Revenue Recognition and the Construction Industry
By now, you likely know that there is a new revenue recognition standard that will soon be effective and it will impact the way that construction companies recognize revenue. You have heard the doom and gloom scenarios that every contract will have multiple performance obligations and the percentage of completion method of recognizing revenue will disappear. Don’t panic!!! Over the past six years, as the new standard has been developed and clarified, it is becoming closer and closer to the way we recognize revenue today in the construction industry. So what are the basics that you need to know about the standard? Let’s take a look at the five-step process of recognizing revenue under the new standard.
- Determine whether you have a contract. Here are some specifics to look for when identifying a contract under the new standard: a contract is approved and the parties have committed (written or oral); it identifies the rights of the parties; it’s clear what each party is giving and/or receiving and it has payment terms. In other words, how much or what is being exchanged for the goods and/or services being supplied?
- Identify the performance obligations. Now that you have a contract, it’s time to identify what exactly you are delivering to the customer. Under the new standard, you’ll need to specify each performance obligation into distinct pieces or bundles. In short, the rule says that if a customer can use or benefit from an individual good or service on its own, or with other readily available resources, that it is considered distinct. But if a good or service is dependent on, or highly interrelated with, other items promised in the contract, that piece alone cannot be considered distinct. In most cases, a normal construction contract will have just one performance obligation.
- Determine the transaction price. The new standard provides several things to consider when determining transaction price: Variable consideration. You need to estimate what you will actually receive in exchange for this contract, taking into account such factors as incentives/penalties, change orders, claims and other, similar items. Historical and forecast data should also be considered when estimating. Any such events should be considered when estimating whether some or all of variable consideration should be included in the transaction price.
- Allocate the transaction price. If the contract includes several separate performance obligations, revenue should be recognized as each is completed. While most construction contracts will just have one obligation, there will be instances where there will be multiple performance obligations and revenue will need to be recognized on each one.
- Recognize revenue as performance obligations are satisfied. Construction contracts for the most part will be recognized on the percentage of completion basis using an input or output method to recognize revenue.
All issues are not resolved with the new standard. The FASB is still seeking comments from the public on a number of different issues that will affect the final version of the standard. Although we are not ready for the implementation stage, it is never too early to start to understand how the new standard will impact how your company recognizes revenue.