As a construction firm, your revenue cycle is unique. Once a contract is signed, you complete the project incrementally and often need to make adjustments throughout the project’s lifecycle that alters the original estimate. In addition, you often receive payments for the project long after the ink on the contract has dried. In terms of financial accounting, this cycle can make revenue recognition challenging, particularly under the updated 606 Revenue Recognition Standard.
In 2014, in partnership with the International Accounting Standards Board, the Financial Accounting Standards Board (FASB) released additional guidance that changes the way contractors recognize revenue in financial accounting and related reporting. The core principle of the updated 606 Revenue Recognition Standard is that entities must “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 entitled in exchange for those goods or services.”
For most construction companies, adoption began with their financial statements for the period ending December 31, 2019. As a result, revenue recognition has shifted dramatically in both amount and timing. Under the updated 606 Revenue Recognition Standard, contractors must follow the following five-step process:
| 5-Step Process for Determining the When to Recognize Revenue | ||||
| 1. | 2. | 3. | 4. | 5. |
| Identify the contract* ** | Identify the performance obligations in the contract*** | Determine the transaction price | Allocate the transaction price to the performance obligations in the contract | Recognize revenue as each performance obligation is met or satisfied |
| *While they are contracts by nature, leases, certain insurance contracts, guarantees (other than those tied to product or service warranties), and some non-financial exchanges are not considered contracts under the updated 606 Revenue Recognition Standard. However, in some circumstances, non-financial transfers between contractors and non-customers may merit the same treatment as customer contracts. | ||||
| ** Should the results be essentially the same, contractors may apply the new 606 Revenue Recognition Standard to a portfolio of contracts instead of individually. | ||||
| ***Some types of contractual rights and obligations are also excluded. | ||||
Under legacy GAAP standards, industry-specific guidance outlined the specifics of revenue recognition for contractors, offering the flexibility to choose between the percentage of completion or completed contract accounting methods. However, the new standard contains specifics that govern which method a contractor should utilize, and some methods of measuring relative completion status may mean legacy methods are not suitable options.
Rather than providing outright guidance that applies specifically to the construction industry, the 606 Revenue Recognition Standard encompasses the basic accounting principles that define how and when businesses of all types account for income earned through contracted work. And to follow the five-step process outlined above, the updated 606 Revenue Recognition Standard includes many rules and tests for implementing each step in the five-step process. Because the new standard is principal-based, and despite the level of detail included in the new standard, estimates, reasonable interpretations, and judgment play a more important role than ever before, and contractors must consider both the intent of the new standard and the terms of a particular contract. Because of this, the updated 606 Revenue Recognition Standard also requires additional disclosures that enable financial statements users to understand the nature, amount, and timing as well as the uncertainty of revenue and cash flow that stems from contracts with customers.
| Additional Quantitative and Qualitative Disclosure Requirements: | ||
| Contracts with customers, including revenue and impairments recognized, disaggregation of revenue, and information about contract balances and performance obligations (including the transaction price allocated to the remaining performance obligations) | Significant judgments and changes in judgments, including those made in determining the timing of satisfaction of performance obligations (overtime or at a point in time) and used to determine the transaction price and amounts you allocate to performance obligations | Assets recognized from the costs to obtain or fulfill a contract |
In addition, if the new standard is applied to a portfolio of contracts, the contractor must be able to provide supporting documentation for the assumption the approach will not lead to materially different results.
As contractors shift to the new standard, many find that the new balance sheet and disclosure requirements necessitate internal processes and systems changes. Often, the changes are extensive, and compliance is complex, and it is critical to have the right professional advisors by your side to help you with this process.
Contact LGA
The construction and real estate team at LGA provides construction firms with business advisory, tax, audit & assurance services. I help contractors understand and navigate compliance with new regulations and guidance, including those related to revenue recognition. If you’re ready to get started, contact me today.
by Matt Touma, CPA, MSA
