Accurate accounting is essential for every business, but until recently, it’s been particularly complicated for those in the engineering and construction industries. That was due in part to discrepancies between the generally accepted accounting principles (GAAP) in the US and the International Financial Reporting Standards (IFRS).
The Financial Accounting Standards Board has changed the way construction and engineering businesses must account for revenue recognition. At Cook Martin Poulson, we’ve been hearing from our clients in these industries with questions about how the changes will impact them and their financial statements. Here’s what you need to know.
Goals of the Revenue Recognition Rule Change
The first thing you need to know is why the FASB changed the rule. They wanted to accomplish three specific things:
- Remove inconsistencies and weaknesses in the prior model;
- Improve the comparability of revenue recognition practices across business entities and industries; and
- Provide better and more reliable information to those who use financial statements.
In other words, the FASB decided that the previous standards were not consistent or transparent enough. The changes to Topic 606, which covers revenue recognition, address these issues.
Five Steps to Meet the New Requirements of Revenue Recognition
While the language of the new rule may be confusing to some, the requirements are actually fairly simple. To adhere to them, you’ll need to follow five steps as you contract with clients. Here they are.
1. Identify the contract with your customer
Contracts may be written, oral, or implied. To be counted as a contract under the new standard, it must:
- Identify the rights of each party
- Identify the payment terms
- Have commercial substance
- Be approved by all parties
For obvious reasons, a written contract is most likely to do all of these things without leaving room for misunderstanding.
2. Identify all performance obligations of the contract
Every contract includes promises to deliver goods or services. To adhere to the new standard, you must identify each good or service distinctly to make it count as a separate performance obligation. To be distinct, the customer must be able to benefit from the good or service alone or together with other resources that are readily available to the customer. Your obligation to transfer the good or service must be separately identifiable within the contract.
3. Set a price for the transaction
After you have identified the good or service to be delivered, you must identify the amount of consideration you expect to receive in exchange for the transfer of those items. According to the new standard, the price must exclude any amounts that you will collect on behalf of third parties – sales tax is an example. The guidelines say that the transaction price can be fixed, variable, or a combination of the two.
4. Match the transaction price to the performance obligations
The next step is to match the price to each of the various performance obligations identified in the contract. You’ll need a standalone price for each obligation. If no such price exists, then you may use the adjusted market approach. That means taking the expected cost and adding it to your gross margin. Alternatively, you may use a residual approach to allocate the transaction price to the obligations that you’ve defined in the contract.
5. Recognize your revenue
The final step is to recognize the revenue from the contract. The revenue may be recognized when the performance obligation(s) are satisfied according to the contract. Control may be transferred at a specific point in time, or over time via milestones in the contract.
The new standards may require some adjustments on your part, but ultimately, the FASB believes they will be beneficial to companies in the construction and engineering industries.
Tips for Applying the New Revenue Recognition Standard
Every contract is different, but there are some things that may help you to apply the new revenue recognition standard appropriately.
- Evaluate your most common performance obligations and decide if they are distinct from one another in the context of the contract. If you determine they are distinct, then you must recognize the revenue separately.
- Treat a contract with milestones as a series of performance obligations. It’s common for construction and engineering contracts to have multiple units, and each unit is distinct from the others. Your obligation is to recognize revenue at each unit and recognize the revenue accordingly. If your contract does not have distinct units, then the entire contract should be considered a single performance obligation.
- Combine contracts as needed. The new standard specifies that you must combine contracts if you enter into two or more contracts at or near the same time with the same customer. To be combined, they must also meet one or more of these conditions:
- You negotiated the contracts as a package deal with a single commercial objective
- The goods or services to be delivered in the contracts constitute a single performance obligation
- The amount to be paid for one contract is dependent upon the price or performance of the other contract
If you have contracts that meet these guidelines, then you must recognize the revenue at the appropriate performance obligation level. Then, you must combine the contracts and present them as one contract including net overbilling and underbilling for the combined contract.
- Estimate amounts for variable consideration and add them to the contract price at the beginning of the contract. This standard applies only if variable consideration is not constrained. You can use the expected value method or the most likely amount method to arrive at your variable consideration estimation.
- Transfer uninstalled materials from your inventory to job cost when you deliver them to the job site, and recognize revenue to the extent of your cost. In other words, you’ll defer the profit on the uninstalled materials until they are installed. The revenue and profit from the remaining contract will be based on the percent of the job you have completed, less the uninstalled materials.
- When you are calculating the percentage of a contract that’s complete, you should also exclude costs related to wasted materials or rework. That’s because those costs don’t represent a transfer of goods or services to your client, nor do the costs associated with them affect the progress on the project.
- You must defer and amortize the costs of obtaining a contract over the life of the contract, using an amortization method that’s consistent with how you are recognizing revenue for the project. The exception is if the contract period is one year or less. In that case, you may expedite and expense the cost immediately.
- The same standard applies to the costs of fulfilling a contract, but there is no expedient in that case.
- You must account for any warranty you provide as a separate performance obligation and allocate a price to it if the warranty period is more than a year, the warranty provides a separate service beyond assurance of the product’s compliance with your agreed-upon specifications, or the customer can purchase the warranty separately.
You’ll need to disclose the adoption of the standards laid out in Topic 606 and calculate their impact on your financial statements using either the full retrospective method or the modified retrospective method.
All companies in the construction and engineering industries must adopt the Topic 606 changes. Remember, the goal is to improve transparency and clarity – but you should expect to notice a difference on your financial statements as you make these changes.
These changes can be simple to apply, and they should not impact your ability to do business comfortably. However, we understand that any changes to financial regulations can be difficult to follow, and concerns over compliance can be stressful. If you have any questions or concerns about what you should do with these new changes, contact the experts at Cook Martin Poulson to get you on the right track.