How to Apply New Revenue Recognition Rules to Uninstalled Materials and Equipment
It comes as no surprise that the COVID-19 pandemic has led to substantial economic challenges in the construction industry. Supply chains have been inhibited, leading to less than desirable lead times for equipment and materials needed to get projects completed. More recently, inflation has resulted in contract costs that are higher than originally planned. Many contractors have had to take measures to mitigate these challenges, such as purchasing equipment and materials earlier in the contract life cycle than in the past or placing bulk orders for materials in excess of what is needed for a contract completion to take advantage of volume pricing discounts.
While these strategies are excellent ways to help to control the impact the pandemic has had on profitability, it is important for contractors to consider the revenue recognition requirements under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 606 for upfront contract fulfillment costs and uninstalled materials when accounting for contracts, since the timing of revenue recognized in relation to these types of costs will likely be different than under previous Generally Accepted Accounting Principles (GAAP).
Under accounting practices prior to implementation of ASC 606 for reporting periods beginning after December 15, 2019 (calendar 2020), upfront contract fulfillment costs, including costs of production equipment and materials related to a specific contract, could be charged to job costs and included in the inputs used to measure the percentage of completion on the project, which ultimately drove the revenue recognized to date on the contract.
Conversely, ASC 606 requires revenue to be recognized to depict the transfer of control of goods and services to a customer and specifically calls for upfront contract costs to be recorded on the balance sheet and amortized to contract cost over the expected contract term. While under past practices, revenue would be recognized immediately for materials and equipment purchased specifically for a contract, when accounting for contracts under ASC 606, the materials and equipment cost is required to be charged to contract costs when consumed or installed, delaying the revenue recognized related to these costs.
The method of accounting for materials purchased for contracts is also different under ASC 606 than it was under previous GAAP. Prior to the implementation of ASC 606, accounting for the cost of contract materials depended on whether materials were purchased specifically for a contract, or whether it was general inventory available to be used on several contracts as needed. For materials purchased specifically for a contract, the revenue recognition method was like the previous method described above for upfront contract fulfillment costs, while general materials purchases were included within inventory in the balance sheet until segregated for use on a specific contract.
Under ASC 606, the cost of materials that are not specific to a contract would be accounted for in a similar manner as past practice as inventory on the company’s balance sheet. However, accounting for contract-specific materials under ASC 606 requires some consideration of the timing for when control of those materials has passed to the contract owner. In situations where materials are purchased for a contract or segregated out of inventory for use on a specific contract and billed to the owner but have not yet been installed, the contractor must limit the revenue recognized on these materials to be equivalent to the cost, effectively no gross profit may be recognized. Under ASC 606, recognition of the gross profit component of the contract price related to these materials must be withheld until the materials are installed. Accounting for these situations can be a challenge and requires coordination between project managers, procurement managers and accounting personnel to ensure the transactions are appropriately reflected in the contractor’s financial statements.
It is important for contractors to remember these key changes related to revenue recognition when accounting for their contract activity, especially in the challenging economic environment created by the COVID-19 pandemic. Be sure to contact us with any questions.
Contributing author: Benjamin A. Sumner, CPA, is an audit partner with over 12 years of experience providing auditing, accounting and consulting services to a wide variety of privately-held businesses. Contact us to learn more about how we can help.