New Revenue Recognition Guidelines for the Construction Industry

What does the new standard (ASC 606) mean for your construction contracts?

By now, most construction contractors and managers are well-versed in navigating the winding world of contracts. These complicated documents keep the cogs in the construction industry turning by clearly and carefully laying out each party’s expectations, responsibilities and risks for a given project. However, the rules recently changed when it comes to “revenue recognition” for contractors—which is the point at which income is officially earned as revenue in your financial records.

Revenue drives the financial results used by owners, banks, and sureties to measure success for a construction company. So it stands to reason that revenue recognition must be recognized consistently and within established standards. But revenue recognition for contracts with customers can get tricky, particularly in the construction industry.

What is the new standard of revenue recognition?

On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) collectively issued an update in their reporting standards for revenue recognition from contracts with customers. Referred to as “the new standard,” Accounting Standards Codification Topic 606 (ASC 606), Revenue from Contracts with Customers was in response to the wide range of accounting practices for the same types of transactions.

Previously, industries often had their own specific criteria to define revenue, leading to varying accounting practices for the same types of transactions. Two of the most common revenue recognition methods prior to the new standard included:

  • Percentage-of-completion method. In this method (primarily used for long-term construction contracts), all revenues and costs were recognized each accounting period as costs were incurred as a percentage of the total estimated cost.
  • Completed-contract method. In this method, all revenues and costs were deferred until the project was mostly completed.

Instead of basing their guidelines on specific transactions and industries, FASB adopted a principle-based revenue recognition approach to replace existing methods with the new standard.
The objective of the new standard is to establish the principles to report useful information to users of financial statements about the nature, timing, and uncertainty of revenue from contracts with customers.

What are the 5 steps of the revenue recognition process under the new standard?

Under the FASB’s new standard, revenue recognition will be achieved by applying the following 5 steps:

  1. Identify the contract with a customer.
  2. Identify the performance obligations (promises) in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to the performance obligations in the contract.
  5. Recognize revenue when (or as) the reporting organization satisfies a performance obligation.

While these 5 steps are similar in some ways to the old revenue recognition methods used by many contractors, there are some important and nuanced differences in how revenue is recognized that must be accounted for.

What does the new standard mean for construction contractors?

Under the new standard, revenue is recognized when the contractor satisfies certain performance obligations when the control of either goods or services are transferred to the customer. The transfer of control to a customer can occur over a period of time or at a single point in time. Since most construction contracts transfer control over a period of time, we believe that contractors will continue to recognize revenue on the percentage-of-completion method as they always have.

The biggest change for construction contractors will be determining whether they have a single or multiple performance obligations in each contract. Each performance obligation must be evaluated as a separate revenue stream recognized based on facts and circumstances. If the contract has multiple performance obligations then each has to be evaluated and revenue recognition may be different for each performance obligation.

The FASB’s new standard also includes disclosure requirements regarding revenues that will make financial statements a more clear and useful tool for users of the financial statements.

How can you ensure that you’re meeting revenue recognition standards?

If you haven’t done so already, make sure you do the following:

  1. Review the new standard and talk to your CPA regarding how the accounting changes may impact accounting for your current and new contracts.
  2. Determine how your company will implement the new standard.
  3. Review current customer contracts and identify performance obligations, and evaluate new contracts within the context of the new standard to identify any implementation issues.
  4. Determine any impacts to current bank covenants, surety requirements, and employee performance bonus plans that are tied to revenue or net income.

What are the 4 criteria for revenue recognition?

According to the U.S. Securities and Exchange Commission, “revenue generally is realized or realizable and earned when all of the following criteria are met”:

  • Persuasive evidence of an arrangement exists,
  • Delivery has occurred or services have been rendered,
  • The seller’s price to the buyer is fixed or determinable,
  • Collectability is reasonably assured.

What about fulfillment costs?

Under the new standard, certain costs to fulfill construction contracts are to be capitalized on the balance sheet. The contractor should then amortize the capitalized costs over the expected contract life in most cases.

Fulfillment costs are:

  • Directly related to an existing contract or specified anticipated contract,
  • Used to generate or enhance resources of the entity to satisfy performance obligations in the near future, and
  • Expected to be recovered.

The most common examples of fulfillment costs include:

  • Engineering and design
  • Mobilization costs incurred by contractors to mobilize equipment and labor to and from a job site
  • Surety bonds and insurance costs incurred for a contract

Who does the new standard impact?

The new standard affects all public and private entities that have contracts with customers, with exceptions for certain leases, insurance, financial instruments and guarantees other than product or service warranties (these exceptions are accounted for under other FASB standards).

When did ASC 606 go into effect?

The adoption requirements of the new standard differ between public and nonpublic entities:

  • Public entities were initially required to adopt the new standard for reporting periods beginning after December 15, 2017. Early adoption was not permitted.
  • Non-public entities were required to adopt the new standard for reporting periods beginning on or after December 15, 2018. There were several variations of early adoption available to these entities. This meant that the new guidelines should have been implemented starting on January 1, 2019 for calendar year companies.

NOTE: Due to the COVID-19 pandemic, the FASB pushed back the required implementation date for 1 year.

How has the COVID-19 pandemic impacted construction revenue recognition?

The coronavirus continues to impact construction companies in unprecedented and unknown long-term ways, particularly when it comes to revenue recognition of existing and future contracts. In fact, any of the 5 steps laid out in the new standard revenue recognition process can be affected by the pandemic and therefore it may be time to reassess your compliance obligations and financial risks.

For example, due to pandemic-caused supply disruptions, labor shortages and shutdowns, your project may be delayed and therefore unable to meet the performance obligations of finishing by a specified time. As a result, it may be necessary to consider modifying certain contract provisions with customers, such as the timing of revenue recognition.

Why consult with JMCO for revenue recognition solutions?

James Moore provides accounting and consulting services for construction revenue recognition.
To successfully implement the new standard, there are various approaches you can take when it comes to revenue recognition for professional services. Ultimately, determining which approach is right for your business is dependent on your individual circumstances such as your entity type and the nature of your contracts.

Our Florida construction CPAs and accountants can evaluate how the ASC 606 will impact your business—from the combining of contracts and contract modifications, to variable considerations and uninstalled materials. Through our revenue recognition solutions, we’ll ensure you remain compliant with the new standard by creating new accounting practices, and help communicate these changes to your stakeholders and executives. Most importantly, we’ll help you avoid any unanticipated and unwanted surprises down the road.