Changes are coming to contractors’ financial statements.
The Financial Accounting Standards Board’s issuance of the new revenue recognition standard, Revenue from Contracts with Customers, will fundamentally change accounting and disclosures for construction contractors. The standard is effective for public companies in calendar year 2018 and for private companies in calendar year 2019. This accounting standards update eliminates most of the existing industry-specific guidance, including the term “percentage of completion,” and replaces it with an overriding principle and five-step model:
- Identify contracts with customers
- Identify separate performance obligations in contracts
- Determine transaction price
- Allocate transaction price to performance obligations
- Recognize revenue when (or as) performance obligations are satisfied
We’ll touch on a few key considerations for contractors preparing to implement the new standard.
Under current U.S. generally accepted accounting principles, the percentage-of-completion method is commonly used to recognize revenue based on costs incurred to date as a percentage of total estimated contract costs. Though the term “percentage of completion” is removed from the accounting guidance, the standard does provide for revenue to be recognized over time if at least one of these three criteria is met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as it occurs.
- The customer controls the asset as it’s created or enhanced by the entity’s performance.
- The entity’s performance doesn’t create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
These criteria will generally be met with the performance of construction contracts, but if one of the criteria isn’t met, the revenue will be recognized at the time the performance obligation is completed.
Identifying Performance Obligations
Under the new revenue recognition standard, revenue is to be recognized based on satisfaction of performance obligations on a contract-by-contract basis. Management will need to use judgment to determine if contracts include more than one distinct performance obligation. Promised goods or services are considered distinct when they are both:
- Capable of being distinct because the customer can benefit from the good or service on its own or with other readily available resources
- Distinct within the context of the contract—the good or service to the customer is separately identifiable from other promises in the contract
Accounting for Change Orders
Change orders are common occurrences for many contractors, and the new guidance makes accounting for them more complex. Under the new variable consideration 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 a standalone selling price would be recognized as a separate contract. If a change order doesn’t add distinct goods or services, the contract modification would be accounted for on a combined basis, with the original contract using a cumulative catch-up approach. When change orders are unpriced, additional judgment will be required.
Changes in the Cost-to-Cost Method
For contractors that have historically used the percentage-of-completion recognition method based on cost-to-cost measures, the new guidance excludes certain costs from the calculation. Only the costs incurred that contribute to 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 progress measurement and expensed as incurred. Management will need to be diligent when determining which costs or labor hours should be included in the measurement of progress.
Finance executives in the construction industry should consider these steps when implementing these changes:
- Evaluate the new standard’s expected effect on the company’s revenue recognition based on contract types
- Determine whether all information needed to implement the new standard is being captured by the company’s finance and/or information technology systems
- Communicate to company stakeholders the new standard’s potential effect
Contact Matt or your trusted BKD advisor for more information or with questions.