Revenue Recognition for Construction Contracts: Everything You Need to Know
Construction contractors must now document when promised goods or services are transferred to their clients and the amount the company expects to receive for the job.3 min read
Revenue recognition for construction contracts is a dynamic field, changing with the Financial Accounting Standings Board (FASB) and the International Accounting Standings Board (IASB) rules and regulations. The most recent update was in 2014.
The required disclosure changes include information about the amount, timing, and uncertainty of revenue from contracts with customers, as well as how this information is determined. Although the new standards are higher than the old ones, most private companies will not have to completely overhaul how they account for contract revenue.
Construction contractors must now document when promised goods or services are transferred to their clients and the amount the company expects to receive for the job.
The New Revenue Recognition Model
A company may want to consider the following five-step model:
- Identify the contract with a customer. A contract must contain the consent and commitment of everyone involved, the rights, payment terms, the commercial substance, and the ability to collect must be probable at time of inception.
- Identify the performance obligations in the contract. Once the contract is identified, the performance obligations, or promises to transfer goods or services, that require separate accounting should be identified. These are distinct if they have a stand-alone benefit for the customer, aren't used to produce output, do not significantly modify another service or good in the contract, and are not highly dependent on another good or service in the contract.
- Determine the transaction price.
- Allocate the transaction price to the contract's performance obligations. There are three methods for doing this:
- Top-down approach, which is done by making a market assessment.
- Bottom-up approach, which estimates the expected cost with a reasonable margin of error.
- Residual approach, which is typically only used if the stand-alone prices are highly variable and the company has not established stand-alone prices.
- Recognize revenue as or when the company meets a performance obligation - in other words, when goods or services are transferred to the customer.
Revenue can be recognized either at one point or over time. Revenue should be recognized at one point in time unless:
- The customer receives and uses the benefit as the work is performed.
- The work enhances or creates a customer-controlled asset as the work is performed.
- The work builds an asset with no other use and the contractor has an enforceable right to payment for performance to date (an example would be wiring a building to which the contractor has lien rights).
A contractor using the overtime method needs to determine a progress gauge toward successful completion of the performance obligations by either the input method or the output method. The input method measures progress by resources consumed, while the output method measures progress by the results of the work performed.
One noteworthy area worth special consideration is change orders, which qualify as contract modifications. Depending on the circumstances, contractors should:
- Create new and separate contracts for the additional work.
- Terminate the old contract and negotiate a new one.
- Continue the existing contract.
Another noteworthy area is retainage, which typically is not considered in financing because it deals with protection for the customer if the company fails to meet the performance obligations.
Uninstalled materials are also worth considering, as are loss contingencies and warranties.
Mobilization should also be considered since many contractors incur expenses to move equipment and labor. While contractors can bill for this in advance, it typically is not included in the estimated costs or considered in calculation of costs incurred in the course of meeting the performance obligations. This is because under the new criteria, mobilization does not add to the accomplishment of a performance obligation on the contract.
Precontract costs are also worth noting. The cost of obtaining the contract should be considered an asset if it is expected to be recovered.
Impact of Revenue Recognition
While there is no FASB statement for construction, since most construction contracts are long-term there is a special niche. There are two methods of revenue recognition: percentage of completion and completed contract.
Percentage of completion (PC) measures revenue over the life of the project. Fifty percent completion means 50 percent revenue.
Completed contract (CC) measures revenue only at completion.
The PC method must be used when:
- Reliable cost estimates can be made.
- The construction contract specifically states the parties' rights to goods, consideration to be paid and received, and the resulting payment or settlement terms.
- The contract purchaser and the contractor have the ability and expectation to fulfill the contract.
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