Revenue Recognition: Four Key Issues for Construction Contractors

  • Regulations
  • 8/28/2018
Two Men Discussing Work

The quarterly reporting for public construction companies demonstrates how changes in revenue recognition have affected their financial reporting.

Revenue recognition changes are already effective for many public companies, and they will soon will be effective for private companies and fiscal year public filers. So it’s time to start putting real numbers behind these new concepts. Although technical guidance continues to be developed, I’ve been watching the quarterly reporting for public companies in the construction industry to see how they were impacted by adopting ASC Topic 606, Revenue from Contracts with Customers.

Identifying performance obligations

Early on in the process of creating a new standard, contractors were interested in how performance obligations would be segregated. Initially, they were concerned that a single construction project would result in many separate performance obligations which would be a significant change from current practice. After years of discussion throughout the industry, the general consensus is that contractors will recognize revenue on most contracts as one performance obligation. This isn’t an absolute conclusion, but typically when there is one contract to build one building or one road, this will result in one performance obligation.

In May 2018, first-quarter public filings provided some initial insights into the impact of ASC 606 on construction companies. Though most filers reported performance obligations closely correlating to existing contracts, there was one issue that resulted in significant changes to revenue recognition. Previously, some companies had been segregating engineering contracts from construction contracts. Under ASC 606, because these phases are significantly integrated, they will be accounted for as one performance obligation.

Initially, we anticipated disaggregation of contracts into multiple performance obligations, but the current practice appears to have gone the opposite direction. Multiple contracts on large projects are now being grouped into a single performance obligation.

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Precontract costs

Contractors are also concerned about accounting for precontract costs. ASC 606 identifies costs which are outside the scope of this topic and should be accounted for in accordance with other guidance. In the construction industry, contractors frequently incur costs related to design, engineering, and mobilization prior to obtaining a signed contract. Under the new standard, they would not book revenue when they incurred these costs. If the costs meet the criteria to be capitalized as deferred charges and amortized over the life of the contract rather than grouping them with other contract costs, additional accounting resources will be required to track them.

The application of this is still being assessed, but it appears that the public companies have not found significant impacts on net income because most public contractors reported immaterial impacts on their current-year operations as a result of adopting ASC 606. When contractors are developing their new accounting policies, they will need to consider the costs and benefits of tracking these costs based on their impact to the overall financial statement.

Measurement of progress

Currently, the construction industry commonly uses cost-based, percentage-of-completion accounting, but there are a number of other methods as well, such as tying the measure of progress to units of production or waiting to recognize any profit until the job is 10 percent complete. Under IRS code section 460, a policy of deferring all profit until contracts reach 10 percent complete and then recording a catch-up, is currently allowable for tax reporting.

The new principles-based standard for financial reporting will require contractors to reasonably estimate profit, even at early stages of a contract. This could include reporting revenue on the job at the profit margin estimated during the bidding process or an average margin on similar projects until a given milestone is reached. There is a provision in the new guidance that profit should be deferred in early stages of a contract if the company is unable to reasonably measure the outcome of a performance obligation. However, it appears that the typical fluctuations on a construction project will probably be viewed as reasonable estimates.

Other measures of progress, such as units produced, are proving harder to support under ASC 606 than they were under ASC 605. Something that appears as homogenous as providing truckloads of aggregate to a highway project will likely need to use cost as its measure of progress when the length of each haul will change over the course of the project. As a general rule, contractors should assume that measuring progress using costs incurred will be the best representative measure of progress unless they can identify a reason why an alternative measure is more accurate.

Methods of adoption

The new standard allows companies to use a full retrospective method (which requires adjusting prior years), or a modified retrospective method (where a cumulative catch-up adjustment is posted to beginning equity in the period of adoption). The trend among public construction companies has been to elect the modified retrospective method, which requires additional disclosures related to the impact of adoption in the current-year financial statement.

Initially, some were concerned about private company contractors presenting comparative statements under the modified retrospective method because the statements would not be comparable and could potentially mislead users. However, the industry appears to prefer comparative statements, and the modified retrospective method minimizes the accounting burden on contractors. This method appears to give users the necessary information to make decisions.

How we can help

Typical accountants are never excited about change, and contractors only want to hear about change when it’s followed by “order.” But ASC 606 is a change that can’t be pushed off any longer. After working through the process of applying the new rules and understanding the differences that have been identified, the resistance has lessened. After years of discussing examples of revenue recognition, construction companies are finally getting to see real examples of what’s new ― and for the most part, they don’t mind the change.

CLA’s construction professionals have been closely following the revenue recognition issue so that we can provide the industry with the most current thinking on the subject. Each construction company’s contracts and book of business are different, but as a national firm, we track general trends across the country. CLA’s professionals can provide insightful analysis of your unique situation and offer valuable resources.

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