Living in a Material World
We’ve worked with the revenue recognition standard under ASC 606, Revenue from Contracts with Customers, for a few years now. How’s it going? Pretty good? Well, now may be an excellent time to reexamine a somewhat dubious but significant area of the standard.
This article will examine revenue recognition for materials cost related to a construction contract. Specifically, we will discuss critical factors that impact how a contractor who uses the cost-to-cost input method recognizes revenue associated with uninstalled materials.
The FASB has an underlying concern that cost-to-cost revenue recognition could result in an overstatement of revenue. ASC 606-10-55-21 points out a potential shortcoming of the cost-to-cost method input method. There may not be a direct relationship between the cost charged to the contract (the input) and the transfer of control of goods or services to the customer, resulting in an overstatement of revenue. For example, significant uninstalled materials charged to job cost may not be indicative of progress toward project completion and thus result in an overstatement of revenue.
It’s a Matter of Control. ASC 606-10-25-23 states that entities (contractors) recognize revenue as it satisfies performance obligations by transferring a promised good or service (i.e., an asset) to the customer. It further states that assets are transferred when (or as) the customer obtains control of the asset.
Under ASC 606, depending on when control of the materials passes to the customer, uninstalled materials are accounted for and presented in one of three ways:
- When Control has not Passed. Generic uninstalled materials, even those transferred or delivered directly to the job site, for which control has not been transferred to the customer, should be accounted for as inventory on the contractor’s balance sheet in accordance with ASC 330. Contract revenue (including profit) and cost are not recognized if control has not passed to the customer.
- When Control has Transferred, but Materials Not Installed. When control of the uninstalled materials (located in the contractor’s shop or at the job site) has passed to the customer, but the materials remain uninstalled, the contractor may recognize contract revenue, but only to the extent of the cost of the materials. No profit can be recognized before installation. ASC 606-10-55-21suggests that such an adjustment to the cost-to-cost input method may be required in the following circumstance:
- When a cost incurred is not proportionate to the entity’s progress in satisfying the performance obligation. In those circumstances, the best depiction of the entity’s performance may be to adjust the input method to recognize revenue only to the extent of that cost incurred. For example, a faithful depiction of an entity’s performance might be to recognize revenue at an amount equal to the cost of a good used to satisfy a performance obligation if the entity expects at contract inception that all of the following conditions would be met:
- The good is not distinct.
- The customer is expected to obtain control of the good significantly before receiving the services related to the good.
- The cost of the transferred good is significant relative to the total expected costs to completely satisfy the performance obligation.
- The entity procures the good from a third party and is not significantly involved in designing and manufacturing the good.
An excellent example of how to account for uninstalled materials when control of the materials has passed to the contract owner is found at Example 19- ASC 606-10-55-187 through 192.
Transfer of Control. ASC 606-10-25-25 states that:
(c)ontrol of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.
When, exactly, does control of materials transfer to the customer? Unfortunately, there is no simple answer. Like many things in life, the answer is maybe yes, maybe no, it ain’t necessarily so.
In short, control of the materials transfers to the customer when ownership transfers to the customer. And in our federalistic system, property ownership laws vary from state to state. It varies and is, therefore, complicated. Depending on the jurisdiction, ownership of the materials may transfer upon delivery to the job site; the transfer may be upon billing the materials, or the ownership transfer may be upon collection of the billing. And lien laws come into play that may determine the point when material ownership transfers from the contractor to the customer. The contract itself may stipulate when the transfer of ownership happens. Sorry, there is no boilerplate black-letter answer. Nevertheless, to properly recognize and account for revenue, it is essential to understand at what point ownership of the materials passes to the customer.
Because of this complexity, you should only travel this path when required. That is when doing so is necessary because it significantly affects revenue measurement which may not be indicative of progress toward project completion.What About Material Designed and Manufactured by the Contractor?
Such materials should be charged directly to contract costs, and revenue (including all profit) should be recognized using standard cost-to-cost percentage of completion computations.
What About General Contractors or Prime Contractors?
Even general or prime contractors may find they are not exempt from the rules related to uninstalled materials. If the general or prime contractor has subcontractors with significant uninstalled materials whose costs are then billed to the general or prime contractor, those pay items may have to be excluded from their percentage of completion calculation in the manner discussed above.