Revenue Recognition For Contractors
Does it Seem Easier Now?
Now that contractors have a few years of practical experience working with the revenue recognition standards under ASC 606, does it seem a bit friendlier than expected? Perhaps so. Or maybe it seems that way because we’ve been working with it for a while now.
We thought this would be an excellent time to review a few significant tenants of the standard. After working with ASC 606 for a time, a refresher of pivotal provisions may help solidify our understanding. So briefly–here we go.
Remember the five steps?
- Identify the contract(s) with a customer
- Identify the performance obligation(s)
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognize revenue when (or as) performance obligations are satisfied.
Identify the Contract. For a contractor, identification of a contract is usually the easy part. It’s in the name– right? Unfortunately, a contractor’s contract may be a mountain of documents, including the core contract, specs, drawings, and many change orders. Or depending on the nature of the contractor’s business, it may be very sketchy and driven by purchase orders. Nevertheless, if there’s a meeting of the minds between two or more parties and it creates enforceable rights and obligations – you have a contract. However, to recognize revenue under ASC 606, all of the following must be met:
- It has the approval and commitment of the parties
- Rights are identified
- Payment terms are identified
- It has commercial substance, and
- The collectibility of substantially all consideration is probable. Probable means it is likely to be collected.
What does “likely to be collected” mean? From a practical viewpoint, if the likelihood of collection is 75% or better, many practicing accountants consider the probable threshold met.
When should the contractor reassess collectability? Question 10 of the FASB’s Revenue Recognition Implementation Q&As (January 2020) (FASB Q&A) addressed this question. There must be a significant change in the customer’s ability to pay before the contractor reassess whether revenue recognition must stop.
- Identify the performance obligation(s). Are the costs of pre-production activities included in the percentage of completion (POC) measurement? For example, consider the cost of mobilizing equipment, labor mobilization, and construction of a temporary site office. Do those activities provide goods or services impacting POC revenue recognition? Also, what about pre-construction design services? Do such cost activities transfer a service measured under the POC calculation?
The FASB Q&A attempts to shed some light on this. Question 16 is as follows: How should an entity assess whether pre-production activities are a promised good or service (or included in the measure of progress toward complete satisfaction of a performance obligation that is satisfied over time)?
The pre-production activity will enter into the POC measurement if the activity is a promised good or service. However, if the activity does not transfer a good or service to the customer, it is not included in the POC measurement.
Whether or not to include pre-production activities in the POC measurement is a matter of judgment. Consider whether there has been a transfer of goods or services to the customer. Suppose mobilization is a line item on the schedule of value, whereby the company has the right to payment for its cost plus a reasonable profit. In that case, mobilization represents progress toward completion because it is a contractual promised good or service, as evidenced in the contractual schedule of values.
On the other hand, if the site office is not included in the schedule of value, its cost probably doesn’t transfer a good or service to the contract owner. Therefore, it would not be a cost included in the POC revenue measurement.
An acid test that the FASB Q&A offers is whether control of the good or service is ever transferred to the customer. The overriding question is whether the customer simultaneously receives and consumes the benefits provided by the construction company. For example, if pre-construction design drawings are provided to the contract owner, the owner has received and consumed the benefit. This is because he has the drawings in hand and under his control. Therefore, the cost of the design services would impact the POC calculation.
- Determine the transaction price. Due to the nature of construction contracts, estimating total revenue at completion is complex. Much of the complexity relates to variable consideration. Variable consideration can take many forms. For example, variability can relate to performance bonuses, incentive payments, liquidated damages, unpriced change orders, and contract claims.
ASC 606 provides two methods for estimating variable consideration.
- Expected value approach
- Most likely amount approach
The choice of approach is not an election. Instead, the company can select whichever method is expected to predict the amount better.
After estimating variable consideration, the company must consider the revenue recognition restraints. Then, based on an evaluation of those restraints, variable consideration is included in the transaction price when it is probable that a significant reversal of cumulative revenue recognized will not occur or when the uncertainty is resolved. In other words, the contractor includes the amount they expect to be entitled to in the transaction price.
- Allocate the transaction price to the performance obligations. This step is required if you identify more than one performance obligation embedded in the construction contract. In that case, the contract price will be allocated between the several performance obligations.
On the other hand, the contractor may find that many complex tasks in a contract intertwine into a single performance obligation. This happens when the contractor provides a significant service of integrating a complex set of tasks and components into a single project.
- Recognize revenue when (or as) performance obligations are satisfied. For a contractor, the question is, at inception, will revenue recognition be over-time or at a point in time? To decide this, the company must first determine if the revenue stream meets the over time recognition criteria. If not, then revenue is recognized at a point in time by default.
ASC 606 provides three criteria to determine if control of a good or service transfers to the customer over time. If any of the criteria described below are met, revenue recognition is over time. If none of the criteria below are met, revenue is recognized at a point in time.
- The customer simultaneously receives and consumes the benefits as the company performs.
- The customer controls the asset as it is created or enhanced by the company.
- The company creates or enhances an asset that has no alternative use to the company, and the company has a right to be paid for work completed to date.
An example of the first criterion noted above would be hauling services. If the customer contracted for materials to be hauled from Nashville to Memphis, it’s likely that the customer simultaneously receives and consumes benefits as the trucker performs (over time). Why? If the truck breaks down at Bucksnort 60 miles up Interstate 40, the customer could (theoretically, anyway) hire another nearby trucker to haul the materials for the remainder of the route. The replacement trucker would obviously not be required to repeat the trip from Nashville to Bucksnort. That means the customer both received and consumed the benefit of the materials being hauled from Nashville to Bucksnort.
An example of the second criterion would be a commercial building constructed on real property owned by the customer (contract owner). As the contract owner is progress billed, he accepts control of the asset as work is completed in stages. That’s the justification for percentage-of-completion revenue recognition and, for that matter, progress billing. It’s revenue recognition over time.
The third criterion can be illustrated as follows. The contractor has a long-term contract with the U.S. Department of Energy for civil construction on a project unique to the Department’s classified purpose. Therefore, the contractor has no alternative use for the asset under construction. Additionally, if the DOE halted construction after 50% completion, the contractor has a contractual right to payment for the work completed. Accordingly, revenue recognition will be measured over time.
