How the New Revenue Recognition Standard Will Impact the Construction Industry
New revenue recognition standard are effective for nonpublic entities for annual periods beginning after December 15, 2018. Now is the time to assess how these new standard may affect the way your company recognizes revenue and change your company’s internal accounting policies, procedures and financial statements. The new standard will impact the construction industry in specific ways. Below are a few key considerations for the construction industry.
Step one of the revenue recognition process requires you to identify the contract with the customer. New criteria require the combination of contracts when certain criteria are met, such as for contracts that are negotiated together with the same customer and contain interdependent pricing. Previous guidance did not require the combining of contracts.
Under this new requirement, change orders must be assessed to determine whether they are modifications to existing contracts and need to be combined, or whether they represent a new contract. This may require you to develop new internal procedures to analyze and track change orders. Proper consideration should be given to each change order to ensure the consistency and appropriateness of revenue recognition.
Step two of the revenue recognition process requires you to identify the performance obligation. Initial concerns in the industry surrounded the identification of hundreds of obligations within a typical construction project – architecture, engineering, plumbing, HVAC, electrical, painting, finishing, etc. Additional clarity has been provided to simplify contract obligations. Due to the high level of integration of the multiple facets of a construction project, projects could be considered to have only one performance obligation. It’s important to consider each contract to determine whether a good or service is separately identifiable and benefits the customer on its own. This may require preliminary analysis of contracts that had not previously been done.
Percentage of completion is the current status quo in the construction industry, but this method will see some changes under the new standard. Step five of the revenue recognition process requires you to recognize revenue when or as the performance obligation is satisfied. This can be done at a point in time or over time. There are a handful of requirements that must be met to recognize revenue over time, but it is anticipated that a majority of construction contracts previously recorded under the percentage of completion method will meet these requirements.
In order to recognize revenue over time, a company must select an input or output method to determine progress towards completion. Under the current percentage of completion method, this is generally done using an input of costs to date in relation to total estimated costs. While costs are still considered an acceptable input method, a few modifications to the calculation must be considered. For example, any costs incurred due to mistakes or rework must be removed from the calculation. Additionally, materials purchased for a job that haven’t been used or installed yet can only be reflected in revenue to the extent of costs incurred. Contract costs should be tracked and documented in a way that facilitates the determination of their effect on revenue recognition. This may require additional procedures not already in place.
The Financial Accounting Standards Board has limited the required disclosures for private entities, but private entities will likely see changes to their disclosures. First, private entities are required to disaggregate revenue according to whether revenue is recognized at a point in time or over time. Additional information must also be disclosed regarding qualitative factors that affect the nature and timing of revenue. Second, entities must carefully distinguish between contract assets and receivables. Invoicing a client does not solely determine the establishment of a receivable. A receivable is recorded when the performance obligation is fulfilled. Consideration should be given to when an invoice represents a receivable. Third, companies must disclose whether revenue is recognized at a point in time or over time, significant payment terms, and details surrounding any variable consideration. Some relief to this disclosure is provided should the performance obligations and variable consideration meet certain criteria. Lastly, for revenue recognized at a point in time, the significant judgments must be disclosed in the company’s assessment of when a customer obtains control of the goods or service. Each of these disclosures may require an entity maintain additional documentation not previously maintained. Establishing new procedures prior to implementing the revenue recognition standard will help alleviate the challenges during the transition.
While implementing the new revenue recognition standard may seem daunting, the Anders Audit and Advisory Services Team can assist with the transition. Contact an Anders advisor for help establishing new internal procedures, evaluating contracts for revenue recognition requirements or general guidance on the new standard.