Business

An Early Look at New Revenue Recognition Rules for Construction Contractors

Topic 606, Revenue from Contracts with Customers, uses a principles-based model designed to improve consistency, comparability and usefulness of revenue disclosure. Here's a look at how it will impact the construction industry.
By Alan Stein
April 18, 2019
Topics
Business

The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, uses a principles-based model designed to improve consistency, comparability and usefulness of revenue disclosure. The guiding principle is this:

An entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

From the beginning, the standards outlined a five-step process for compliance:

  1. Identify the contract to be certain it is fully enforceable.
  2. Identify the contract’s performance obligations.
  3. Determine the price.
  4. Allocate the transaction among the performance objectives.
  5. Recognize revenue as point-in-time or over time.

In a review of the effects the new revenue recognition rules in accounting are having on public companies, the Securities and Exchange Commission (SEC) indicated that 69.7% of its comments dealt with performance obligation measurements or the second step.

The SEC addressed many of the early adopters of the Topic 606 standards, which were a limited number of public corporations, such as Alphabet (Google), Raytheon and Ford. However, the comments are lessons learned and a potential cautionary tale as construction firms come on board, which are among the groups that fell under the Jan. 1, 2018 deadline for adoption for private companies.

While the number of changes needed to comply with the new standards varied among companies, the FASB said that the construction industry would be among those having the most difficulty because it requires some of the most sweeping changes.

A closer look

Chief among the SEC comments were concerns about “obligations satisfied at a point in time” and “timing of satisfaction of performance obligations.” It’s clear that the comments deal with a large part of the five-step process (numbers two, four and five). Since those areas are drivers of revenue recognition, it’s apparent that they should be addressed at the front end of the contract process.

For example, clarity in determining performance obligations is the beginning of the road toward revenue recognition. If the contract specifies the contractor will deliver design, engineering and construction of a process, consider whether it should also specify if these three elements are each deliverables, and how much of the total cost of the project can be allocated to each.

By also specifying a timetable for design, engineering and construction, with benchmarks for each deliverable, allocations can be made along the way to determine the timetable for revenue recognition.

How does this differ in the percentage-of-completion method of accounting that has been used for decades? It might not differ at all, depending on how a contractor’s agreements have been written in the past. But it could differ greatly in the additional requirement for judgment necessary for both parties in determining price, time, method and other aspects of the building process.

A hard look at existing contracts and changes necessary for future contracts to meet Topic 606 standards could drive a need for re-educating sales people and estimators.

It could also become necessary to make changes in a construction firm’s IT system that deals with revenue recognition. The new rules require more data injections for the additional disclosures necessary for compliance. Software developers are taking Topic 606 into account in producing new tools to provide new data for companies, whether in construction or other industries.

Changes

It’s common for construction projects to change from beginning to ribbon-cutting, as customer needs change and evolve with time. A contract should have methods for dealing with change that includes accounting for it. Remember, beginning timelines and benchmarks can be impacted by change orders. Incentive payments generated by meeting benchmarks could be impacted.

Those payments are generally included in revenue recognition as long as it’s likely—the rule of thumb is 75%—the payments will be realized. But what if a change impacts the likelihood of achieving the incentives? And what if the contractor is financing part of the construction cost with a belief that the customer will make those financing payments as scheduled? Will the change order impact those payments?

All of these and others are reasons for clarity and specificity in the contract to make certain that percentage-of-completion calculations can be accurately made, and so that revenue can be realized as either “over time” or “point-in-time.”

Help is available

The beginning of any change, particularly those as complex as Topic 606 and the new Tax Cuts and Jobs Act of 2017, can be difficult. Companies highlighted in the recent review of these new standards indicated considerable time and expense in creating infrastructure for compliance. They are the primary reasons a vast majority of public companies chose to take their times in adhering to Topic 606.

Through lessons learned from early adopters and from additional advisories from those who monitor application of the new revenue recognition rules, accountants/consultants can cut through some of that time and expense and lessen the pain for private construction firms.

by Alan Stein
Alan Stein is a Principal, Audit and Accounting Services at Gorfine, Schiller & Gardyn. He has more than 10 years of public accounting experience. Alan manages audits, reviews and agreed upon procedures and engages with clients in a wide variety of industries, including the commercial construction arena.

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