In May 2014, the long-awaited revenue recognition standard was issued with the intent of creating consistent revenue reporting across all businesses in varying industries throughout the world. The implementation of the accounting standard means the construction industry-specific guidance currently used in the United States will no longer be applicable, and will require different approaches for recognizing revenue as well as additional disclosures.
The construction industry has long been very concerned about the impact the new guidance will have on reporting contract revenues. The Financial Accounting Standards Board (FASB) has acknowledged that implementing this guidance may prove to be challenging, particularly in the first year, as a re-statement of all prior years presented in the financial statements is required.
The good news is there is time to prepare as the new standard does not go into effect until calendar year 2018 for private companies, and 2017 for public companies. The core principle of the new guidance, known as Topic 606 (Revenue from Contracts with Customers), is that a company should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled for those goods or services. Revenue is recognized when a company satisfies a performance obligation by transferring the promised goods or services to the customer (at which point the customer obtains control of those goods or services).
There are a lot of moving parts to this process. However, construction companies that follow the five steps presented in the standard will find themselves well-prepared to handle the changes.
Step 1: Define the contract
Similar to current practice in the U.S. construction industry, the new guidance requires contracts to identify payment terms, customer and contractor rights, and approval of the parties involved. Additionally, contracts must have “commercial substance,” meaning that the transaction will impact the company’s future cash flow, and payment collection is “probable.”
Current accounting standards allow for combining and segmenting contracts, but Topic 606 requires that contracts be combined when entered into on or about the same time if one of the following exists: contracts are negotiated with a single commercial objective; consideration of one contract is dependent on the other contract; and/or goods and services promised are a single performance obligation.
Step Two: Identify distinct performance obligations
Topic 606 mandates that a contract’s distinct performance obligations be identified by two criteria: customers can benefit from the goods or services on their own or with other resources readily available to them; and that the promise to transfer the goods and services is separate from the other promises within the contract.
Where services or goods are highly integrated or customized, performance obligations may be combined into a single performance obligation, similar to current standards. In contrast, current U.S. standards presume that each contract is a profit center for revenue recognition, cost accumulation and income.
Step Three: Determine the transaction price
Topic 606 defines the transaction price as the consideration the contractor expects to receive in exchange for satisfying the contract’s performance obligations. This determination becomes more complex when the contract price is variable. Common considerations here include accounting for awards and incentive payments, customer-furnished materials, claims and the time value of money.
When the consideration is variable in nature, the transaction price is to be based on an estimated or probability-based expected value. Non-cash consideration is to be measured at fair value or a standalone selling price (if fair value cannot be reasonably estimated).
For awards and incentive payments, Topic 606 accounts for them as variable consideration if it is probable, based on experience, in the future that a significant reversal of cumulative revenue recognized will not occur. This is similar to current practice.
Customer-furnished materials are included as non-cash consideration if the contractor controls the materials after they are provided. However, current guidance includes the value of customer-furnished materials in contract revenue when the associated risk for those materials is with the contractor.
Claims are included as variable consideration, provided that upon resolution, it is unlikely a significant reversal in the amount of cumulative revenue recognized will occur. Current U.S. guidance recognizes claims as revenue when it is probable and can be estimated reliably, but only to the extent of contract costs incurred.
Current U.S. guidance also discounts contract revenue in only limited situations, but under Topic 606, any significant financing component related to payments over one year should take into account the time value of money.
Step Four: Allocate the transaction price to the performance obligation
The new standard dictates that the transaction price (and any subsequent changes in the price) is allocated to each separate performance obligation based on the relative standalone selling price for each. If there is not a clear standalone price readily available, then an estimate may be used, such as cost plus a reasonable margin.
Step Five: Recognize revenue
Under current U.S. guidance, most revenue is recognized as the contract is performed using the percentage-of-completion when reliable estimates are available and the completed-contract method when there are no reliable estimates. The new standard recognizes revenue when a performance obligation is satisfied, which occurs when control of a good or service transfers to the customer – whether transferred over time or at a point in time. The measurement of performance includes input and output methods.
Satisfaction over time occurs when either:
- • The customer simultaneously receives the benefits provided by the contractor’s performance;
- • The contractor’s performance creates or enhances a customer-controlled asset;
- • An asset with an alternative use to the contractor is not created but the contractor has a right to payment for performance completed to date.
Satisfaction at a point in time occurs if it does not meet the criteria above and the following indicators related to the asset are present:
- • The contractor has a right to payment;
- • The customer holds legal title;
- • The contractor transferred physical possession;
- • The customer has significant risks and rewards associated with ownership;
- • The customer has accepted the asset.
Because the new accounting standards introduce many different concepts and terms, it is critical for construction companies to understand how the new standard impacts them. Although the current use of percentage-of-completion based on costs-to-costs could still correctly depict revenue, a careful assessment under the new guidance should be performed to determine the contract performance obligations as well as when control transfers to the customer.