Practical Considerations for Implementation of Revenue Recognition
Preparing for and complying with Accounting Standard Codification No. 606, Revenue from Contracts with Customers (ASC 606), may be more challenging than many companies realize. The new revenue recognition standard, which vastly changes the revenue recognition model for contractors, is now in effect for private companies.
The core principle of ASC 606 is that an organization should recognize revenue in a way that matches when the organization has met each obligation (whether goods or services) under the contract, and the revenue should be recognized at a value commensurate with such obligation. To achieve that principle, the organization would apply the follow five-step model when accounting for each and every contract.
- Identify the contracts with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the entity satisfies the performance obligation(s)
While this model may seem straightforward, the nature of the construction industry causes many nuances in the application of ASC 606. Accounting professionals in the construction industry may find that the new standards require a reevaluation of their accounting functions and a closer application of judgment. Some of the key issues that construction companies need to be aware of and whose impact can be evaluated during implementation process include:
Variable Consideration
Variable consideration is inherent in many construction contracts and includes, but is not limited to, refunds, performance bonuses, rebates, incentives, credits, price concessions, and penalties. Contractors will need to estimate the amount of variable consideration to include in the contract amount utilizing a method that best predicts the amount of variable consideration that will be realized. The guidance provides for two methods to estimate variable consideration: the expected value method and the most likely amount method.
Cost of Obtaining and Fulfilling a Contract
Incremental costs of obtaining a contract (i.e. travel costs to deliver bid proposal, commissions paid, etc.) and costs incurred in fulfilling a contract (i.e. Surety bonds, mobilization, etc.) need to be deferred and amortized over the life of the contract, and the amortization method should be consistent with how revenue is being recognized on the project.
Uninstalled Materials vs. Inventory
Construction companies may hold substantial quantities of materials that have not been installed or used in a specific contract and therefore control has not been transferred to the customer. The new guidance states that costs related to these materials cannot be included in a contract where control transfers over time (and therefore, revenue may not be recognized related to these materials). This is because these costs do not represent progress towards completion of the contract until they have been installed or used in the specific contract. Until these materials are installed/used in a specific contract, they must be accounted for as inventory assets on the balance sheet.
Waste and Inefficiencies
If a company incurs cost that does not contribute to progress in satisfying the performance obligation, such as costs related to rework or wasted materials, these costs must be removed from the contract and expensed as incurred. Therefore, these costs would not be considered when determining revenue recognition under the new standard.
Warranties
Companies may need to account for a warranty as a separate performance obligation and allocate a portion of the transaction price to the warranty, if at least one of the following is true:
- Customer has the option to purchase a warranty separately;
- Warranty period is over a year; or
- Warranty provides a separate service other than assurance of a product’s compliance with agreed upon specifications.
The impact of the new revenue recognition standard may be more significant to some segments of the construction industry than others, but you will not know until you put an implementation plan in place and fully assess that impact. The implementation and consideration of the issues discussed in the article with involve significant judgement and will require detailed evaluation, documentation and disclosure.
There are several valuable resources available to assist in implementing the new standard through the FASB, AICPA, CFMA and CICPAC to name a few. However, involving and consulting with your accountant/auditor is important and a good start to implementation. Periodic meetings and consultations with them during the process will also be beneficial so that you both are on the same page and possibly reduce any duplication during the implementation process. This will make your reporting period engagement be efficient and go much smoother so that you can meet your reporting deadline.
Dannible & McKee, LLP, has a team of construction accountants that are available to assist you with the implementation process. To learn more, contact Joseph Chemotti, CPA, CCIFP, at 315-472-9127 or jchemotti@dmcpas.com. For additional tools, guides and articles on the new revenue recognition standards, visit our Revenue Recognition Resource Center.