8 ways the new revenue recognition standard may change construction accounting

Construction entities will have to apply a new accounting standard for revenue recognition, effective Dec. 15, 2016, for public entities and the following year for private businesses The standard creates a new topic with ASC 606, Revenue from Contracts with Customers, and supersedes existing industry-specific guidance within ASC 605, Revenue Recognition, except for loss contracts rules in ASC 605-35-25-45 through ASC 605-35-25-50.

Grant Thornton LLP’s Alvin Wade, Construction practice leader, and Lynne Triplett, Accounting Principles partner, discuss some of the more significant changes that construction businesses can expect.

The 5-step model for the new recognition standard (ASU-2014-09)1. Contracts must meet certain criteria before revenue can be recognized
Under the new standard, contracts must meet certain criteria before an entity can account for them under the revenue recognition model, potentially resulting in fewer contracts qualifying for revenue recognition at their inception. If the criteria under ASC 606 are not met initially, then the entity should reassess whether the criteria are met in subsequent periods. Revenue cannot be recognized until the criteria are met, unless the entity receives consideration from the customer and either of the following has occurred:
  • Performance is completed and all consideration received is nonrefundable.
  • The arrangement has been canceled and any consideration received is nonrefundable.

One of the criteria in evaluating whether a valid contract exists is that collectibility of the consideration must be considered probable. This differs from ASC 605-35 guidance, which does not include a collectibility threshold.

The new guidance may also result in more contracts being combined. Today, construction entities may combine contracts that meet certain criteria. The new rules require that two or more contracts entered into at or near the same time be combined if one of the following conditions is met:
  • The contracts were negotiated with a single commercial objective.
  • The amount of consideration in one contract depends on the other.
  • The goods or services promised are a single performance obligation.

2. New rules for contract modifications
Under ASC 606, claims and change orders will be evaluated using guidance on contract modifications. Until the parties in a contract approve a modification, the revenue recognition model is applied to the existing contract. If the parties have approved a scope change but have not yet reached agreement on the corresponding change in price, the new standard requires an entity to estimate the contract price change by applying the variable consideration and revenue constraint concepts discussed earlier in this summary.

Depending on the circumstances, contract modifications are accounted for as separate contracts, as the termination of the existing contract and creation of a new contract, or as a part of the existing contract.

3. New rules govern performance obligations
The new standard requires construction entities to account for promises to provide distinct goods or services with different transfer patterns as separate performance obligations. By contrast, current rules allow entities to segment a contract that meets certain criteria.

The new standard also states that a single performance obligation exists when the entity provides a significant service of integrating goods or services with other goods or services in a contract to provide a combined output to the customer. As a result, many construction contracts will be accounted for as a single performance obligation, but significant judgment will be needed to determine if a contract contains more than one. For example, a single contract could contain engineering, procurement and construction services that should be accounted for as separate performance obligations.

4. Including variable consideration in a contract’s transaction price
Under ASC 606, variable payment amounts (e.g., awards or incentive payments) are estimated and included in the contract price using a probability-weighted or most-likely-amount approach. This amount is further subject to a revenue constraint such that estimated amounts are included in the contract price only to the extent it is probable that a subsequent change in the estimate will not result in a significant reversal of cumulative contract revenue. We do not expect these requirements to have a significant impact on revenue timing. That is because existing guidance requires incentive payments be included in contract revenue only if the specified performance standards are probable of being met and the amount can be reasonably estimated.

5. Transaction price is allocated to each performance obligation
If the entity determines that a contract contains more than one performance obligation, it will be required to allocate the transaction price to each separate performance obligation based on the relative standalone selling price. Currently, there is no guidance in ASC 605-35 on allocating revenue to multiple deliverables within a construction contract, so the allocation process will be new to many construction entities.

6. Timing of revenue recognition may change
Many construction contracts will transfer control of a good or service over time and might result in a similar pattern of revenue recognition compared to the percentage-of-completion method under existing rules. However, entities cannot presume that there will not be a change in revenue timing and must carefully assess when control transfers to determine when to recognize revenue.

Likewise, the cost-to-cost input method often applied today cannot be presumed to be the most appropriate measure of performance when a performance obligation is satisfied over time. For instance, if the entity is essentially providing a procurement service related to certain materials for a project and those materials are delivered and not yet installed, it would only recognize revenue to the extent of the materials costs incurred and would recognize no margin until the materials are installed. Costs of unplanned inefficiencies and wasted materials should be expensed as incurred. This would result in an uneven profit margin over the life of the contract.

With the superseding of ASC 605-35, the completed contract method will no longer be an acceptable revenue recognition method.

7. Incremental costs of obtaining a contract will be recognized as an asset
Contract costs, including fulfillment and costs of obtaining a contract, will be accounted for using the guidance in ASC 340-40, Other Assets and Deferred Costs — Contracts with Customers, which was added to the codification in the new revenue recognition guidance.

Under ASC 340-40, an entity would capitalize the incremental costs of obtaining a contract — defined as costs that an entity would not have incurred if it had not obtained the contract (e.g., some sales commissions) — if it expects to recover those costs. Costs that an entity incurs, regardless of whether it obtains a contract, will be expensed as incurred unless the costs are explicitly chargeable to the customer, regardless of whether the entity obtains the contract. Application of this guidance could result in different conclusions regarding pre-contract costs than are currently reached under ASC 605-35.

8. More disclosures will be required
All construction entities, especially those with contracts greater than one year in duration, will be required to provide additional disclosures beyond those currently required.