This week’s post focuses on the effects of the new revenue recognition standards on the construction industry. There have been a lot of concerns throughout the industry about the impending impact of the new standards, and we hope to address some of the most prevalent issues in this post.
Identifying Performance Obligations
As we have seen in previous posts, businesses are now required to identify “Performance Obligations” on their contracts. To review, this phrase refers to what clients can expect to receive from transactions. In simpler terms, performance obligation means “promises” or “commitments” to the client.
The concept of performance obligation is difficult in the construction industry. What are the deliverables to a customer and at what time are they transferred? No revenue could be recognized if the deliverable is the completed construction building. If it’s every single type of task, when does the customer get control? When the concrete is dry? When the 6th floor framing is complete? As you can see, there were strong concerns that the new standards would require companies to list an almost endless string of performance obligations. This in turn would require businesses to track progress and revenue for each of these items separately.
As well, in situations where a company is providing multiple services to a client, it may be necessary to list several performance obligations on the contract. Imagine, for example, a company that is providing architectural design, construction, procurement, and even building maintenance on the same contract. That company would need to recognize each performance obligation separately, and as they are completed.
Fortunately, the new Revenue Recognition standards are ultimately designed to streamline and simplify the revenue reporting process. In line with that goal, the standards include provisions that allow you to list bundles of goods and services; or, goods and services that are essentially the same as a single performance obligation. These can be recognized as being “transferred over time” and revenue can be recognized as it is incurred – similar to the percent of cost method used by most construction companies today.
Of particular interest to the construction industry is the idea that interrelated elements may also be listed as a single performance obligation. Basically, if the client can’t get value from a product or service on its own, it doesn’t need to be listed as a distinct performance obligation. Instead, it can be combined with interdependent elements into a single performance obligation.
Determining Transaction Prices
The third step, in the five-step revenue recognition process deals with determining the price for your contract. Currently within the construction industry, the standard is to provide an estimate of the work, without taking into account certain variables. Under the new standards, however, you need to integrate variable considerations into your contract pricing.
Variable considerations are anything that may change the final price. This includes bonuses for early completion or any other performance incentives or discounts. The application of these variables is subjective, but as a general rule of thumb, you need to estimate how likely the variable is to have an effect on the final price and apply the variable accordingly.
Recognizing Revenue Over Time
A lot of the construction industry concerns swirl around how the new standards change the recognition of revenue during the course of the project. The new standards divide revenue recognition into two main categories:
- recognition at a point in time
- recognition over time
With point-in-time recognition, you record revenue for each performance obligation as it is completed, or as the client takes control of the asset. This approach only makes sense in certain situations, and in most cases, construction firms will opt to recognize revenue over time.
Recognizing revenue over time mimics the percentage-of-completion model with a slight adjustment. Under the FASB’s new revenue recognition standards, you must meet one of two conditions to recognize revenue incrementally. Either:
1. The customer must control the asset as it is built or improved, or
2. The asset has no use to your firm and you have right to payment
Typically, right to payment can be established by a contract that requires the client to pay for the portion of completed work if the project is terminated.
If you have other concerns about the new revenue recognition standards or if you just want to share your thoughts, we’d love to hear from you in the comments section below the post.
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For more information, check out this resource:
From the American Institute of CPAs, this link features information on The Engineering and Construction Contractors Revenue Recognition Task Force, which identifies and discusses implementation issues with the new standards:
If you didn’t have a chance to read last week’s post about the 5-steps Revenue Recognition, read about it here: http://revenuerec.com/five-steps-revenue-recognition/
