Changes are coming to contractors’ financial statements.
After Dec. 15, 2018, updates to the Financial Accounting Standards Board’s Revenue from Contracts with Customers section will affect nonpublic businesses for annual reporting periods. This accounting standards update eliminates most of the existing industry-specific guidance, including the term “percentage of completion,” and replaces it with an overriding principle and five-step model:
1. Identify contract with customer
2. Identify performance obligations
3. Determine transaction price
4. Allocate transaction price
5. Recognize revenue
We’ll touch on a couple here, as well as a few other common items.
The percentage of completion method is used to recognize revenue based on costs incurred to date as a percentage of total estimated contract costs. Though the term “percentage of completion” is removed from the accounting guidance, the standard does allow revenue to be recognized over time if these three criteria are met:
• the customer receives and consumes the benefits of the entity’s performance as it occurs;
• the customer controls the asset as it’s created or enhanced by the entity’s performance; and
• the entity’s performance doesn’t create an asset with an alternative use to the entity and the customer doesn’t have control over the asset created, but the entity has an enforceable right to payment for performance completed to date and expects to fulfill the contract as promised.
These criteria generally will be met with the performance of construction contracts, but if one of the criteria isn’t met, the revenue will be recognized at the time the performance obligation is completed.
Identify performance obligations
Under the new revenue recognition standard, revenue is to be recognized based on the performance obligation rather than the contract. Management will need to use judgement to determine if contracts in process include more than one distinct performance obligation meeting the following criteria:
• capable of being distinct because the customer can benefit from the good or service on its own or with other readily available resources; and
• distinct within the context of the contract – the good or service to the customer is separately identifiable from other promises in the contract.
Accounting for change orders
Change orders are common occurrences for many contractors, and the new guidance makes accounting for them more complex. Under the new guidance, accounting for change orders will depend on the type of modification. A change order that adds distinct goods or services for additional consideration that reflects their stand-alone selling prices would be recognized as a separate contract. If the change order doesn’t add distinct goods or services, the contract modification would be accounted for on a combined basis with the original contract. Since almost every construction contract is unique, change orders will have to be evaluated to determine whether they’re part of an existing or new performance obligation. If a contract modification is treated as a new contract, the revenue recognition pattern likely will be different.
Changes in the cost-to-cost method
For contractors that have historically used the percentage complete on the cost-to-cost method, the new guidance has excluded certain costs from the calculation. Only the costs incurred that contribute toward the progress of satisfying the contract will be included in the estimated and actual costs; the cost of defective material, inefficiencies due to errors, etc., would be excluded from the calculation of percentage complete and expensed as incurred. Management will need to be diligent when determining which costs or labor hours should be included in the calculation of percentage complete.
Finance executives in the construction industry should consider the following actions prior to the standard’s effective date:
• evaluate the new standard’s expected impact on the company’s revenue recognition based on typical contracts;
• determine whether all information needed to implement the new standard currently is being captured by the company’s finance and/or information technology systems; and
• communicate to company stakeholders the new standard’s potential impact.
Matt Cash is a director in the Springfield office of BKD LLP. He may be reached at firstname.lastname@example.org. John Gernand, a managing director in the firm’s Bloomington, Ind., office, and Dallas Williams, an associate in the firm’s Springfield office, also contributed to this article.