Updated December 2023
The construction industry dances to the beat of its own drummer. And not always in a good way. But that's the nature of the sector, one that features long timelines, complex contracts, and extended periods of feast or famine. As a result, revenue streams can be a tangled mess, creating quite the headache on the revenue recognition front.
That's why we're discussing some of the unique challenges engineering and construction companies face regarding ASC 606 compliance. So stick around as we look at the guidance as well as some key insights and best practices engineering and construction firms can use to stay in lockstep with the standard.
Revenue Recognition in the Construction and Engineering Sectors
We know you want to get to the meaty part of the discussion – the standard and our best practices – but we want to take a moment to level set upfront.
Revenue recognition refers to the process by which a company records revenue in its financial statements – but you already knew that. However, unlike retail businesses that record revenue at the point of sale, construction companies often deal with projects that span weeks, months, or even years. And that adds a layer of complexity most industries simply don't have to deal with.
As we discussed in our comprehensive guide on 606, from a broader perspective, revenue recognition helps stakeholders, contractors, banks, and other financial institutions assess a construction company's financial health. Put another way, it shines a light on profitability, financial stability, and cash flow metrics that might otherwise slip through the cracks.
ASC 606, Revenue from Contracts with Customers – Understanding the Basics
Although the newest guidance in ASC 606 certainly makes things more straightforward for companies, revenue recognition still has some gnarly teeth to it. At its heart, the standard strives to create a level playing field by standardizing revenue recognition across all industries, a notion particularly important for construction since revenue streams can be so twisted and knotted, at least compared to other sectors.
Further, the FASB’s version of revenue recognition for US GAAP– we'll save a conversation on the IASB's IFRS 15 for another day – zeros in on a handful of key components:
- Performance Obligations: Under ASC 606, companies must identify all promised goods or services in their customer contracts and determine whether these constitute separate performance obligations.
- Transaction Price: The transaction price refers to the amount of consideration a company expects to receive in exchange for transferring goods or providing services. This may include variable consideration like incentives, rebates, or other discounts such as discounts or concessions granted after the original sale.
- Disclosure Requirements: The standard requires entities to provide more detailed information about their revenue streams in financial statements. For example, this might include disaggregating revenues by product line, geography, market segment, as well as disclosing significant judgments made when applying the guidance.
- Evaluation of Contract Modifications: If there are changes in contract terms after inception but before complete satisfaction of all performance obligations, companies need to evaluate whether these modifications should be accounted for as a separate arrangement or combined with existing arrangements under ASC 606 guidelines.
We’ll be plunging into most of these points in far greater detail in just a bit. To complete our level-set, however, many companies have seen shifts in how they recognize revenue relative to the old guidance in ASC 605, which, of course, could affect their financial statements and performance metrics. For instance:
- Revenue may be recognized earlier or later than under 605 under the new standard, affecting top-line growth rates.
- The timing of expense recognition might have changed as companies allocated costs to different performance obligations within a contract.
- Companies needed to reassess existing revenue-related contracts and update their accounting policies accordingly.
The bottom line – while the FASB attempted to detangle rev rec for organizations, it remains a confounding corner of US GAAP for many, including engineering and construction companies. That makes a thorough understanding of the five-step model to recognizing revenue – as spelled out in the guidance – so crucial for finance leaders and, not coincidentally, what we’re tackling next.
The Five-Step Revenue Recognition Model
As you’re about to see, the rev rec model at the center of ASC 606 entails a critical assessment of a company's arrangement with its customers.
Step One: Identifying the Contract with the Customer
Within the context of ASC 606, a contract is more than a mere agreement. It's an arrangement approved by all involved parties, one that possesses identifiable rights, payment terms, commercial substance, and a high probability of collecting due consideration. Collectively, these factors qualify an arrangement as a contract under ASC 606.
In the construction industry, it's not uncommon for companies to enter into multiple contracts with the same customer and at the same time. ASC 606 provides specific criteria companies can use under such circumstances, dictating when they should and should not combine these contracts. This type of consideration is essential for accurate revenue recognition.
The Role of Master Service Agreements (MSAs)
Master service agreements are another common feature in the construction industry, establishing the general terms and conditions of the work a company will perform. However, under ASC 606, an MSA alone does not constitute a contract unless it includes specific tasks or jobs.
Companies must assess revenue recognition for each task rather than the entire MSA, requiring more granular tracking of revenue that can easily impact financial reporting and project management.
Navigating Contract Modifications
To add yet another layer of fog to the identification of contracts, changes, or modifications to contracts in the construction industry are extremely common. From a reporting perspective, these modifications can impact the initial contract's scope and require reassessment under the guidance, sometimes even requiring an entirely separate contract. Fun.
Step Two: Identifying Performance Obligations in the Contract
Moving on, the second step involves the identification of performance obligations. Without this step, customers and companies might not clearly understand the deliverables in an agreement.
Understanding Performance Obligations
Performance obligations are the backbone of a contract. They represent the promises a company makes to transfer goods or services to a customer. Each distinct good or service the company agrees to deliver is a performance obligation.
Note the use of "distinct" in the previous paragraph. This is an essential concept in identifying performance obligations. A good or service is distinct if a company can separate it from other items in the contract and the customer can benefit from it, either on its own or with other readily available resources.
For example, in a construction contract, services like electrical installation, plumbing, and structural work can each be distinct, single-performance obligations if they are separable and beneficial on their own or in conjunction with other services.
Moreover, distinction can affect the allocation of the transaction price and the timing of revenue recognition as well. So, if a construction contract includes both the construction of a building and subsequent maintenance services – and these services are distinct – the construction company would recognize them as separate performance obligations.
Performance Obligations in Engineering and Construction
Obviously, identifying performance obligations in construction can be a challenge given the complex nature of the services provided. After all, a contract to build a commercial complex could include performance obligations for site preparation, construction of the actual building structure, interior finishing, landscaping, and countless other possible tasks. These services can be distinct if they can be separately identified and benefit the customer independently or with other readily available resources.
Revisiting a previous point, changes and modifications can significantly impact performance obligations as well. For example, if a customer requests an additional floor in a building under construction, it might create a new performance obligation for the construction of that floor.
Of course, depending on the initial performance obligations under the contract, if the entire project is determined to be a single performance obligation, then the added good or service for the additional floor would be combined and bundled with the existing bundle of goods and services. So, yeah, it can get complicated.
Therefore, from the perspective of a construction, engineering, or architectural firm, it's important to reassess performance obligations whenever a contract is modified to ensure accurate revenue recognition.
Step Three: Determining the Transaction Price
This third step in the rev rec model is crucial since it defines the total consideration a construction company expects in exchange for the promised goods or services.
However, just like everything else we've discussed thus far, the transaction price isn't always clear-cut. Many factors can influence the final figure, including the contract terms, the nature of the project, market conditions, and the customer's creditworthiness. Remember, the transaction price should represent the amount the construction company expects, not necessarily the amount stated in the contract.
Variable Consideration
One of the factors influencing the transaction price is variable consideration. This term describes price-dependent elements like incentives, penalties, performance bonuses, or even the potential for refunds, all of which can cause the transaction price to fluctuate.
Under ASC 606, companies must estimate the amount of variable consideration to include in the transaction price. It's important to note that companies should reevaluate this estimate each reporting period to ensure accuracy. Also, estimating variable consideration requires a detailed understanding of the contractual terms and conditions, along with a sound judgment of future events. The guidance presents two methods for estimating variable consideration:
- Expected Value Method: This method involves calculating the sum of probability-weighted amounts in a range of possible consideration amounts.
- Most Likely Amount Method: This method involves identifying the single most likely amount in a range of possible consideration amounts.
Choosing the most appropriate method depends on the nature of the variable consideration and the construction company's specific circumstances.
Financing Components
A significant financing component arises when there is a substantial period between the transfer of goods or services to the customer and the payment by the customer. This delay effectively results in customers providing financing to the construction company, or vice versa.
Under 606, the construction or engineering company must adjust the transaction price accordingly if the financing component is significant to the contract. However, determining if a significant financing component exists and how it affects the transaction price can be complex, requiring careful analysis of the contract terms and payment conditions.
If a significant financing component is present in a contract – like if the customer pays in advance or payment is deferred until long after the work is completed – the entity must adjust the transaction price to reflect this. Such an adjustment essentially discounts the amount of consideration to its present value, reflecting the time value of money.
However, a practical expedient exists where if the period between payment and transfer of the promised goods or services is one year or less, the company can ignore the financing component.
Step 4: Allocating Transaction Price to Performance Obligations
Next up in the model is the sometimes challenging allocation of the transaction price to performance obligations.
Considerations in Allocating the Transaction Price
This is an absolutely critical part of revenue recognition, where the goal is to depict the amount of consideration the entity expects in exchange for transferring the promised goods or services to a customer.
Standalone Selling Price
The Standalone Selling Price (SSP) is vital in allocating the transaction price to the performance obligations. The SSP is the price at which an entity would sell a promised good or service separately to a customer. Of course, the best evidence of SSP is an observable price from standalone sales of identical or similar goods or services, all under similar circumstances.
Discounts and Incentives
Discounts and incentives are very common in construction contracts and can significantly impact the transaction price. Under the guidance, a company allocates a discount or incentive to one or more – but not all – performance obligations in the contract if certain criteria are met. If not met, the company allocates the discount to all performance obligations in the contract.
Contracts with Different Customers
Construction and engineering companies often face situations where they enter into multiple contracts at or near the same time but with different customers. According to ASC 606, contracts with different customers cannot be combined. Only contracts with the same customer, or related parties, can be combined under certain circumstances:
- Contracts are negotiated together with a single objective
- The amount of consideration paid in one contract depends on the performance or price of the other contract
- Some or all of the goods or services promised in the contracts are a single performance obligation
Ultimately, the decision to combine contracts depends on whether the contracts meet specific criteria outlined in the standard, such as having a single commercial objective, interdependence of pricing, or forming a single performance obligation.
Step 5: Recognizing Revenue When or As Each Obligation Is Satisfied
With the first four steps now under our belt, we can finally see the finish line. In this last step, we focus on recognizing revenue as performance obligations are satisfied. Put another way, this is where the rubber meets the financial reporting road.
Timing of Revenue Recognition: Over Time versus At a Point in Time
As we've said, revenue recognition isn't always a straightforward process, especially in construction. It can occur over a period of time or at a specific point in time, depending on the nature of the performance obligation and the transfer of control.
Over-Time Revenue Recognition
Sometimes, a company recognizes revenue over time as the customer continually and simultaneously receives and consumes the benefits provided by the entity's performance. This is often relevant in long-term construction projects where progress can be measured – and value is created – throughout the contract period.
Points-in-Time Revenue Recognition
Alternatively, companies can recognize revenue at a point in time. The exact timing of this transfer can depend on various factors, like when the customer obtains legal title, takes physical possession, or accepts significant risks and rewards of asset ownership.
Indicators of Transfer of Control
The transfer of control from the contractor to the customer is a critical event in revenue recognition. Thus, determining when this happens can be complex and requires careful evaluation.
The guidance considers the transfer of control to occur when the customer can direct the use of and substantially obtain all of the remaining benefits from the asset or service. Indicators of this transfer include, once again, the construction contractor's right to payment, legal title passing to the customer, physical possession transfer, and the customer assuming significant risks and rewards of ownership.
Challenges in Measuring Progress – Input and Output Methods
Measuring progress toward the satisfaction of performance obligations can be a complicated endeavor, especially for large-scale, long-term construction projects.
Contractors typically use either input or output methods– like costs incurred or units produced/delivered, respectively – to measure progress. The method chosen should best depict the performance in transferring control of goods or services to the customer.
Wasted Materials under ASC 606
Wasted materials and rework costs are immediately recognized as expenses when incurred rather than capitalized as part of the cost of the constructed asset. This treatment impacts the total cost input used in the over-time revenue recognition, as these costs are required to be excluded from a company’s measure of progress.
Best Practices for Compliance with ASC 606
But what about practical, roll-up-your-sleeves, boots-on-the-ground advice, you ask? We have you covered in this section, where we'll highlight some of the best practices construction companies can adopt to navigate the ASC 606 landscape effectively.
Open Lines of Communication
Understanding and applying ASC 606 shouldn’t be a lone-wolf effort. It requires active communication with specialists, including industry experts and trusted advisors. These groups can provide valuable insights into ASC 606 and how it applies to your specific business context. They can also provide guidance on the appropriate steps to take to ensure compliance.
Review Current Contracts and Performance Obligations
A key aspect of compliance is regularly reviewing your current contracts and performance obligations. This involves thoroughly examining your contracts to identify the elements that constitute performance obligations under ASC 606. It's essential to not only understand the terms of each contract, but how they interact with the broader principles of ASC 606 as well.
Consider Variable Consideration and Discounts
Complexities often arise in the construction industry due to variable considerations and discounts. For instance, some contracts may include incentive payments or penalties tied to project completion timelines. These elements can significantly affect the transaction price and, thus, the revenue recognition. Therefore, it’s crucial to consider these factors and understand how to treat them under ASC 606.
Regularly Update Standalone Selling Prices
Under ASC 606, a company allocates the transaction price to separate performance obligations based on their standalone selling prices. However, these prices aren't static, potentially changing due to various factors like market conditions, cost changes, and business strategies. Therefore, it's vital for construction companies to regularly update their standalone selling prices to ensure accurate revenue recognition.
The Final Word
Construction accounting has nooks and crannies that other industries don't have to bother with. And while the revenue recognition standards in ASC 606 are meant to normalize rev rec between sectors, the very nature of the construction business means it will always have at least a few more moving parts than most.
The point is, it's a lot more than balance sheets and income statements on the line. Compliant, transparent, reliable revenue recognition is critical to preserving the faith and trust of stakeholders, customers, investors, and the public itself. So, if you find yourself scratching your head over your construction or engineering company's books, US GAAP, and how everything fits together, our team of rev rec experts is ready, willing, and able to ensure your accounting gets and stays on the straight and narrow. So let's talk.
