Impact of ASC 606 Revenue Recognition on Contractors

After two years of implementation delays, construction contractors, other private companies, and certain not-for-profits must now implement a new accounting framework for revenue recognition. The comprehensive changes outlined in Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, Topic 606, is designed to improve the consistency of financial reporting of businesses across different industries. The standardization is meant to help external stakeholders better understand a company’s financial position and compare data across industries. While the changes apply to all companies and nonprofit organizations, construction companies and contractors will be uniquely affected because of the use of long-term contracts. Achieving compliance with the new standard will not be a simple task. Atlanta contractors will need to take careful analysis and no shortage of subjective decision-making. To help clients, prospects, and others, Wilson Lewis has provided a summary of the key details below.

Previous Revenue Recognition

Prior to ASC 606, most construction contractors recognized revenue in one of two ways: percentage of completion or completed contract.

• Under percentage of completion, the contractor would recognize revenue at key milestones throughout the contract; for example, at the midway point, half of the contract’s revenue, cost, and income would be recognized.
• Under completed contract, all revenue, cost, and income are recognized at the end. This was less common and only applicable to short-term contracts and other extenuating circumstances.

Traditionally, contracts – even when there was more than one from the same owner and at a similar time – have been treated individually. Combining contracts only made sense in certain situations.

ASC 606 In Detail

ASC 606 changes how companies report the nature, amount, and timing of customer contracts. For private companies and not-for-profit organizations, the change is effective for:

• Annual reporting periods after December 15, 2019.
• Interim reporting periods beginning after December 15, 2020, if the interim falls within an annual period and financial statements were not issued as of June 3, 2020.

Since it can be hard for contractors to know when distinct milestones happen, FASB and IASB broke the framework into a 5-step process. In following the framework, construction contractors can best determine when to recognize revenue. It comes down to control: at the point when control of the good or service transfers from the contractor to the customer, that’s a recognition event.

 Step 1: Identify the customer contract.

Assess: Customer ability and intent to pay, whether to combine multiple contracts into one and how to account for contract modifications and change orders.

Step 2: Identify contract performance obligations.

Assess: promised goods or services and whether the contractor is acting as a principal or agent.

Step 3: Determine the transaction price.

Assess: variable costs, if the customer is providing any goods or services, and financing.

Step 4: Allocate the transaction price.

Assess: the price on its own and how to account for variable allocations and changes.

Step 5: Recognize revenue when performance obligations are met.

Assess: when control is transferred to the customer, either at once or overtime.

Challenges With ASC 606 in Construction

Two of the bigger challenges will be identifying multiple performance obligations and situations when there is more than one contract with the same customer around the same time.

Regarding the latter, contracts will probably need to be combined into a single contract if it’s for the same project, pricing for one depends on the other, or if there’s a single performance obligation. Further, contracts with subs or other vendors related to the same project may need to be combined into one contract for that project.

Contractors will need to define what similar timing looks like, how to tell if one contract depends on another, and related parties.

It can also be hard to measure project completion according to performance obligations. Contractors can either measure inputs or outputs. Input examples are cost incurred to date, labor, machine hours, and/or lapsed time. Output examples include agreed-upon milestones, results, and other project-specific KPIs.

Contract Considerations

There are several areas that contractors will need to address as they begin to implement ASC 606.

• Contract modifications – how will revenue be recognized when there are project delays? Are there different scenarios depending on why the job is delayed?
• Change orders – if the change is approved in both price and scope, the change order amount is simply added to the original contract; however, if the scope is the only element that changed, then any amount added to the contract is variable. In that case, use one of two approaches to recognize revenue:
  • Most Likely: revenue recognition when the cost can be reasonably measured.
  • Expected Value: revenue recognition when the final amount is paid; a weighted average is included in the change order in the meantime.
• More than one performance obligation – because ASC 606 requires each performance obligation to be recognized separately, decide how to identify and handle multiple obligations in one contract.
• Claims – accounted as variable consideration and included in the contract if its outcome is probable.

Contact Us

The new revenue recognition will require Atlanta contractors to carefully review existing contracts and make several changes to how revenue is reported on the financial statement. It is important to ensure efforts are underway to be ready to meet the new reporting deadline. If you have questions about the information outlined above or need assistance with a construction tax or accounting issue, Wilson Lewis can help. For additional information call us at 770-476-1004 or click here to contact us. We look forward to speaking with you soon.