The new revenue recognition model issued by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) substantially converged previous final standards. Known as Revenue from Contracts with Customers (or ASU 2014-09), the new model virtually replaced all existing revenue recognition guidance in generally accepted accounting principles. Because ASU 2014-09 is so broad in scope, it may mean significant changes for companies' current revenue and financial reporting processes, especially in the construction sector.
What changed with the new model?
Previous U.S. generally accepted accounting principles (GAAP) for revenue recognition were often industry specific. The new guidance creates a single, principle-based model. This change is designed to improve consistency and comparability across entities, industries, jurisdictions and capital markets, and improve the usefulness of financial disclosures.
ASU 2014-09 will cover all revenue-generating customer contracts, except for:
- Lease contracts
- Insurance contracts
- Various contractual rights or obligations related to financial instruments
- Guarantees other than warranties
- Certain non-monetary exchanges
The core principle of the new recognition model is to recognize revenue as the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. While the update is applicable for almost all entities that account for revenue and certain related costs, it is anticipated that the new model for recognizing revenue will affect some industries more than others.
"The new model for recognizing revenue will likely affect some industries more than others."
In addition to the core principle, ASU 2014-09 outlines a five-step process for applying the new recognition model to customer contracts:
1). Identify the contract and what is promised to be paid
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 when (or as) each performance obligation is satisfied
ASU 2014-09 also includes many new disclosure requirements for customer contracts designed to help financial statement users understand the nature, amount, timing and uncertainty of the revenue and cash flows tied to these contracts. These requirements cover both high-level and detailed information, including:
- Contract assets, contract liabilities, receivables and performance obligations
- Transaction price allocated to remaining performance obligations at the end of the reporting period
- Disclosure of any significant judgments used for determining when performance obligations are satisfied, as well as in estimating the transaction price and the amounts allocated to performance obligations
- Capitalized costs related to the customer contract
Changes for construction contractors
Applying the new FASB standard to construction contracts will result in significant changes for how contractors recognize the timing and amount of revenue. In fact, all construction contractors' revenue recognition policies will be affected by the new guidance, though the degree to which the update will affect an individual contractor will depend on his or her current revenue and financial reporting processes and systems.
Simply put, the new model relies more heavily on the customer's perspective, as opposed to the contractor's, when determining whether a promised good or service should be accounted for as a separate performance obligation.
This is especially applicable to step two in the new recognition revenue model, which deals with identifying performance obligations. A customer's expectation may not align with how the contractor has envisioned the project as a whole or in phases. Determining the performance obligations of the contract will then require contractors to carefully evaluate their agreements for any promised goods or service that are 1). capable of being distinct and 2). distinct without the context of the contract. These goods or services would be considered separate performance obligations, and as such, one contract may contain multiple performance obligations that must be accounted for individually.
"The new model relies more heavily on the customer's perspective, as opposed to the contractor's."
Additional considerations for contractors
Contractors must also be judicious in determining the transaction price (step 3) of their performance obligations under ASU 2014-09. When recording transaction price, contractors must include an estimate of any variable considerations constrained to the extent that a significant reversal in cumulative revenue will not occur.
As the construction sector deals with many variable considerations, including incentives, bonuses, rebates and penalties, contractors must conduct a diligent accounting of how these factors can affect transaction price in order to maintain compliance. Contractors will also be required to account for any approved change orders in their revenue accounting. If scope related changes are approved before the price related changes, variable consideration guidance is applied to estimate the transaction price.
Additionally, contractors must determine whether their customer contracts call for performance obligations that are satisfied at one point in time or over several phases. A single contract may also contain performance obligations that fall into both of these categories. This may present added difficulty as the performance obligation's revenue must be recognized when it is satisfied – either at one point in time or over time. If revenue is recognized over time, contractors are required to disclose progress toward completion and what method they used to access this progress.
Effective date and preparation
For public businesses with a calendar year end, the new revenue recognition model is effective on Jan. 1, 2017 for both interim and annual reporting periods. It cannot be applied early. For all other entities, such as private companies, the effective date is for annual reporting periods beginning on or after Dec.15, 2017, and beginning after Dec. 15, 2018, for interim periods within annual periods.
The significant changes outlined in the update require thorough evaluation of current revenue and financial reporting processes and systems to ensure compliance with the new model. While the ASU will likely issue additional guidance for construction contractors, the update will undoubtedly require substantial review of contracts and involvement and insight from those with direct knowledge of the customer contract – signifying the need for a meaningful partnership between contractors and their accountants.
The LaPorte Construction Services Group has more than half a century of experience working with this industry and LaPorte's professionals are keeping up to date on the latest guidance for revenue recognition to better assist our clients with implementation requirements. Though the effective dates are still some time in the future, it's never too early to speak with your LaPorte CPA about implementation.