What Contractors Need to Know About Revenue Recognition
Author: John Gernand
The new revenue recognition standard will affect every industry differently; companies in the construction industry need to understand the implications of the new standard and devise an implementation strategy. In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. This ASU eliminates most of the existing industry-specific guidance and replaces it with an overriding principle and five-step model.
BKD’s white paper, “Revenue Recognition: A Comprehensive Look at the New Standard,” provides an overview of the revenue recognition standard, description of the five steps and guidance on Steps 1 through 4.
While the new standard removed the term “percentage of completion,” it does allow revenue to be recognized over time if these three criteria are met:
- The customer receives and consumes the benefits of the entity’s performance as it occurs, e.g., a cleaning service.
- The customer controls the asset as it’s created or enhanced by the entity’s performance—could be tangible or intangible.
- The entity’s performance doesn’t create an asset with an alternative use to the entity and the customer doesn’t have control over the asset created, but the entity has an enforceable right to payment for performance completed to date and expects to fulfill the contract as promised.
Contractors should begin to perform a general analysis of their contracts to evaluate whether they meet the criteria to recognize revenue over time. If one of the criteria isn’t met, the revenue will be recognized at the time the performance obligation is completed.
Accounting for Change Orders
Change orders are a common occurrence for many contractors, and the new guidance makes accounting for them more complex. Currently, change orders are recognized in revenue when it’s probable they’ll be approved and the amount can be estimated. Under the new guidance, accounting for change orders will depend on the type of modification. A change order that adds distinct goods or services for additional consideration that reflects their standalone selling prices would be recognized as a separate contract. If the change order doesn’t add distinct goods or services, the contract modification would be accounted for on a combined basis with the original contract.
Since almost every construction contract is unique, change orders will have to be evaluated to determine whether they’re part of an existing or new performance obligation. If a contract modification is treated as a new contract, the revenue recognition pattern likely will be different than if combined with the original contract.
Changes for Contractors Using the Cost-to-Cost Method
For contractors that have historically used the percentage complete on the cost-to-cost method, the new guidance has excluded certain costs from the calculation. Only the costs incurred that contribute toward the progress of satisfying the contract will be included in the estimated and actual costs; the cost of defective material, inefficiencies due to errors, etc., would be excluded from the calculation of percentage complete and expensed as incurred.
Management will need to be diligent when determining which costs or labor hours should be included in the calculation of percentage complete.
Public entities will be required to apply the new revenue standard to annual reporting periods beginning after December 15, 2017, including interim reporting periods therein. Nonpublic entities will be required to apply the new revenue standard to annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019.
Finance executives in the construction industry should consider the following actions prior to the standard’s effective date:
- Evaluate the new standard’s expected impact on the company’s revenue recognition
- Determine whether all information needed to implement the new standard is currently being captured by the company’s finance and/or IT systems
- Communicate to company stakeholders the new standard’s potential impact before the effective date
Contact your BKD advisor for assistance implementing this new revenue recognition standard.