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 guidance specific to contractors. While this is a substantial change considering the amount of guidance replaced and superseded, the changes for contractors may not be as substantial as anticipated.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 can still be accounted for on a contract-by-contract basis. Here are a few key questions we think contractors may have as they assess the changes their company would expect in reporting under the new standard.
When is the standard effective?
For private companies, the standard is effective for annual periods beginning after Dec. 15, 2017. Calendar-year entities would first be required to apply the standard in their financial statements for the year ending Dec. 31, 2018.
Is adjustment of my prior year’s reported revenue required?
Upon adoption, a retrospective adjustment to revenue in the prior year column of your audited financial statements is allowed but not required. A calendar year-end company would need to reassess revenue recognition using the new standard for any contracts that were in progress at the beginning of the year of adoption (i.e., Jan. 1, 2018). Upon adoption, if an adjustment is required to any of those in-progress contracts, the company can either retrospectively adjust the 2017 column in their comparative financial statements or record a Jan. 1, 2018 cumulative adjustment directly to retained earnings upon adopting the new accounting principle.
What is a performance obligation?
The new revenue recognition standard will represent a change in mindset as revenue is no longer driven by contracts, but by performance obligations. Performance obligations can be most easily thought of as a promise to provide goods and services. Under the new standard, companies will identify their performance obligations, determine the consideration to be received for those performance obligations and recognize the consideration into revenue as the obligations are satisfied. The good news is that very often a single contract represents a single performance obligation. Therefore, the company’s current monitoring process for contracts may be sufficient.
Are contracts required to be broken up into multiple performance obligations?
Under the standard, satisfaction of performance obligations is the key driver of revenue recognition, as a company recognizes revenue when it satisfies a performance obligation. Some contracts may contain several performance obligations and others just one. The revised revenue recognition guidance also allows companies to combine performance obligations when the goods/services provided are interrelated. For example, a company may both design and build a structure for a customer. The design and build would not necessarily be separate performance obligations, as the company provides the service of integrating the two.
However, in a situation where one contract is entered into with a customer to provide separate finished products that are not related, such as a single contract to construct a bridge and unrelated building, 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 is a matter of judgment and depends on the relative standalone value (i.e., the price it would sell for separately) of each performance obligation.
How would contingent consideration (incentives, bonuses, etc.) affect revenue recognition?
Under the new standard, a company may recognize revenue for contingent consideration earlier than in the past. The new standard is largely judgment and principles based. For example, a company will make a judgment when it estimates the amount of variable consideration to include in the price of the contract. When incentives or bonuses are probable, companies will include their best estimate of the amount they expect to receive in the total price of the contract and recognize it into revenue accordingly.
Change orders are also treated in this manner, as the company provides its best estimate of the consideration to be received from the change order and includes that amount in the total contract price. Note that there is an upper limit on the estimate, as it must be probable that there will not be a significant reversal in the cumulative amount of revenue recognized when the contingent consideration is finalized.
This treatment of revenue recognition for contingent consideration differs from the existing GAAP that includes contract modifications (such as change orders) in revenue when it is probable of being approved and the amount of revenue can be reliably measured.
Can contractors still apply the percentage of completion revenue recognition method?
Yes, the new standard allows companies to recognize revenue over time in the appropriate situations, such as when a customer is receiving and consuming the benefits of the company’s performance over time, or when the company’s performance creates or enhances a customer-controlled asset. The company can measure this progress over time using the method that best depicts the transfer of goods and services to the customer, such as cost-to-cost input methods. The method the company selects should be applied consistently across similar contracts.
What other types of items might I have to be aware of?
While it would be difficult to prepare a list of all potential accounting issues arising from the new standard, here are a few items that may trigger new accounting under the new standard.
- Warranties purchased separately by the customer may represent separate performance obligations that require their own revenue recognition treatment. Warranties included as part of the company’s normal contract may represent additional costs to include in the company’s cost-to-cost revenue recognition method.
- Under the new standard, the company records a contract asset or receivable if the revenue is recognized before the consideration is paid by the customer. Typically, a contract asset will be recorded when services are provided, and will then be transferred to a contract receivable once there is an unconditional right to receive payment. When the customer pays in advance of revenue being recognized, a contract liability is created. This represents a change from the current GAAP terminology of unbilled receivables and billings in excess of costs and estimated earnings.
- Costs incurred by the company that would have been avoided had it not obtained the contract (i.e., sales person commission expense) are recognized as contract assets if they are expected to be recovered. They are amortized as an expense over the time period that control of the goods or services is transferred. Costs that were unavoidable (i.e., bid costs, general sales force salaries) are expensed as incurred. There is an exception to these capitalization criteria for contracts that are for less than a year in length, as such costs can be expensed directly.
- If the company has claims on a contract, the revenue associated with the claim is recorded based on the company’s estimate of the expected amount of claim that will be received, if it is probable that a significant reversal of revenue will not occur in the future. This is in contrast to the current standard under which companies only record claims revenue when it is probable and reliably estimable.
- Accounting for loss contracts is consistent under the new and preexisting standards. The revised guidance states: “When the current estimates of the amount of consideration that an entity expects to receive in exchange for transferring promised goods or services to the customer, determined in accordance with Topic 606, and contract cost indicate a loss, a provision for the entire loss on the contract shall be made. Provisions for losses shall be made in the period in which they become evident.”
Are additional disclosures required in my financial statements?
The new revenue recognition standard changes the required disclosures relating to recording of revenue. These include disclosing both the amount of revenue recorded from contracts with customers and any impairment losses on receivables or contract assets.
The new standard also requires a company to separately disclose the amount of revenue recognized over time from the amount recognized at a point in time. Also, if not otherwise separately presented, the company will disclose the opening and closing balance of receivables, contract assets and contract liabilities from contracts with customers.
In addition to the disclosures on receivables and revenue, a company will need to disclose information about its performance obligations, including descriptions of when the company typically satisfies its performance obligations (i.e., as services are rendered), any significant payment terms and the nature of services that the entity has promised to transfer. For those performance obligations satisfied over time, the company will also disclose the method used to recognize revenue (i.e., the use of a cost-to-cost input method).
Please note that there are numerous other disclosures listed in the new revenue recognition standard that are not discussed herein because the standard allows non-public entities the option of not providing them.
While the terminology and thought process for revenue recognition has shifted, the fundamental objectives remain consistent. We will continue to monitor the implementation of this standard and pass along the lessons learned. In the meantime, if you’d like more information on how revenue recognition standards affect your business, the advisors at Skoda Minotti are happy to assist. Contact Ryan Siebel, Principal at firstname.lastname@example.org or 440-449-6800.