Revenue Recognition Options
Companies with long-term fixed-priced contracts typically recognize revenue using one of two methods:
- The percentage-of-completion method, whereby income is recognized over the life of the contract, typically using cost-to-cost recognition
- The completed contract method, whereby income is recognized upon substantial fulfillment of the contract
The selection of a revenue recognition policy is typically driven by the fiscal size of the company, corporate tax strategy, level of difficulty in cost estimation, and external financial statement users.
Accounting for Losses
Regardless of the revenue recognition policy chosen, generally accepted accounting principles or GAAP requires that both options include the recognition of loss provisions in the period during which the loss becomes evident (Financial Accounting Standards Board Accounting Standards Codification [FASB ASC] 605-35-25-46 // FASB ASC-606-10-65-1). That is, when the current estimates of total revenue (i.e., consideration) and total contract cost remaining to fulfill the job indicate a loss, the entire value of the loss would be recorded against a loss provision (i.e., an “accrued” contract expense and a liability).
Although the wording changes slightly in the upcoming ASC 606 Revenue Recognition guidance, the concept remains the same. A company will want to make sure that it considers all direct cost types that are applicable to the contract’s performance obligations in computing the loss. Additional cost factors to consider will have updated definitions in the pending guidance, including variable consideration, non-reimbursable costs on cost-plus agreements, and costs on change orders defined as contract modifications. If a company were unable to estimate and record such loss provisions reasonably on a job-by-job basis, the company would not meet the requirements of GAAP.
In general, if GAAP allows for the combination of multiple contracts for revenue recognition purposes, then these contracts could also be combined for assessing and estimating the loss provision. Conversely, if the contracts are not combined or are segmented for revenue recognition, loss provisions would be recognized for each segment. This concept generally holds true in the upcoming ASC 606 Revenue Recognition guidance, with the clarification that contracts that are not combined are analyzed for provision at the contract level.
However, with the addition of the “performance obligation” term in the upcoming guidance, loss provisions can now be computed on an individual performance obligation level, if elected in accordance with company policy. This would be applicable to all contracts, including those that have been combined per ASC 606-10-25-9. The performance obligations would have to meet the criteria defined in GAAP (ASC 606-10-25-14 – 22).
If significant to the financial statements, provisions for losses are shown as a separate liability on the balance sheet. The contract provision would generally be shown as a contract cost on the income statement.
If you are interested in learning more about the provisions for estimated contract losses or the upcoming ASC 606, our Construction Industry Group members welcome the opportunity to talk to you and answer your questions.