The new revenue recognition standard (ASC 606, Revenue from Contracts with Customers) affects construction companies in unique ways, particularly in the area of purchased material. How a contractor will account for these costs under the new standard depends on a variety of factors, including how the material is classified, when the customer obtains control of the material, and whether or not the material is installed, designed and manufactured by the contractor.
Determining the Classification of Purchased Material
Transfer of control is an important concept in the determination of revenue and the recognition of costs under the new accounting guidance. Contractors need to follow this guidance to determine the classification of material purchased as either inventory, uninstalled material or contract costs, and understand when the materials transfer from one classification to the next. Topic 606 states revenue is recognized when (or as) the customer obtains control of the promised good or service. When performance obligations are to be recognized over time, an appropriate driver should be selected to measure the progress of transferring control to the customer. Using the cost-to-cost input method as the driver, progress towards completion is computed based on the costs incurred in a project. Costs that relate directly to a contract include, among other costs, direct materials such as supplies used to provide the promised services to a customer. Direct costs are costs that relate directly to an existing or specific anticipated contract.
Materials Job Cost Practice Prior to Topic 606
It has been common practice for contractors to charge purchases of materials, even commodity items and supplies to a specific job as they are incurred or purchased. Simply put, any cost incurred with the objective of a contract was immediately charged to job costs and a contract often without consideration of control or ownership. Some contractors, particularly trade subcontractors, maintained inventory of materials common to jobs, or to stockpile materials, anticipated for future work when cost increases were expected. These inventory items were usually charged to a contract and to job costs when they were transferred to the job site, but the contractor may have used some other trigger to determine when the reclassification from inventory was appropriate. When a contract was completed, the contractor would restore any usable materials back into inventory and reduce contract costs. Contractors that perform fabrication under contracts might have an inventory of raw goods such as dimensional steel or sheet metal. Those goods would be held in inventory until they enter into the fabrication process under a contract.
Topic 606 does not have the intent to change inventory accounting, but it is likely that as companies evaluate their practices for Topic 606 implementation, that they may determine that their prior accounting practices for materials should be changed and inventories recorded to reflect materials where control has not been transferred to the customer.
How to Apply the Transfer of Control Concept to Materials
Companies cannot properly account for contract costs and revenue without a clear understanding of “transfer of control.” As discussed above, a contractor may incur costs for materials, and control remains with the contractor for a period of time. A contractor may incur costs for materials, equipment, services, etc., related to a contract that enhances resources that will be used in satisfying performance obligations in the future (mobilization costs) that is recognized as an asset and amortized into job costs over time (Capitalized Costs to Fulfill a Contract). The contractor may incur costs for common materials that immediately (or in an insignificant amount of time) are transferred to the customer. The contractor may incur costs for customized materials that do not have an alternate use other than the particular contract, and generally, these items will constitute contract costs. However, the fact that an item meets the specifications of a contract does not necessarily infer that it is, therefore, a contract cost as incurred. This would be the case if the specifications contained a description of materials that are in the common supply chain.
In applying transfer of control standards, it is imperative that an entity has a thorough understanding of the indicators of control. The entity will normally conclude that control has transferred if ownership has transferred to the customer. The construction industry has many unique laws regarding ownership, rights, and obligations that arise from individual state laws as well as common law. In some states, ownership of materials passes to the owner of the real estate (for a subcontractor, the property owner is the customer of the customer) when it is delivered to the project site. In other states, ownership interest arises in the customer’s hands when the material supplier obtains the right to impose a material lien on the property (normally at the time of purchase with a disclosure of the target job location – even if the material is delivered to another location). In some states, ownership passes to the customer at either billing or collection. What are the laws applied in the jurisdiction of the contract? It is critical that contractors obtain legal advice regarding ownership interest in construction materials before implementing accounting policies regarding materials.
On the other hand, an incurred cost for materials may be for an item that is customized for the particular contract, does not have an alternative use by the contractor, and the contractor has an enforceable right to payment (this does not necessarily mean it is currently billable, but that the contractor would be paid for the unique material if the contract is terminated for convenience). These costs are properly accountable for as contract costs as incurred.
As material costs are incurred, accounting policies and internal controls should be in place to identify:
- Materials that are inventory (control not transferred to customer)
- Materials that are contract costs (control transferred to customer)
- Materials that are highly customized with no alternative use (deemed transferred due to rights and obligations under the law or by contract)
- Materials transferred to the customer, but not installed
Uninstalled materials is one of the more complicated areas under 606, and how your company accounts for these costs could impact your financial statements. If you need help in determining how it affects your company, please contact Bob Biehl, Director of Construction Industry Services, or your GBQ representative.