net over-billing of $100,000 on the combined contract would be recorded and presented on the balance sheet. In addition, if one job had a loss, but on a combined basis the contract was profitable, a loss would not be accrued for the job loss.
2. Variable consideration - There are many forms of variable consideration. Some examples include claims, unpriced change orders, incentives, penalties, shared savings, and price concessions.
Prior to this update, many contractors waited until they received incentives before recognizing the revenue. Contractors are now required to estimate variable consideration throughout the life of the contract. They're also required to include these amounts in the total contract value if it is probable that significant reversal of revenue will not occur due to subsequent changes in the estimate.
The original estimate of variable consideration should be determined using the expected value approach or the most likely amount approach. For example, if there is a $100,000 incentive if the job is completed one month early, the contractor would use the most likely amount approach to estimate the variable consideration because there are only two options: completing one month early or not completing one month early. If it is estimated the contract would be completed at least one month early, the $100,000 would be included in the contract value. If there was a range of incentives or penalties for each week the contract was completed early or late, the expected value approach would most likely be used to estimate the variable consideration.
3. Contract modifications/change orders - A contract modification should be treated as a separate contract if it is for distinct goods or services and priced at the standalone selling price for those services. Otherwise, the contract modification and remaining contract value should be accounted for in one of the following ways:
- If the services to be provided under the remaining contract and contract modification are distinct, it should be treated as a termination of the existing contract and creation of a new contract based on the remaining revenue to be recognized under the existing contract plus the contract modification.
- If the services remaining are not distinct, the modification should be treated as if it were part of the existing contract. This would result in a cumulative catch-up adjustment to the overall recognition under the contract.
4. Uninstalled materials - The treatment of uninstalled material has been clarified and contractors should understand this clarification in order to evaluate whether or not they need to make changes to their revenue recognition process. For example, if your customer takes control of uninstalled material when it is delivered to the job and these materials are significant to the overall contract, you should only recognize revenue up to the cost of the material.
For contractors using the cost-to-cost method to determine job progress and revenue recognition, these material costs need to be excluded from the cost-to-cost calculation to determine contract progress and revenue to recognize on that progress. The uninstalled material component would then be added to the progress-based contract revenue at cost. Some companies are planning to create a separate job number for each impacted job to track these material costs if they are significant to the contract.
5. Wasted materials/inefficiencies - Similar to uninstalled materials, unexpected costs for wasted materials or inefficiencies should be excluded from the contract progress calculation using the cost-to-cost method. These costs should be included as costs for reporting purposes, but not for measuring contract performance to date.
6. Service/maintenance agreements - These may be considered stand ready obligations. Many companies record revenue from service and maintenance contracts on a straight-line basis over the term of the agreement. Under the new standard, there needs to be some analysis and consideration on the expected timing of the efforts under the agreement. For example, if you have a snow removal business that uses annual contracts, revenue should not be recognized on a straight-line basis throughout the year, but should be recognized over the expected period you will be performing services under that contract. The key question is, does the customer benefit equally throughout the contract period or does the customer benefit more at certain times during the contract period?
7. Warranties - Contractors must distinguish between assurance type warranties and those that provide the customer with additional services. Assurance type warranties are considered part of the basic contract. Warranties that provide additional services are separate performance obligations and therefore revenue is recognized on these warranties over the warranty period.
8. Customer-supplied materials - If a customer supplies materials to the job and the contractor takes control of those materials, the contractor should include the materials in their job costs and in the contract value. This grosses up revenue and expenses on the income statement.
9. Joint ventures - If you control the books and records of the joint venture, the expectation is that your accounting treatment will be similar to your other jobs and the revenue recognition accounting policies that you have adopted. However, if you are not in control of the books and records of the joint venture, you should evaluate how that party is accounting for it to verify it is consistent with your revenue recognition accounting policies. If it is not, then you should make adjustments to account for the joint venture consistent with your policies.
10. Retainage - Many contractors include retainage in accounts receivable. Under the new guidance, retainage is not considered an accounts receivable because it is not yet an unconditional right to receive payment. Therefore, it will now be considered a contract asset and disclosures around retainage will change.
The list above is not all encompassing, but it highlights key areas that you should evaluate as you work through adopting the standard and updating your revenue recognition policies and procedures. Hopefully you are well on your way to be in compliance by the end of 2020. If you have questions or are unsure how to proceed, Kreischer Miller is here to assist you with implementation.
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.