The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09 (updated in 2016), Revenue from Contracts with Customers, which addresses revenue recognition under U.S. Generally Accepted Accounting Principles (GAAP).The new rules, known as Topic 606, attempt to standardize and simplify the revenue recognition process for customer contracts across all U.S. industries and geographic locations.
Topic 606 requires businesses to recognize contractual revenue on their financial statements using a five-step approach. But there are still uncertainties, and whether the new standard will actually simplify the accounting process for contractors, in particular, remains to be seen.
New Five (5) Step Process
Construction companies have long relied on Statement of Position (SOP) 81-1 (Topic 605), which since 1981 has offered a clear set of rules regarding construction industry-specific guidance for reporting revenues. Topic 606 moves contractors from this 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:
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. But 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.
For instance, say a construction company is building a local school. The contractor will likely file periodic change orders to resolve routine issues that arise during construction. Revenue associated with the changes can be considered part of the original contract if the work can realistically fit within the project’s original scope.
So 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. For example, a price increase for widening the diameter of a water service pipe would require an adjustment to revenue recognized under the original contract under Topic 606 just as it does under Topic 605.
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.
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. But 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 and not wait until it gets 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 with current GAAP.
Under Topic 606, certain contract incentives or disincentives - such as performance bonuses, liquidated damages, and other penalties or discounts - 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 as under Topic 605.
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.
This rule has been subject to ongoing scrutiny, and may change before its implementation is required.
Making it happen
Since so many parts of the revenue and cost recognition process for contractors will be changing, it is important that contractors start now to implement these changes. Using the following process will help:
Inside your company, this should include 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.
This will include choosing a team leader (most likely the CFO/controller), identifying 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. They 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.
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 as discussed earlier, 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.
Collect the necessary information and categorize contracts appropriately during the year to facilitate providing required disclosures (see Disclosure requirements expanded, below) 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. We can help you address what is required, what is optional, and when inclusion of the optional detail would be helpful.
Develop a schedule and set deadlines for learning the new standard and applying the new procedures, then follow-through until it is complete.
Required reporting dates
Nonpublic companies must comply with the new standard for annual reporting periods beginning after Dec. 15, 2018 (calendar year-end December 31, 2019), and interim and annual reporting periods thereafter.
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.