New Revenue Recognition Standard for the Construction Industry
Published in 2014, the Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), is effective now for most public companies. For private companies, the new update will go into effect after December 31, 2018. It calls for a single, five-step model by which most companies worldwide must recognize revenue under U.S. Generally Accepted Accounting Principles (GAAP). The implementation process will vary from industry to industry, often depending on the complexity of customer transactions.
The overarching principle behind the new revenue recognition standard holds that companies recognize revenue when goods or services are transferred to a customer. The amount of revenue recognized should represent the consideration “to which the company expects to be entitled.” The goal of the new standard is to provide one broad principles-based method for businesses to utilize across the board, as opposed to different versions of industry-specific guidance.
Accounting professionals in the construction industry may find that the new standards require a reexamination of their accounting functions and a closer application of judgment. Adopting the new standard will be a significant undertaking, and the impact will likely extend far beyond just the finance and accounting teams. Companies may change operating practices or parts of contracts to more clearly and accurately align with the new standard.
Two methods of transition
The ASU outlines two methods of transition upon adoption of the new standard: the full retrospective method or the modified retrospective method. Under the full retrospective approach, all reporting periods presented are reported under the new standard, and you are required to disclose any prior period information that has been adjusted. This approach, while requiring more effort, will provide comparative financial statements.
In 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. While financial statements will not be comparative under this method, it will be simpler, as it only requires one cumulative adjustment.
This is the five-step model businesses will use to correctly determine revenue recognition:
- Identify the contract with a customer. A contract is an agreement that creates enforceable rights and obligations. Contracts now have several criteria they’re required to meet.
- Identify the performance obligations in the contract. Performance obligations are promises in a contract with a customer to transfer goods or services. Goods or services count as performance obligations if they are distinct or a bundle of goods and services that is distinct.
- Determine the 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 to a customer.
- Allocate the transaction price to the performance obligations in the contract. The transaction price should be allocated to each performance obligation in an amount that depicts the amount of consideration the company expects to be entitled. Transaction prices should be allocated on a relative stand-alone selling price basis.
- Recognize revenue when the entity satisfies a performance obligation. Once the contract and performance obligations are identified, the transaction price is determined and allocated to the individual performance obligations, revenue can be recognized when performance obligations are satisfied.
Special considerations for contractors
Uninstalled materials. Uninstalled materials should be excluded from measuring progress toward satisfying a performance obligation, if the entity is only providing a procurement service. Revenue can be recognized only to the extent of cost incurred if certain conditions are met.
Change orders. Change orders (contract modifications) are changes in the scope and/or price of a contract that is approved by the parties to the contract. Contractors should treat change orders one of three ways, depending on the situation:
- Create a separate contract if the modification results in a separate performance obligation and the consideration to be received reflects the standalone selling price.
- Terminate the existing contract and create a new one when the additional goods or services are distinct from those transferred before the modification. The remaining consideration in the original contract is combined with the consideration promised in the modification to create a new transaction price that is allocated to all remaining performance obligations.
- Continue the existing contract when the new goods and services are not distinct and are part of a single performance obligation that is partially satisfied.
Loss contingencies. The accounting for loss contracts was excluded from the scope of the new revenue recognition guidance, so the existing requirements in this area still apply.
Warranties. Optional warranties purchased separately by the customer are treated as separate performance obligations. However, if the warranty is an assurance-type warranty (against defects), there is no distinct performance obligation.
Precontract costs. Costs of obtaining a contract (those costs that an entity would not have incurred if the contract had not been obtained) can be recognized as an asset and amortized only if they are expected to be recovered. As a practical expedient, such costs can be expensed as incurred if the amortization period is less than one year. If selected as an accounting policy, this should be applied consistently to similar contracts.
Mobilization. In general, since these costs do not add to the satisfaction of a performance obligation, they are not included in measuring progress toward completion. These costs are considered to be contract fulfillment costs.
Disclosures. Nearly all companies will be affected by the expanded disclosure requirements. Several disclosures will be required, regardless of which transition method your company chooses. Some of these disclosures include:
- Disaggregated revenue
- Reconciliation of contract balances
- Performance obligations
- Costs to obtain or fulfill a contract
- Practical expedients
- Transition disclosures
Request for relief
The AICPA has asked the Financial Accounting Standards Board (FASB) for special breaks for private companies as they begin to implement the new revenue recognition standard in 2019. The AICPA has requested that private companies be allowed to employ less restrictive interpretations for five aspects of the new standard. Read more about those provisions here. Stay tuned for more information.
Adopting the changes under the new revenue recognition standard will be time-consuming and complex. This will likely include more closely evaluating the accounting for customer contracts, implementing new financial reporting systems and upgrading financial reporting controls to deter fraud. It will also require more coordination between accounting departments and operations. Contact us with any questions about putting procedures into place or to discuss the latest developments from the FASB.