Each step has its own nuances that may affect how you recognize revenue from these contracts. For some contractors the change won’t be a full overhaul; for some it might shift things significantly. The critical part is to do a full assessment of these steps and nuances and how they apply to your business.
Good practice is to make a full documentation of your assessments and conclusions. These assessments will help you understand your contracts from legal and economic perspectives, as well as from an accounting point of view. Our goal is to help point out some of the splinters that may be in those ladder steps.
STEP one: Identify the contracts (do you have a contract?)
The components of a contract (per ASC 606-10-25-1) are:
- It’s been approved by both parties
- Rights and obligations of each party can be identified
- Payment terms are in place
- Contract has commercial substance – there’s risk, timing or amount of cash flows that will change as a result of the contract
- It’s probable that you’ll collect all or most of the consideration in exchange for the goods/services
Termination clauses may affect the term of your contract by extending or reducing it.
The treatment of change orders may change for some scenarios and may even terminate the existing contract and create a new one. Value of unpriced change orders will have to be estimated and will include significant judgement by the company. Therefore, it’s important to consider history with the client, experience in negotiating change orders, nature of the change order and collectability.
STEP two: Identify the performance obligations (what have you promised to deliver?)
- Can you identify the deliverable (performance obligation) that you’ll be providing/constructing? Is it a service like construction management or design? Is it a finished structure? Can these items be separated into distinct goods/services?
- Criteria for determining whether the goods or services are distinct or not (per the guidance 606-10-25-19) is:
- The client can benefit from the good or service, either on its own or together with other resources that are readily available to the customer.
- The entity’s promise to transfer the good or service to the client is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).
- It’s important to remember that this determination must be done within the specific contract. A contract that has architectural design and construction of the building may have these as two separate performance obligations if the client can easily take the architectural design to another construction firm (such as a simple residential home design). But if that architectural design and construction job was for a specialized nuclear waste facility, then they may represent one performance obligation. Key word being “may,” as it all depends on the terms of the specific contract.
STEP three: Determine the contract price (not always the contract amount in the contract)
Will the revenue you plan to receive from the contract be collectible? Credit risk is a component in the assessment of the contract and contract value. Contractors with robust controls and policies have the tool set to assess client’s ability to pay. Smaller contractors can benefit from implementing a process to evaluate their client’s ability to pay.
Are the terms of the contract such that the client is getting a financing benefit based on the payment schedule/timing? If so, the standard requires that such payments are adjusted for time value of money when they’re being recorded.
If the contract price has a variable component, then estimations need to be made using specified methods with the objective of finding the most probable outcome.
STEP four: Allocating the transaction price to the performance obligations (The contract price – what part of the contract does it relate to?)
In the previous steps, the total contract price and the distinct parts of your contract with the client (performance obligations, even if it’s one performance obligation) have been identified. If you have more than one performance obligation, how do you allocate the price to the different obligations? The best criteria is observable market price for that good/service. However, that’s hard to find in many situations, and the entity must estimate that stand-alone price for each project-distinct component.
There are several methods that can be used to achieve this estimation:
- Adjusted market approach – look at the market you sell your service/product in and estimate what it would cost a customer. Or refer to competitor pricing for similar projects.
- Expected cost plus a margin approach – forecast expected costs of doing the project (satisfying your performance obligation), add an appropriate margin.
- Residual approach – look at the price you allocated to all the other components of your contract, and the remainder can be allocated to the last performance obligation. Important to note, this approach can only be used in certain situations (never sold this service/product on a stand-alone basis, or the price is highly variable).
STEP five: Recognize revenue as you’re completing the performance obligations and transferring control (as you’re working on the contract and the client is getting control over these goods/services)
You’ve climbed all the ladder steps and are now at the final revenue recognition step. The new approach is to measure revenue as you’re making progress in producing the promised goods/service and transferring the control of this good/service to your client over time. There are Input and Output methods as options for recognizing revenue. Using the Input method has some similarity to the percentage of completion, because it’s based on the job costs the contractor spends to satisfy the contract deliverable (performance obligation). Important to note the required criteria to include job costs in the calculation of the inputs that drive revenue recognition is that they were spent on creating value and completing the contract (satisfying the performance obligation).
Job costs spent on rework, wasted materials or other costs that don’t contribute to actual progress on the job (don’t contribute to satisfying the performance obligation) must be excluded from the calculation of revenue recognition. However, previously disallowed, uninstalled materials may now be included in costs incurred prior to installation, provided certain criteria are met.
Output methods are also available and are driven by the value and transfer of control the client received. However, these approaches are deemed less appropriate for many types of construction contracts. An evaluation of your contracts, methods of doing business and production cycles would be important to make the right determination.
Loss contracts will be accounted for in the same manner without changes, except to note that Loss calculations are to be done at the contract level and not applied to each separate obligation in the contract. Entities are allowed to make the election to do it at the obligation level as a formal accounting policy. However, the value of the contract with the loss should be calculated using the new guidance ASC 606 – see STEP three above.
Author: Tatyana Hixon, Senior Manager