The threat of revenue recognition has been around since 2010, when the first draft of the new standard was released. Three exposure drafts and numerous accounting standards later, we are finally on the doorstep of being required to recognize income under the five step approach found in Accounting Standard Codification (ASC) 606. Although public companies have been reporting under ASC 606 for all of 2018, non-public companies are not required to adopt until years beginning after December 15, 2018.
The main goal of ASC 606 was to create a similar revenue recognition policy and calculation across all industries. The construction industry, which has historically had its own guidance and industry practices, is no exception. After completing the first four steps as required by ASC 606 – identifying the contracts, identifying the performance obligations, determining the transaction price, and allocating the transaction price to the performance obligations – here are five items that may affect the construction industry when finally recognizing revenue in step five:
Timing of recognition
ASC 606 has two basic options for recognizing revenue once control has been transferred:
- over time or
- at a point in time.
In order to recognize revenue over time, one of the following criteria needs to be met:
- The customer receives and consumes the benefits provided by the seller’s performance as they perform.
- The seller’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. For example, you are constructing a building on the customer’s land, even if construction is stopped half way through the project, the customer’s asset (land) has received value.
- The seller’s performance does not create an asset with an alternative use to the seller, and the seller has an enforceable right to payment for performance completed to date. For example, pre-fabricated wall panels are customized for a specific project and the contract stipulates once production starts costs are the customer responsibilities.
Before determining if a contract meets one of the above requirements, construction companies will need to understand when transferring control of the asset, as defined within ASC 606, occurs. It is not until control is transferred that revenue can be recognized. ASC 606 defines “control of an asset” as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from an asset.
Examples of indicators that transfer of control has occurred include:
- An entity has a present right to payment for an asset.
- Customer has legal title to the asset.
- Physical possession of the asset has transferred.
- Customer has accepted the asset.
These concepts are easier to conceptualize when the end product is a tangible item, but when considered in relation to the construction of a building, parking lot, house or any component within a larger construction project it becomes more difficult. Often in these projects, the customer will not accept the asset until all punch list items have been completed.
Percentage of completion and completed contract methods, in name, no longer exists. In essence, “billings in excess of costs” and “costs in excess of billings” will shift to the concepts of “contract liability” and “contract asset.” Additionally, instead of percentage of completion, contractors will use a cost “input method” as described in ASC 606 when calculating the contract liability/asset. Although the actual math using the new input method will be nearly identical to the calculation used for over and under billings, the path to that point will be different.
Under ASC 606, the scope of a change order determines if it should be considered a separate contract or should be combined with the original contract. The determining factors in that decision is based on if the change order results in an addition of a distinct good or service and if that good or service reflects the standalone selling price.
The accounting for wasted material was emphasized within ASC 606. If a company has wasted costs (purchased the wrong materials, had re-work due to error, poor job management, etc.) those costs are recognized immediately and not taken into account as a job cost. Therefore, this is not part of the cost input calculation when recognizing revenue over time.
High material costs
Based on the type of construction project, material costs can be the majority of the total job costs. ASC 606 requires construction companies to consider the realistic progress made on a job when determining if the material costs can be included in the cost input method calculation.
Example – If a $500,000 job includes a $300,000 generator and on day one of the job the generator is purchased, the calculation would exclude the $300,000 in costs and in contract value when completing the cost input calculation.
Even with nearly a decade of warnings, revenue recognition has arrived quickly, and is now requiring the attention of construction companies. Without careful planning and reviewing of contracts, revenue streams could unintentionally change.
To learn more about the revenue recognition standard and how it may affect your construction business, contact a member of the Smith Schafer Construction & Real Estate niche. Smith Schafer has been a recognized leader in providing accounting, auditing and consulting services to the construction and real estate industry since 1971. We look forward to speaking with you!