On May 28, 2014, the Financial Accounting Standards Board (FASB) issued ASU No. 2014-09, Revenue from Contracts with Customers, which replaces all existing guidance for revenue recognition. For many contractors, implementation of the new standards may not have a significant impact on revenue recognition; however, all contractors face significant changes in disclosure requirements. The new revenue recognition standards were applicable to nonpublic entities for annual reporting periods after December 15, 2017.
Under previously existing U.S. GAAP, contractors accounted for revenue using either the percentage-of-completion method or the completed-contract method. Industry specific guidance existed regarding accounting for long-term construction contracts, change orders and other contract modifications as well as the determination of contract price and addressing variable consideration. All of this has been superseded and replaced by the new revenue recognition standards, ASU No. 2014-19.
The core concept of ASU No 2014-09 is that an entity will recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. The timing of revenue recognition over a contract period is determined through the application of a five step process:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations.
- Recognize revenue when or as performance obligations are satisfied.
It seems pretty simple, right? It is…until you start thinking about some of the complexities inherent in construction contracts. Let’s take a look at a couple of key concepts.
Multiple Contracts with the Same Customer
If a contractor has two or more contracts with the same customer (or related parties of that customer), for purposes of applying the five step process above, the contracts must be combined into a single contract if they meet any one of the following:
- The contracts are negotiated with a single commercial objective.
- The amount of consideration to be paid under one contract depends on the price or performance of the other contract.
- The goods or services promised in the contracts are a single performance obligation.
Contracts with different customers may no longer be combined, even if the contracts are economically linked.
Recognizing Revenue Over a Period of Time
Step 5 above requires that revenue recognition when the contractor satisfied performance obligations, which occurs when control of goods or services are transferred to the customer. This transfer of control can occur over a period of time or at a single point in time. In the construction industry, transfer of control generally happens over a period of time. However, under the new standards, one of the following conditions must be met in order to recognize revenue over a period of time:
- The customer simultaneously receives and consumes the benefits provided by the contractor’s performance as the contractor performs.
- The contractor’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.
- The contractor’s performance does not create an asset with an alternative use and the contractor has an enforceable right to payment for performance completed to date.
If one of these criteria has not been met, revenue must be recognized at a single point in time.
Determining when control transfers will require judgment. Some questions to ask in determining when control transfers are as follows:
- Does the contractor presently have a right to payment?
- Does the customer have legal title?
- Has the customer taken physical possession?
- Have significant risks and rewards of ownership transferred to the customer?
- Has the customer accepted the asset?
Contract Modifications and Change Orders
Under the new revenue recognition standards, if a contract is modified resulting in a change in scope or price (or both), the contractor must determine if the modification creates a new contract or if it should be accounted for as part of the existing contract. For purposes of application of the standards, a contractor will account for a contract modification only if it has been approved by both parties. In general, approval of a contract modification could be in writing, by verbal agreement or implied based on facts and circumstances.
The amount of variable consideration to be included in the transaction price (Step 3 above) requires significant judgment under the new revenue recognition standards. The contractor must determine the amount to include in the transaction price by estimating the expected value or most likely amount to which the contractor will be entitled. Variable consideration may only be included in the transaction price to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Contractors will have to make a qualitative assessment as to whether or not the revenue associated with variable consideration, if recognized, may have to be reversed, all or in part. This assessment may include the following considerations:
- Is the amount of variable consideration susceptible to factors outside of the contractor’s influence?
- What is the contractor’s experience with similar types of contracts in instances where uncertainty is involved?
- Does the contract have a broad range of possible consideration amounts?
Identification of Performance Obligations
Judgement is going to be needed to determine whether all promises or deliverables in a contract constitute a single, combined performance obligation, particularly when assessing contracts such as engineering, procurement and construction contracts or design and build contracts. In the context of a specific contract, the promised good or service may not be separately identifiable from other promises in the contract. The new standard provides a list of indicators for the contractor to consider in determining whether separately identifiable goods or services exist within a single contract.
Contract Assets and Liabilities
Under the new standards, a contract asset is recognized when a contractor satisfies a performance obligation and has earned a right to consideration from the customer. A performance liability is recognized if a customer has prepaid consideration before a performance obligation is satisfied.
ASU 2014-09 includes comprehensive disclosure requirements to provide more information regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The disclosures are intended to provide both qualitative and quantitative information about contracts and judgements in accounting for those contracts.
The topics discussed above are only selected concepts. There are several other considerations applicable to the construction industry that are addressed in the new revenue recognition standards, including (but not limited to) set up and mobilization costs, warranties, claims for overruns, contracts that include financing components, unpriced change orders and customer-furnished materials. For an overview of the revenue recognition standard, check out this article. And if you need help determining how the new standards are applicable to your specific situation, contact Landmark.