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Five Steps to Identify Contractual Revenue

by: Smith and Howard

January 27, 2015

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Construction companies have long relied on a mishmash of GAAP and industry-specific guidance for reporting revenues. Yet doing so often produced inconsistent financial statements that confused and frustrated key stakeholders such as banks and sureties. The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606). This Standard Update addresses revenue recognition under U.S. Generally Accepted Accounting Principles (GAAP) and attempts to standardize and simplify the revenue recognition process for customer contracts across different industries and geographic locations.

5 steps to identification

ASU 2014-09 provides a road map for businesses to more clearly recognize contractual revenue on their financial statements via a five-step approach:

  1. Identify the contract(s) with a customer,
  2. Distinguish the separate performance obligations in the contract,

  3. Determine the transaction price,

  4. Allocate the transaction price to the separate performance obligations, and

  5. Recognize revenue when (or as) the entity satisfies a performance obligation.

Under previous industry-specific guidance, such as Construction-Type and Production-Type Contracts (Topic 605-35), accounting records typically reflected the percentage-of-completion approach, which was usually estimated based on past experience.

Using the new rules, revenue is recognized when specific performance obligations are met — in other words, when a promise is fulfilled in a contract with a customer to transfer a good or service to that customer. The guidance also specifies the accounting for some costs to obtain or fulfill a contract with a customer.

Remaining uncertainties

Revenue still may be 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. Several factors may indicate customer control, such as the contractor’s right to payment, the customer’s legal title to the asset, or the customer’s physical possession of the assets along with the risks and rewards of ownership.

Unfortunately, as of this writing, it’s not completely clear in every case how the new rules differ from existing guidance. Also unclear is precisely how specific terms, such as “performance obligations,” are defined in a construction context. There is, however, a general expectation that the percentage-of-completion method will remain a common approach to recognizing revenue from construction contracts.

Handling change orders

Under ASU 2014-09, contractors must account for a change order as a separate contract if the additional work provides a separate distinct benefit to the customer or the asset can be transferred to the customer separately from other promises in the contract. The contractor also must increase the contract price for the standalone selling price of the additional work in order for the change to qualify as a separate contract.

On the other hand, if the change is bundled with other related tasks and services — and doesn’t provide a separate, distinct benefit — it’s generally considered part of the original contract. Therefore, it wouldn’t qualify as a separate contract under the new rules.

For instance, say a construction company is building a local school. The contractor will likely file periodic change orders to resolve routine issues that come up during construction. These change orders can involve adjustments that are priced either at the time of the update or once the full price of the change is known.

Any revenue associated with the changes can be considered part of the original contract if the work could realistically fit within the project’s original scope. For instance, a price increase for widening the diameter of a water service pipe would require an adjustment to revenue recognized under the original contract.

But if the work couldn’t be considered part of the original scope — say, the construction of an entirely new building is added to the job — the revenue associated with the change would generally be considered as part of a new contract.

Following the rules

Nonpublic companies must comply with ASU 2014-09 for annual reporting periods beginning after December 15, 2017, and interim and annual reporting periods thereafter. You may elect early adoption but not before Dec. 15, 2016, which is the effective date for public entities. 

If your construction company follows GAAP, start preparing now to follow these new rules. Smith & Howard’s strong construction team can help not only with compliance, but also in understanding how this revised approach to revenue recognition may change how outside stakeholders view your business. Call us at 404-874-6244.

For an earlier article on this topic, go here.

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