How Should Construction Companies Recognize Revenue Under ASC 606: Navigating Different Contract Types

Understanding ASC 606

ASC 606 revolutionizes the method by which construction companies recognize revenue, introducing a standardized approach for all entities adhering to GAAP.

Foundational Principles of Revenue Recognition

ASC 606, issued by the Financial Accounting Standards Board (FASB), aligns with principles set forth by the International Accounting Standards Board (IASB) to provide a more robust framework for revenue recognition. These principles ensure that revenue is recognized in a manner that accurately reflects the transfer of goods or services to customers. Under ASC 606, revenue is recorded when it is probable that the economic benefits will flow to the company, and the revenue amount can be measured reliably.

• Control Transfer Criteria: The recognition of revenue at a point in time is based on the transfer of control, which includes:
  • Present right of payment for the asset.
  • Transfer of legal title.
  • Physical possession of the asset by the customer.
  • Passage of significant risks and rewards.

5-Step Process for Revenue Recognition

The method introduced by ASC 606 follows a five-step process that applies consistently across various industries, including construction. This process is methodical, ensuring that revenue recognition aligns with the delivery of performance obligations.

1. Identify the Contract: Contracts with customers are the basis of the revenue recognition process.
2. Identify Performance Obligations: Recognition corresponds to distinct goods or services.
3. Determine the Transaction Price: The price reflects the amount to which the company expects to be entitled.
4. Allocate the Transaction Price: This allocation is based on the standalone selling prices of the performance obligations.
5. Recognize Revenue When (or as) Performance Obligations are Satisfied: This can occur over time or at a specific point, depending on when control is transferred.

The adoption of ASC 606 by construction companies necessitates a comprehensive understanding of the contract details and a thorough analysis of the performance obligations to ensure proper revenue recognition. This harmonization of accounting practices brings increased comparability and transparency to financial statements.

Contract Requirements Under ASC 606

Construction companies must carefully assess their contracts with customers in light of the ASC 606 guidelines to ensure proper revenue recognition. This assessment is pivotal because it impacts the timing and amount of revenue recognized.

Identifying the Contract with the Customer

Under ASC 606, a contract with a customer is defined as an agreement between two or more parties that creates enforceable rights and obligations. The criteria for a contract to be considered under ASC 606 include:

• Approval and Commitment: Both the vendor and customer must approve the contract and be committed to fulfilling their respective obligations.
• Rights Regarding Goods or Services: The contract must identify the rights of the customer and the vendor regarding the goods or services to be transferred.
• Payment Terms: The contract must have identifiable payment terms for the goods or services to be provided.
• Commercial Substance: The contract must have commercial substance, meaning the risk, timing, or amount of the vendor’s future cash flows is expected to change as a result of the contract.
• Collectability is Probable: It must be probable that the vendor will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.

Contracts are often complex and can encompass multiple goods or services promised to a customer. A key aspect of ASC 606 is identifying performance obligations, or promises within a contract, and ensuring they are distinct and should be accounted for separately.

Contract Modifications

Contract modifications occur when the enforceable rights and obligations of the original contract are changed, for example by changing the contract scope or the consideration of the contract. ASC 606 also provides guidance for modifications, which can include additions, terminations, or changes in the scope or price of a contract.

• Modification as a Separate Contract: A contract modification should be accounted for as a separate contract if the scope of the contract increases due to additional goods or services that are distinct and the price of the contract increases by an amount of consideration that reflects the vendor’s standalone selling price of the additional promised goods or services.
• Modification Not as a Separate Contract: If both criteria are not met, companies should then assess the remaining goods or services promised in the modified contract and, if these goods or services are not distinct from those transferred on or before the date of the modification, they should treat the modification as part of the existing contract.

In both cases, recognizing revenue from contract modifications requires careful consideration to ensure the treatment aligns with the principles of ASC 606. It is critical for construction companies to evaluate each contract modification to determine the appropriate accounting method for revenue recognition and to maintain an enforceable right to payment.

Performance Obligations

In ASC 606, revenue is recognized when a performance obligation is met. This process is essential for construction companies as it dictates the timing and amount of revenue to be recognized in their financial statements.

Determining Performance Obligations

To determine performance obligations, a construction company must assess the contract with the customer. A performance obligation is a promise to transfer a good or service that is distinct. Each promise in the contract must be evaluated to ascertain whether it constitutes a separate performance obligation. This step is critical:

• Review the contract: Break down the contractual agreement into promises of goods or services.
• Identify goods or services: Consider whether each promised good or service is separately identifiable.

This analysis ensures that the revenue is recognized accurately in line with the entity’s delivery of value.

Distinct Goods or Services

A good or service is distinct if both of the following criteria are met:

• The customer can benefit from the good or service on its own or together with other resources that are readily available.
• The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.

This means that a company must assess each element of the contract and decide whether it is capable of being distinct, based on whether it has a standalone function or is a key part of the completion of the contract as a whole. The elements that are considered distinct form separate performance obligations. If they are not, they must be bundled with other goods or services until a distinct performance obligation is identified.

Transfer of control is at the core of recognizing revenue for each distinct performance obligation. It occurs when the customer gains the ability to direct the use of, and obtain substantially all of the remaining benefits from, the good or service.

Transaction Price and Allocation

Construction companies need to carefully assess and allocate the transaction price to performance obligations under ASC 606 to recognize revenue accurately.

Determining the Transaction Price

The transaction price is the total amount a company expects to be entitled to in exchange for transferring promised goods or services to a customer. To determine this price, the company must consider all of the following: the fixed amount agreed upon in a contract, any variable consideration, and substaintve rights of return. They must assess the impact of discounts, incentives, rebates, credits, and any price concessions.

Variable Consideration and Constraints

Variable consideration includes price concessions, incentives, performance bonuses, penalties, and contingent payments. Under ASC 606, a company can estimate variable consideration using either the expected value method or the most likely amount method.

Expected value is best when there are a range of possible outcomes, while most likely amount is used when the outcome is binary. Companies must apply constraints to variable consideration, recognizing it only to the extent that it is highly probable that a significant reversal of revenue will not occur when the uncertainty associated with the variable consideration is resolved.

Allocation to Performance Obligations

Once the transaction price is determined, a company must allocate this price to the distinct performance obligations in the contract. The allocation is based on the standalone selling price of each distinct good or service. If a standalone selling price is not observable, a company must estimate it, considering all available information including market conditions and entity-specific factors.

Concerning the allocation of transaction price, any financing component must be assessed. If a contract includes a significant financing component, such as a long payment term, a company must adjust the sales price of the goods or services to reflect this financing arrangement.

After the initial allocation, the transaction price allocated to remaining performance obligations provides insight into the revenue expected to be recognized in the future as performance obligations are satisfied, ensuring compliance with revenue recognition principles of ASC 606.

Revenue Recognition Methods

Construction companies must carefully select their revenue recognition methods according to ASC 606, which can vary based on contract specifics. These methods determine how revenue is reported and recognized over the life of a contract.

Output Method vs. Input Method

Output method accounts for the revenue recognition based on the value of the goods or services transferred to the customer to date. It is a direct measurement of the value delivered, such as units produced or delivered.

By contrast, the input method measures progress towards the completion of a contract by tracking the company’s efforts or inputs, such as costs incurred, labor hours worked, or materials used. Progress is often estimated as a percentage, with revenue recognized accordingly.

Percentage of Completion Method

Previously a common practice, the percentage of completion method recognizes revenue over time as a contract progresses. While ASC 606 has brought in new criteria and has shifted emphasis to control transfer points, this method is still applicable if it aligns with the transfer of control. Revenue is recognized proportionally to the work completed, which is particularly effective when outputs are difficult to measure.

Under ASC 606, a company can recognize revenue over time if any of the following criteria are met: the customer simultaneously receives and consumes the benefits as the company performs; the company’s performance creates or enhances an asset that the customer controls; or if the company’s performance does not create an asset with an alternative use to the company and if the company has an enforceable right to payment for performance completed to date.

Point in Time vs. Over Time

When it comes time to recognize revenue, a key distinction is made between point in time and over time recognition.

Over time recognition aligns with the criteria where a customer receives benefits as the work progresses, or the work performed creates or enhances an asset that the customer controls. Revenue is recognized in a manner that reflects the company’s performance.

Point in time recognition occurs when the control of the asset being constructed is transferred to the customer at a single point in time, typically upon completion or at a specific milestone. Criteria for this method include an enforceable right to payment and the customer taking control of the asset.

Considerations for Construction Companies

The shift to ASC 606 has significant implications on the revenue recognition practices of construction companies. It necessitates a thorough understanding of contract details and the careful consideration of various elements affecting revenue recognition.

Recognizing Revenue for Different Contract Types

Under ASC 606, construction companies must evaluate each contract to determine when revenue should be recognized. The standard distinguishes between contracts where control of the promised goods or services is transferred over time and those where control is transferred at a point in time. For over-time transfer, revenue is recognized as performance obligations are satisfied, which could align with the percentage-of-completion method if it reflects the transfer of control. Point-in-time transfer requires recognition when the customer gains control of the asset, which may be upon completion or installation.

Uninstalled Materials and Wasted Resources

Uninstalled materials contribute to the complexity of revenue recognition. If the materials are distinct and the customer obtains control, construction companies may recognize revenue even if they are not installed. However, if the materials are not distinct, or control has not been transferred, revenue recognition must be deferred.

Wasted resources can occur during construction. While ASC 606 does not directly address waste, construction companies should consider the implications on their total contract costs and, accordingly, the overall transaction price, affecting the timing and amount of revenue recognized.

Accounting for Change Orders and Claims

Change orders and claims are frequent in construction contracts and can have a significant impact on revenue recognition. Construction companies must assess:

• Whether change orders result in the addition of distinct goods or services, thus creating separate performance obligations.
• If claims for price increases are both probable of being received and measurable, they can be included in the transaction price, affecting the timing and amount of revenue recognized.

Construction companies, contractors, and other stakeholders in the construction industry must adapt to these principles within ASC 606 to ensure compliance and accurate financial reporting.

Financial Reporting and Disclosure

The transition to ASC 606 necessitates a meticulous approach in the preparation of financial statements and disclosures. Construction companies must understand and apply new criteria for reporting revenue and provide enhanced disclosures that offer greater transparency into their revenue processes.

Developing Financial Statements

Under ASC 606, financial statements should report income in a manner that reflects the transfer of promised goods or services to customers. Companies must present the disaggregation of revenue from different types of contracts and disclose any significant changes in contract balances during the reporting period. The income statement should clearly identify different revenue streams and align them with corresponding performance obligations.

Disclosure Requirements and Qualitative Information

Disclosures under ASC 606 extend beyond quantitative data, encompassing qualitative information that imparts the nature, amount, timing, and uncertainty of revenue and cash flows. Companies must describe the revenue recognition process, including the principles for recognizing revenue from contracts with customers. Details pertaining to performance obligations, including significant judgments and changes in judgments, should be clearly reported.

Quantitative Disclosures and Revenue Disaggregation

Quantitative disclosures under ASC 606 are aimed at unpacking the complexity of revenue recognition. They provide insights into the nature, amount, timing, and uncertainties of revenue and cash flows. This includes a disaggregation of revenue into categories that depict how economic factors affect the nature, amount, timing, and uncertainty of revenue and cash flows. Entities should disclose the opening and closing balances of receivables, contract assets, and liabilities for each reporting period.

Compliance and Implementation

In order to align with ASC 606’s requirements, construction companies must overhaul their revenue recognition practices and ensure accurate reflection of financial and cash flow impacts. This process includes adapting to new standards, recalibrating financial systems, and potentially investing in specialized accounting software.

Conforming to New Guidance

Construction companies, whether they are private or public entities, are required to identify the contract with a client and define the performance obligations within. ASC 606 insists on a five-step approach:

1. Identify the contract.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue as each performance obligation is satisfied.

These steps must be meticulously followed to establish compliance.

Impact on Financial Metrics and Cash Flows

The implementation of ASC 606 can alter key financial metrics, significantly affecting both lease accounting and reporting of cash flows. Companies must exercise judgment in determining the timing of revenue recognition, either over time or at a point, influencing how financial results are reported. For example, recognizing revenue over time may smoothen cash flow reports, while point-in-time recognition could result in spikes of reported income.

Utilizing Construction Accounting Software

Construction accounting software has become an essential tool for companies transitioning to ASC 606 compliance. It facilitates tracking of contracts, performance obligations, and variations in transaction price, thereby managing the complexities of revenue recognition. Moreover, software solutions often offer modules tailored to ASC 606, which help in reassessing contracts and adjusting financial statements to provide a transparent and streamlined reporting process.

Significant Judgments and Estimates

When implementing ASC 606, construction companies must exercise significant judgments and estimates that affect the amount and timing of revenue recognized from contracts. Adherence to the new standard requires a careful analysis of contract details and an evaluation of various factors.

Assessing Significant Judgments

Under ASC 606, construction companies must disclose the specific judgments made during the application of the revenue recognition standard that significantly affect contract revenue. These judgments include:

• Determining whether a contract should be accounted for as one performance obligation or segmented into multiple obligations.
• Assessing transfer of control to the customer, which may occur over time or at a point in time and significantly impact when revenue is recognized.
• Evaluating the methodology for measuring progress towards complete satisfaction of a performance obligation, which could range from input methods like costs incurred to output methods such as milestones reached.

Judgments related to contract balances are critical as they determine the timing of revenue recognition, whether it relates to unbilled receivables or deferred revenue on the balance sheet. For fixed assets, the allocation of transaction prices to distinct performance obligations can affect their capitalization and subsequent depreciation.

Estimating Costs and Lease Accounting

Estimates play a crucial role in recognizing revenue under ASC 606. Construction companies must develop:

• Estimates for variable consideration, which are included in the transaction price to the extent it is probable that a significant reversal of revenue will not occur when the uncertainty associated with variable consideration is resolved.
• Project costs estimates, which must be periodically reviewed and updated. Any changes can affect the measure of progress and the revenue recognized to date.

Lease accounting, often an integral component in construction contracts, requires companies to distinguish between lease and non-lease components. They should estimate the stand-alone price for each component to allocate the transaction price properly.

For inventory, care must be taken to ensure that appropriate estimates of costs to complete contracts are made, as these can influence revenue recognition as well as the balance sheet representation of work-in-progress or finished goods.

Additional Considerations

When applying ASC 606, construction companies must consider various aspects of revenue recognition beyond the core five-step model. These considerations will affect the timing and amount of revenue recognized.

Warranties and Customer-Controlled Assets

Under ASC 606, warranties provided by construction companies are differentiated between assurance-type warranties and service-type warranties. Assurance-type warranties simply guarantee that the delivered product will function as intended and do not constitute a separate performance obligation. However, service-type warranties, which provide additional services beyond assurance, are treated as separate performance obligations, and revenue must be allocated and recognized accordingly.

For contracts where customers control the asset while it’s being constructed — known as customer-controlled assets — the company recognizes revenue over time. This recognition reflects the customer’s control of the asset and the company’s right to payment for completed work to date.

Combining Contracts and Alternative Use

Combining contracts is another factor under ASC Topic 606, which requires companies to assess whether multiple contracts should be combined and accounted for as a single contract. Contracts are combined if they are entered into at or near the same time with the same customer and if they meet one or more of the following criteria:

• The contracts are negotiated as a package with a single commercial objective.
• The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
• The goods or services promised in the contracts are a single performance obligation.

The concept of alternative use assesses whether an asset has a substantive alternative use to the company at the contract’s inception. If the asset is deemed to have no alternative use, and there are enforceable rights to payment for work completed to date, revenue is recognized over time.

Pre-Contract Costs and Retained Earnings

Pre-contract costs, which are costs incurred to secure a contract, must be considered for capitalization under ASC 606. Only certain costs that directly relate to a specific contract and are recoverable are eligible for capitalization. Those costs that are capitalized are then expensed when the related revenue is recognized.

Finally, construction companies must assess how the adoption of ASC 606 affects retained earnings. Under U.S. GAAP, the cumulative effect of applying ASC 606 may require a company to make an adjustment to its opening retained earnings balance in the year of adoption if the standard is applied retrospectively. This highlights the importance of understanding all transition options and requirements under the new standard.

Frequently Asked Questions

This section answers common queries regarding the revenue recognition practices for construction companies under the ASC 606 standard.

What are the two recognized methods for revenue reporting in construction industry contracts?

Under ASC 606, construction companies typically utilize either the “over time” or “at a point in time” revenue recognition methods. The choice between these methods depends on specific criteria assessing when control of the asset is transferred to the customer.

How do construction companies apply the five-step model of ASC 606 to contract revenue recognition?

Construction companies apply the five-step model by first identifying the contract with the customer. Next, they identify the separate performance obligations. They then determine the transaction price, allocate the transaction price to each performance obligation, and recognize revenue as each performance obligation is satisfied.

Can you provide examples of how construction contracts might impact revenue recognition under ASC 606?

If a construction contract includes multiple deliverables such as design, procurement, and construction services, these may constitute separate performance obligations. Revenue is recognized as control over each element is transferred to the customer, which could be at different times in the project lifecycle.

What are the journal entry requirements for construction contract revenue under ASC 606?

Journal entries under ASC 606 should reflect the recognition of revenue as control is transferred. For example, if revenue is recognized over time, companies will make periodic journal entries aligning with the percentage of the contract completed.

In what circumstances does ASC 606 impact revenue recognition for construction companies?

ASC 606 impacts revenue recognition when the contract involves the transfer of control of a promised good or service. This could affect construction companies when contracts have various distinct performance obligations, change orders, or incentives.

How should revenue be recognized over time for long-term construction contracts in accordance with ASC 606?

For long-term construction contracts where revenue is recognized over time, companies will often measure progress towards completion as the basis for revenue recognition. This could be based on costs incurred, labor hours worked, units delivered, or other measures indicating the transfer of control to the customer.