Revenue is often used by bonding agents and sureties to measure whether a construction company is successful. So it stands to reason that revenue recognition for contractors – the point at which income is officially seen as revenue in your financial records – must be documented consistently and within established standards.
But revenue recognition for contracts with customers can get tricky, particularly within the construction industry. Previously industries often had their own specific criteria to define revenue, leading to varying accounting practices for the same types of transactions. Revenue recognition for construction contracts, for example, has always been accounted for using two basic methods: (1) the percentage-of-completion method, where all revenues, expenses and profits are tracked and recognized each accounting period as the contract moves towards completion; or (2) under the completed-contract method where revenues, expenses and profits are deferred until the contract is complete.
In response to the wide range of accounting practices for the same types of transactions, the FASB (the Financial Accounting Standards Board) issued an update in their reporting standards for revenue recognition from contracts with customers (“the new standard”). Instead of basing their guidelines on specific transactions and industries, they adopted a principle-based approach with the following objective:
The objective of the new guidance 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.
Under the new standard, revenue recognition will be achieved by applying the following five steps from FASB:
- Identify the contract with a customer.
- Identify the performance obligations (promises) in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the reporting organization satisfies a performance obligation.
What Does This Mean for Contractors?
Under the new standard, revenue is recognized when the contractor satisfies performance obligations which occurs 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 still recognize revenue on the percentage-of-completion method as they always have under Generally Accepted Accounting Principles (GAAP).
The biggest change for contractors will be determining whether they need to combine contracts that were previously separated, or have the opportunity to segregate contracts that were previously combined.
What Do You Need to do Now?
If you haven’t done so already, make sure you do the following:
- Review the new standard and talk to your CPA regarding accounting changes for your current and new contracts.
- Determine how your company will implement the new standard
- Identify current contracts with customers, and evaluate new contracts within the context of the new standard to identify any implementation issues.
- Determine any impacts to current bank covenants, surety requirements, and employee performance bonus plans that are tied to revenue or net income.
What Else is Changing?
Under the new standard, certain costs to fulfill 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.
What are fulfillment Costs?
- Costs that relate directly to an existing contract or specified anticipated contract;
- Generate or enhance resources of the entity that will be used to satisfy performance obligations in the near future, and;
- Are expected to be recovered.
The most common examples are:
- 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;
The new standard also includes disclosure requirements regarding revenues that will make financial statements clearer and more useful to the users of the financial statements. The 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).
The adoption requirements of the new standard differ between public and nonpublic entities:
- Public entities must adopt the new standard for reporting periods beginning after December 15, 2017. Early adoption is not permitted.
- Nonpublic entities must adopt the new standard for reporting periods beginning on or after December 15, 2018. There are several variations of early adoption available to these entities.
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