How The New Revenue Recognition Standard Will Affect Contractors And Construction Firms

8/1/2014 - By Molly Murphy, CPA, CIT

Contractors and construction firms have traditionally relied on industry-specific guidance when it comes to how they recognize revenue in their financial statements. But this will soon change, thanks to the recent release of a new revenue recognition standard by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).

On May 28, FASB and the IASB culminated six years of work in creating a single, principles-based model for revenue recognition with the release of Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). This new standard will eliminate all industry-specific revenue recognition guidance that’s provided under U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), while also expanding revenue recognition disclosures that will be required.

ASU 2014-09 will become effective for public companies for annual reporting periods beginning on or after December 15, 2016, including interim reporting periods. They will become effective for nonpublic companies for annual reporting periods beginning on or after December 15, 2017, and interim and annual reporting periods thereafter. Public companies cannot elect early application, but nonpublic companies can elect to apply the new standard one year earlier if they choose.

A New Core Principle
The new revenue recognition standard is based on a core accounting principle: entities must recognize revenue in an amount that reflects the consideration they expect to receive as they transfer goods or services to customers. While this might not sound revolutionary, it will require your firm to approach revenue recognition with a different mindset that takes into consideration new concepts and determinations. In particular, the elimination of industry-specific revenue recognition guidance will require more reliance on professional judgment, contract terms and conditions, and customary business practices on the part of construction firms and contractors.

In order to apply this core accounting principle, you must consider the terms of your contracts along with all related facts and circumstances as you apply judgment. In particular, you must determine how likely it is that you will collect the revenue before you apply the new revenue recognition standard to a contract. This involves evaluating customer credit risk in order to determine whether it’s probable that you will collect the consideration due or not. This evaluation should be based on your customer’s intent and ability to pay as consideration becomes due.

A new five-step model will be used to recognize revenue in accordance with the new standard:

Step #1 — Identify the contract with a customer. The ASU defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations.” In certain cases, you should combine contracts and account for them as a single contract.

Step #2 — Identify the performance obligation in the contract. The ASU defines a performance obligation as “a promise in a contract with a customer to transfer a good or service to a customer.” The identification of specific performance obligations in a contract and how they are satisfied will have a direct impact on when revenue is recognized, so you will need to use sound judgment in distinguishing each performance obligation.

Step #3 — Determine the transaction price. The ASU defines the transaction price as “the amount of consideration to which an entity expects to be entitled in exchange for transferring goods or services to a customer, excluding amounts collected on behalf of third parties.” In determining a transaction price, you should consider the effects of variable consideration and constraining estimates of variable consideration, the existence of a significant financing component, noncash consideration, and consideration payable to the customer.

Step #4 — Allocate the transaction price to the performance obligations in the contract. For contracts with more than one performance obligation, you should allocate the transaction price to each obligation in an amount that reflects the amount of consideration you expect to be entitled to.

Step #5 — Recognize revenue when (or as) performance obligations are satisfied. Finally, revenue should be recognized when (or as) goods or services are transferred to the customer. This is defined by the ASU as “when (or as) the customer obtains control of that good or service.” For services transferred, revenue can be recognized over a period of time, but it must be recognized at a specific point in time for goods that are transferred.

Impact on Contractors
Given the historical reliance of construction firms and contractors on industry-specific guidance under GAAP for revenue recognition, the new revenue recognition standard represents a major accounting change for these businesses. But the change likely will not be as drastic as some in the industry have feared since release of the new standard was first announced. For example:

You will still likely be able to use the percentage of completion method of accounting. Revenue recognized under the new standard may be similar to percentage completion accounting, even though the terminology and thought process will differ.
Cost to cost will still be able to be used to determine the percentage complete on contracts that are in progress, using input or output methods.
In specific situations, you will still be able to recognize revenue on uninstalled materials if the customer has control of the goods.
All contracts will not necessarily have to include multiple performance obligations. You will need to evaluate each contract for separate performance obligations and document your conclusions.
You will not have to recalculate completed contracts when the new revenue recognition standard is implemented. During the transition period, you can either restate prior periods presented, or account for contracts in progress and all new contracts going forward.
While it’s true that more footnotes will likely have to be added to your financial statements, ASU 2014-09 does include some relief for nonpublic companies.

Start Preparing Now
While the effective dates for the revenue recognition standard might seem a long way off, contractors and construction firms often enter into contracts and agreements that span multiple years. So it’s not too early to start thinking about how your firm will adapt your accounting practices to comply with the new standard.

For help in determining how the new revenue recognition standard will impact your company’s accounting practices, be sure to contact Molly Murphy at (800) 477-7458.