The new Revenue Recognition Standard, ASC 606, aims to break down a complex problem into manageable steps. When businesses follow the Standard’s five-step model, financial statements will become more standardized and can even be compared across industries. Although the steps themselves seem to be straightforward, applying them to your own revenue streams can be tricky, especially for those in the construction industry. When contracts span long periods of time, consist of different delivery phases, and frequently get modified, business owners may not know how to apply the standard. Below are a few of the most common questions that clients have been asking.
How will change orders be accounted for under the new standard?
We introduced this topic briefly in a previous article, but it’s important enough to bring up again. Contract modifications should be accounted for as separate contracts only when (1) the additional goods or services are distinct, and (2) the cost of those additional goods and services reflects their standalone selling prices. Otherwise, contract changes should be tied in with the existing contract. If the goods or services are distinct, but the contract price does not increase per the standalone selling prices, you should recognize the revenues as you complete the obligations going forward. If the goods or services are not distinct, recalculate the price of the project and record a catch-up adjustment.
When do I record the revenue of a long-term construction project?
This is a simple question with a not-so-simple answer. It all hinges on the transfer of control. A point-in-time transfer is the easiest concept to understand. If the purchaser does not have any legal rights to the project until you’ve fully completed it, the transfer of control – and therefore the recognition of revenue – will only happen when you hand the metaphorical keys over to the new owner.
However, ASC 606 also lets you recognize revenue over a period in certain circumstances. If the customer can use the property before construction is fully completed, you can recognize revenues over the life of the contract. In this instance, you would recognize revenues as you complete your separate performance obligations.
Should my contract be broken up into multiple performance obligations?
A performance obligation is the promise to provide a distinct good or service. In practice, most contractors have an all-or-nothing philosophy. They argue that their one performance obligation will be to build the road, construct the home, or erect the refinery, and any steps they take to deliver the product is just part of the package. However, some businesses have successfully segmented their projects into multiple performance obligations.
Consider a contractor who agrees to design a new restaurant, build it, and then install the kitchen equipment. Can each of these tasks be segmented into separate performance obligations? Maybe. If the purchaser could have chosen a different designer, the contractor could argue that their design services are separate and distinct from their construction obligations and should be accounted for separately. As with all other sections of this new standard, judgment will come into play. Be prepared to explain your reasoning in the disclosures.
Will the timing of payment affect the recognition of revenue?
Yes, it could impact when you record revenues, but more importantly, it can impact the dollar amount that you record. Construction contracts often include “significant financing components” where there is a mismatch of services rendered and payments received. If you ask your customer to pay you upfront, there is a mismatch of services rendered and payment received. The same can be said when you let your customer pay you upon completion; the services do not correspond with the payment. When there is a significant financing component in any project, you will need to adjust the price of the contract.
If the gap between payment and delivery is less than a year, you won’t need to adjust the transaction price. But if the gap is more than a year, you will need to discount the purchase price using a third-party, arm’s length interest rate. The rate should even reflect the credit rating of the party receiving the financing, which could be you (if your customer pays you upfront) or your customer (if you perform the services before your client pays you).
Revenue recognition requires you to use a great deal of judgment, and you will have to be prepared to justify your decisions. In a way, it can be treated as a thought exercise and an opportunity to inspect existing contracts and think about how you can make the revenue recognition process more streamlined. Since revenue recognition is already in effect, there is not a lot of time left to figure it out. If you have questions about revenue recognition implementation, GBQ can help! If you have general construction accounting questions or need assistance, our team is ready to help.