When it comes to accounting for revenue, the construction contracting industry has long been held to separate accounting principles due to the nature of long-term contracts. For years, the industry – backed by their bankers and accountants – has been successful in resisting efforts to conform to traditional GAAP for revenue recognition.
When the Financial Accounting Standards Board (FASB) issued its new revenue recognition standard in May, it effectively swept away all preexisting GAAP in the area of revenue recognition, including the separate accounting principles specific to contractors. These new GAAP standard is more aligned with the international accounting standard, and will be applied similarly across other industries.
However, changes for contractors may not be as substantial as anticipated. In most cases, the traditional percentage of completion method will still be available and revenue may still be accounted for on a contract-by-contract basis.
The following Q&A summarizes the changes, and explains why it’s important to take steps now.
How Do the New Standards Affect Construction Contractors?
Without a doubt, the new standards mark a substantial change for the industry. However, the news isn’t all bad. The industry was successful in retaining the principles found in the traditional percentage of completion method. In most cases, you will still be able to account for on a contact-by-contract basis.
However, the new revenue recognition standard will require a change in mindset as revenue will no longer be driven by contracts, but by “performance obligations.” This will be the critical driver of revenue recognition. Some contracts may satisfy several performance obligations, and others, just one.
What is a Performance Obligation?
A performance obligation is a promise to provide a unique good or service. In many cases, a single contact contains only one performance obligation. Nothing will change for such contracts.
Under the new standard, companies will:
- Identify performance obligations
- Determine the consideration (payment) to be received for each performance obligation
- Recognize the consideration into revenue as performance obligations are satisfied
Will I Need to Change My Contracts into Multiple Performance Obligations?
Under the new revenue recognition rules, you will be able to combine related performance obligations. Say that Company X has a single contract to build both a structure and the associated parking lot. These would not likely be two distinct performance obligations.
However, let’s say Company X has a single contract to construct a building on Main Street and another building on Parkland Road. Under current revenue recognition standards, revenue recognition for one part of the project would require you to estimate revenue from the total contract.
When the new guidance takes effect, the company would likely have separate performance obligations and would need to allocate the total consideration in the contract among the two performance obligations. The allocation amount will be a matter of judgment and depend on the relative standalone value of each performance obligation.
If Company X has multiple performance obligations with varying completion dates, it may be beneficial to divide them into separate contracts. While it may seem like a lot of administrative red tape to separate your contracts, the upside is that it will be easier to identify your revenue for project and time period.
How Will Contingent Consideration (Incentives/Bonuses) Affect Revenue Recognition?
Under the new standard, your company may be able to recognize revenue for contingent consideration earlier than in the past. You will be able to make a judgment when estimating what amount of contingent consideration to include in the consideration for the contract, according to your best estimate. Change orders will be treated in a similar manner: you will provide your best estimate of the consideration to be received from the change order and include in in the total contact price.
Can Contractors Continue to Apply the Percentage of Completion Revenue Recognition Method?
Yes, in most situations. In many cases your customer is receiving and consuming the benefits of the company’s performance over time, and the company’s performance creates or enhances a customer-controlled asset. Therefore, you would measure the progress over time using whichever method best depicts the transfer of goods and services, such as cost-to-cost input methods. Keep in mind that the same method should be applied consistently across contracts.
When Do the Changes Take Effect?
For private companies the new standard is effective for annual periods beginning after Dec. 15, 2017. Calendar-year entities will be required to apply the standard in their financial statements for the year ending Dec. 31, 2018.
That’s Far Off: What Steps Should I Be Taking Right Now?
It will benefit your company to start reviewing your contracts and having discussions with your bank, accountants, and surety and bonding companies. Here are some recommendations:
- Evaluate your current contracts—are there some that would make sense to separate now?
- Start comparing current contracts with new contracts to determine their complexity; how many performance obligations are there? What are the incentives? Are there any add-on services involved?
- Take inventory of how your contracts impact your executive and incentive compensation programs and determine how the potential separation of contracts will affect it.
- Look at tax issues you might have down the road that could result from changes in timing for revenue recognition.
- Talk to your bank and accountant about future reporting requirements including lines of credit, executive compensation, bank covenants and how the reported revenue will change under new GAAP.
Over the past five years, Skoda Minotti’s Construction Group has participated with industry meetings and stayed close to the issue. Ryan Siebel is a Principal with Skoda Minotti’s Accounting and Auditing Group. You can contact Ryan at 440-449-6800 or firstname.lastname@example.org.