New Accounting Standard May Affect Your Revenue Recognition

Recently, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a new, converged revenue recognition standard, concluding a multiyear effort to develop uniform, worldwide guidelines. By replacing industry-specific rules, the new standard strives to eliminate inconsistencies and improve financial statement comparability.

How will this affect your construction business? For most construction contracts, applying the new standard will produce revenue results similar to those under current standards. But for some contracts, the new standard will change the timing of revenue recognition. It will also require management to exercise greater judgment over revenue reporting and to include new financial statement disclosures about the process.

A new model

The standard outlines a new, five-step model for recognizing revenue:

  1. Identify the contract with a customer. In some cases, two or more contracts will be combined into one for financial reporting purposes.
  2. Look at the performance obligations. One contract may contain a single performance obligation or several distinct obligations.
  3. Determine the transaction price.
  4. Allocate the transaction price among the performance obligations.
  5. Recognize revenue when (or as) the performance obligations are satisfied.

The model involves considerable judgment on the part of management. For example, suppose a contract includes contingent consideration, such as incentive payments. If management concludes — based on its experience with similar jobs — that it will likely achieve the performance goals, it should include incentive payments in the transaction price.

Performance obligations

These obligations are promises to provide goods or services. Contractors typically treat contracts as a single promise (to construct a building, for example). But under the new standard, businesses will need to analyze their contracts and account for each “distinct” good or service — or bundle of goods or services — as a separate performance obligation.

For example, a promise to build a road and a bridge might be treated as two distinct performance obligations, requiring the contractor to allocate the contract price between the two and recognize revenue from each obligation separately. It’s likely, however, that most construction contracts will continue to be treated as single performance obligations. (See the last paragraph: “One performance obligation or many?”)

Recognizing revenue over time

Today, contractors often recognize revenue over the life of a job using the percentage-of-completion method. Under the new standard, performance obligations are satisfied, and revenue recognized, when control of a good or service is transferred to the customer. This may happen at a point in time (when a contract is completed, for example) or over time.

The rules are complex, but, in general, revenue is recognized over time if the customer gains control of the work as it’s performed or if the contractor has no alternative use for the resulting asset and has an enforceable right to payment for work completed to date. Determining whether control has been transferred is a judgment call, but several factors may indicate customer control, including the contractor’s right to payment, the customer’s legal title to the asset or the customer’s possession of the risks and rewards of ownership.

If revenue is recognized over time, there are several ways to measure progress, including output methods (such as surveys or appraisals) and input methods (such as cost-to-cost or labor hours). Often, the results of these methods will be substantially similar to those of the percentage-of-completion method.

Get ready

These are just a few of the areas that will be affected by the new standard. Others include change orders, customer-furnished materials, uninstalled materials, contract costs, claims and warranties.

The new standard doesn’t take effect until 2018 (2017 for public companies). Nevertheless, begin preparing now by reviewing your contracts, evaluating the potential impact on your revenue, and considering changes that might produce better revenue results. Also, compliance with the standard may require you to adopt new policies, procedures, systems or controls, so the sooner you start the better.

One performance obligation or many?

Under the new revenue recognition standard, a good or service (or bundle of goods or services) is treated as a separate performance obligation if it’s “distinct.” Generally, this means that:

  • The customer can benefit from it (either on its own or together with other readily available resources), and
  • It’s separately identifiable in the contract.

Under this definition, many construction contracts will continue to be treated as single performance obligations.

One example in the new standard involves a construction business that contracts to build a hospital. The company is responsible for overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, building construction, piping and wiring, equipment installation, and finishing.

Although the customer can benefit from these goods and services, they aren’t separately identifiable in the contract. Why? Because the company “provides a significant service of integrating the goods and services (the inputs) into the hospital (the combined output) for which the customer has contracted.”

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