Impact of the New Revenue Recognition Standard on Contractors
For years, the construction industry has relied on accounting for revenue using the percentage of completion method, basing revenue recognition on progress toward a long-term contract. The new revenue recognition standard, Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606), is similar to existing guidance, but there are some crucial differences.
The core principle of ASC 606 is that companies should recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration the company expects to be entitled. To achieve that core principle, companies should apply a 5-step model.
Step 1: Identify a contract with a customer
Because contractors use contracts with their clients regularly, this may seem self-explanatory, but ASC 606 may also require combining contracts for accounting purposes.
Step 2: Identify the performance obligations in the contract
The next step is identifying performance obligations within the contract. Distinguishing each performance obligation may require significant management judgment.
To illustrate, consider a contractor who enters into a contract to build an office building. The contractor will pour a foundation; complete framing and roofing, install plumbing, mechanical and electrical systems, insulation and drywall; lay flooring; and perform finishing work. There are several activities in the contract, but the activities result in one distinct performance obligation - the completed office building.
In the same contract, the contractor agrees to update the electrical work at the company’s existing location. This would be a separate performance obligation.
Step 3: Determine the transaction price
Transaction price is the amount of consideration to which the entity expects to be entitled in exchange for transferring goods or services. Consideration might vary based on performance bonuses, discounts, price concessions and other items.
Using the example above, assume the contractor entered the contract agreeing to the new construction and electrical work for $2 million. The contract also includes a $100,000 performance bonus if the new building is completed by June 1.
To correctly recognize revenue, the contractor must analyze the likelihood that it will receive the bonus. The contractor weighs the relevant factors and determines that there is a 75 percent chance of earning the bonus, thus $2.1 million is the most likely transaction price.
Step 4: Allocate the transaction price
Allocate the transaction price to all of the performance obligations based on their relative stand-alone selling price.
In our example, the contractor must allocate the transaction price between the new building and the electrical work. Perhaps the contractor would not typically perform stand-alone electrical work, but agreed to take it on because they were contracted to build the office building. In the absence of a stand-alone selling price, the contractor would need to estimate. The contractor estimates the stand-alone selling price of the electrical work to be $100,000, so allocates $2 million to the new construction.
Step 5: Recognize the revenue
Under the new standard, revenue is recognized when (or as) control of a good or service is transferred to a customer. Revenue can be recognized over time or at a point in time.
A contractor recognizing revenue over time needs to determine a measurement of progress toward satisfaction of the performance obligations, and can use the output method or the input method. Under the output method, progress is measured by the result of the work performed, such as appraisal of the completed portion or milestones reached. Under the input method, progress is measured by resources consumed, such as labor hours or costs incurred.
Since our contractor does not have control over the land and office building, recognizing revenue over time makes sense. The contractor uses the input method to measure its progress toward satisfying the performance obligation. Once the contractor has incurred 20 percent of the expected costs on the new building, it recognizes $400,000 of revenue.
In this simple scenario, applying ASC 606 is very similar to the percentage of completion method, but identifying performance obligations, allocating transaction price and measuring progress all involve significant management judgment. Contractors who are now entering into two- or three-year contracts may want to consider how the new standard will impact those contracts and make modifications to them before they are finalized.