Revenue Recognition: Accounting for Fulfillment Costs
Time is closing in on the deadline for non-public business entities to adopt the new accounting guidance for revenue recognition (ASC 606) for contracts with customers. This new standard will be effective with reporting periods beginning after December 15, 2018 (calendar 2019). The new standard will require retrospective application to the prior accounting period. Companies will need to understand the impact the changes will have on 2018 year-end financial statements.
One of the substantial changes required by the new ASU 2014-09 Revenue from Contracts with Customers (Topic 606) is how to account for fulfillment costs or (or upfront costs). Fulfillment costs are defined as costs that are directly related to a specific contract, generate or enhance a resource that is used to fulfill a performance obligation and are recoverable under the contract. Of particular concern are the pre-contract costs that are incurred prior to the transfer of control of goods or services to the customer. Such costs might include, but are not limited to, insurance/surety bonds, mobilization costs of equipment and labor to a job site, engineering and design, scheduling of workflows and costs of production equipment and materials related to a specific contract. These costs must be deferred and amortized to the contract as transfer of control occurs. There will be no revenue recognition for these costs, since there is no transfer of a control of any good or service. Amortization will be based on a systematic and consistent basis, such as the percentage of completion.
Another category of fulfillment costs that will need to be addressed are incremental costs. Incremental costs are those costs that are incurred in obtaining a contract that would not have otherwise been incurred if the contract had not been obtained. These costs are recognized as an asset similar to fulfillment costs and will be amortized to the contract as goods and services are provided to the customer. Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained (such as bid and estimation costs) will be expensed as incurred unless the contract explicitly states they are chargeable to the customer.
Another set of fulfillment costs addressed by the new standard are costs of waste and inefficiencies. When a cost incurred does not contribute to progress in satisfying a performance obligation, such as costs related to rework or wasted materials. Such costs would be excluded from input measurement used to recognize revenue and instead be directly expensed, as these costs do not represent the transfer of good or services to the customer. Significant inefficiencies in the contractor’s performance that are not reflected in the contract price will also require consideration. Theoretically, these costs should be segregated and charged directly to expense rather than used as an input in the calculation of revenue. However, it seems unlikely that contractor will be able to quantify these costs in any meaningful way.
The new standard raises questions about how a contractor might go about complying with the new rules since it is unlikely that current construction cost accounting software will be able to modify its programming to account for these items differently than current practice. We envision a more practical approach. A contractor might continue to account for its “upfront” costs as it does now, but total its costs incurred up to the point where goods or services begin to be provided to the customer. At year end, these costs for all contracts would be adjusted to the balance sheet, net of amortization, presented separately on the contract schedule by contract, and then subsequently reversed back to contract costs at the start of the new year.
As you can see, the new standard requires the contractor to account for certain costs differently than current practices. With lack of software modifications, contractors will have to find alternative strategies to properly account for and present these costs. Please contact us if you have any questions regarding revenue recognition or visit our revenue recognition recourse center.