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New Revenue Recognition Standard -What it Means for Contractors

The construction industry, in particular, is going to be impacted by this new standard, and there are a number of special considerations within it for which companies will need to prepare.

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The construction industry, in particular, is going to be impacted by this new standard, and there are a number of special considerations within it for which companies will need to prepare.

On May 28, 2014 the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued their final standard on revenue from contracts with customers. At its core, the standard was established to recognize revenue to depict the transfer of promised goods or services to customers, in an amount that reflects the consideration to which the entity expects to be paid in exchange for those goods or services. This is supported by five steps in recognizing revenue:

  1. Identifying the customer contract(s);
  2. Identifying the performance obligation(s) in the contract;
  3. Determining the transaction price;
  4. Allocating the transaction price to the performance obligation(s) in the contract; and,
  5. Recognizing revenue when (or as) the entity satisfies a performance obligation.

So what does this all mean for contractors? Some of these steps will have a significant impact on them, and will lead to changes they should begin to understand sooner rather than later.

Identify the Contract – For contractors the main concern under the first step relates to the combination of contracts. The standard states that contracts should be combined at inception when entered into at or near the same time with the same customer (or related customers) and one or more of the following conditions are met:

  • Contracts are negotiated with a single commercial objective
  • Amount paid in one contract depends on the price or performance of the other
  • Services promised in both contracts are really a single performance obligation

Identify the Performance Obligation(s) in Contracts – Once the contract has been identified the next step is to identify the performance obligations within the contract. This is the most critical step for contractors, as the performance obligation(s) identified in this step will drive the outcomes to steps four and five.

The standard states a performance obligation is a promise to transfer to the customer a good or service that is distinct, or a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. A good or service that is promised to a customer is distinct if both of the following criteria are met:

  • The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct)
  • The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract)

Determine Transaction Price – The transaction price is the amount of consideration to be paid for the exchange of a good or service. In a perfect world, this price would be stated in the original contract.  However, with contractors there are frequently changes to the original contract price (known as variable considerations) that must be considered, such as change orders, performance bonuses, liquidated damages, and other non-cash considerations.

Companies will then have to estimate the likelihood of these variable considerations occurring when determining the overall contract price by using one of two methods set forth in the standard:

  • The Expected Value – This is the sum of probability-weighted amounts in a range of possible consideration amounts; it may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics
  • The Most Likely Amount – This is the single most likely amount in a range of possible consideration amounts, and may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes

Allocate Transaction Price – This step breaks down the overall transaction price and assigns a portion of the total price to each individual performance obligation. For any contracts with a single performance obligation this step is not applicable.

Some contracts may make this easy, assigning a price to each performance obligation within the contract, while others may only state a single transaction price, leaving it up to the company to allocate the transaction price to the different performance obligations based on the stand-alone selling price. Most contractors do not have specific stand-alone selling prices for each performance obligation; these usually relate to unique one of a kind projects and buildings. As such, the company must then estimate the stand-alone selling price using one or a combination of the following three methods:

  • Adjusted market assessment
  • Expected cost plus a margin
  • Residual approach

Recognize Revenue – The final step is determining when to recognize the revenue based on when or how the performance obligations are satisfied. Generally, most contractors recognize revenue over a period of time using the percentage of completion method. Under the new standard this is still allowed, but the standard has given a more defined set of criteria, which states one of the following must be met to recognize revenue over time:

  • The customer simultaneously receives and consumes the benefit as the work is performed.
  • The work creates or enhances an asset that the customer controls as the asset is created or enhanced.
  • The work creates an asset without an alternative use, and an enforceable right to payment exists for performance to date.

Additionally if revenue is being recognized over a period of time the company must still determine how best to measure progress by choosing the input or output method.

There are other significant changes to which contractors will need to adjust—the effective date for all non-public entities are annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019. So clearly the time is now to begin adjusting to this new standard.

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