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Contractors: Are You Prepared for the New Revenue Recognition Standard?

07/16/2019 Andrew Donohoe

It’s been five years since we first heard of the impending revenue recognition update, and the time has finally come for companies to implement the new standards. We’ve been hearing about it for five years and the time has almost come for all companies to implement the new revenue recognition standards set out in Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers. Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, also known as Topic 606, attempts to standardize and simplify the revenue recognition process for customer contracts across all U.S. industries and geographic locations.

While there are still uncertainties as to how much this may affect contractors and how they have recognized revenue under the old standards, every company is required to implement for the year ending December 31, 2019 and interim periods starting in 2020.

There is also some debate surrounding how much these new standards will  materially affect contractors’ financial statements as it pertains to contracts and how we recognize revenue on those contracts.  However, one thing is certain, whether it affects one percent or ninety-nine percent of your contracts, you need to understand the new standard and be able to explain how you came to your conclusions.

New Five (5) Step Process

Topic 606 moves contractors from rules-based guidance for specific situations to a principles-based approach for certain circumstances.

Perhaps the biggest change under Topic 606 is that contracts must now be divided into separate performance obligations for those portions of a contract that have utility (usefulness) on their own and for which there is severable risk. In other words, revenue should be recognized when a promise is fulfilled in a contract with a customer and a specific good or service can be transferred.   

To that end, Topic 606 introduced a 5-step approach for recognizing revenue as follows:

  1. Identify the contract(s) with a customer,
  2. Distinguish any separate performance obligations in the contract,
  3. Determine the overall transaction price,
  4. Allocate the transaction price to the separate performance obligations, and
  5. Recognize revenue when (or as) the entity satisfies a performance obligation.

Percentage of Completion Remains

Revenue on contracts (or separate performance obligations within contracts) will still be recognized on the percentage-of-completion method using either input (such as cost-to-cost) or output (units produced) methods.  However, what gets included in that measurement process, as well as when it is included, will change for some revenues and costs.

Change Orders, or Contract Modifications, and Separate Performance Obligations

Under Topic 606, contractors must account for a change order (referred to as “contract modifications” under the new standard) as a separate performance obligation or contract if the additional work provides a distinct benefit to the customer, or the asset can be transferred to the customer separately from other promises in the contract.

If the change is bundled with other related tasks and services — and does not provide a separate, distinct benefit — it will generally be considered part of the original contract (as it is under current GAAP), and would not qualify as a separate contract under the new rules. 

However, if the additional work could not be considered part of the original scope — like the addition of a press box to an athletic field adjacent to the school — the revenue associated with the contract modification would generally be treated as a new contract. 

Let’s assume the athletic field was complete at period end, the press box work was not to be completed until the following period and the press box had a higher gross profit percentage than the athletic field contract. 

Under the old standard, you would include the signed change order in the full contract amount and recognize revenue (and profit) on a percentage-of-completion method at the end of the period, utilizing the blended gross profit percentage of the athletic field and press box.  Under the new standard, you would recognize all profit on the athletic field but no profit on the press box until the following period when the press box was completed. 

Recognizing Change Orders, or Contract Modifications

In addition, unlike current GAAP, there are other differences in accounting for contract modifications. Under Topic 605, revenue to the extent of cost incurred is recognized if getting an approved change order is likely, but the full amount of the change order is not added to the contract until approved.  Under Topic 606, contractors must estimate the amount of the contract modification and include it in the contract price at the inception of the contract modification, instead of waiting for it to be approved.  Similarly, Topic 606 requires claims revenue to be estimated and included in the contract when the claim is filed, not when it is realized or received as it is with current GAAP.

Variable considerations

Under Topic 606, certain contract incentives or disincentives — such as performance bonuses, liquidated damages, and other penalties or discounts — are called variable considerations and must also be estimated and included in the contract from inception, not when incurred.  Likewise, if portions of a contract might not be collected when billed, the potential bad debt must be estimated and reduce the contract price at inception, not when it becomes known per Topic 605. 

Contract costs

Under current GAAP, pre-contract costs are excluded from jobs and expensed as incurred.  Under Topic 606, they are included in job costs.  However, such things as materials (whether created specifically for the job or not) and wasted effort (materials and labor), must be excluded from the percentage of completion calculation for purposes of recognizing gross profit on jobs.  They do get added to costs-to-date when purchased, but no profit is added to the job for these costs.   

What Should You Be Doing Now?

With so many changes and uncertainties on how this will affect your business, the second half of 2019 is a great time to continue your research and finalize plans on how you will implement these standards come year end.  Using the following steps will help you along the way:

  1. Get your team on the same page

Inside your company, your team includes your CFO/controller, owner, and project managers. Outside the company, include your CPA (who must attest upon — audit or review — your financial statements and determine if you have properly implemented Topic 606), surety, bank, and other creditors.  Your CPA should have access to implementation guides, examples and point you in the right direction for documentation of your implementation of the standard.

  1. Document your Year-End plan

This will include choosing a team leader (most likely the CFO/controller), identifying any software changes needed to accommodate the new standard, making it available to the required users, and educating them on what needs to happen. It also means determining the approach to your company’s different niches, lines of business, and contract types.  Each may be treated differently under Topic 606.  Begin with a couple people (Controller, PM) and a couple contracts, then expand to the entire company from there.

  1. Apply the new accounting policies and procedures

Go through the 5-step approach for determining a contract and its performance obligations (tailored for each of your niches, lines of business, and contract types), estimate and include variable considerations and contract modifications in the contract amounts at inception (discussed above), and account for materials and other costs in accordance with Topic 606.  Then, determine what IT changes you will need and be sure your accounting software provider makes this available.  Determine whether you need to develop any internal checklists or documentation at the start of new contracts. 

  1. Perform Case Studies

It is highly beneficial to perform case studies on new or old completed jobs to determine the likelihood of the new standards affecting your contracts..  We feel that a majority of our clients’ contracts will be unaffected, or have an immaterial affect, but by performing these case studies, you will get a better understanding of what to expect at the end of 2019 and going forward. 

  1. Provide additional disclosures

Even if your contracts have no additional performance obligations or variable considerations, your financial statement disclosure should look different due to new requirements.  Collect the necessary information and categorize contracts appropriately during the year to facilitate providing required disclosures at year end.

Disclosure requirements expanded

Existing revenue recognition guidance (Topic 605) grants construction companies some leeway in disclosing contract-related information. For instance, you are currently required to provide only general disclosures about revenue-related accounting policies and customer payments, and some disclosures (like backlog) are optional.

Topic 606 expands both the qualitative and quantitative contractual details required for contractors to provide in their financial statements.  Footnotes must include more information about the nature, timing, amount, and potential uncertainty of revenue and cash flows arising from a company’s customer contracts.    

While private companies are exempt from some disclosure requirements, these exemptions are limited.  Industry implementation guides are great tools for determining what is required for private vs. public companies.  We can help you address what is required, what is optional, and when inclusion of the optional detail would be helpful.

  1. Be Prepared

If your year-end is December 31, 2019, make sure you’ve had the relevant conversations with your internal team and external advisors.  The more work you do in the second half of 2019, the better off you will be going forward.  If your construction company must provide GAAP financial statements to its bank, surety, or a regulatory agency, you need to be ready for this change.  We can help you with that conversion, and also in understanding how the newly revised approach to revenue recognition may change the way certain stakeholders, both inside and outside of your company, will view your business. 

Andrew Donohoe (CPA, CCIFP) is a shareholder in VonLehman’s Construction and Real Estate Services Group and frequent author and speaker, both locally and nationally, on construction accounting, consulting, and income tax issues.  He is active in various construction trade associations in the Ohio, Kentucky, and Indiana tri-state area.

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