New revenue recognition rules that are now being phased in as part of U.S. generally accepted accounting principles (GAAP) could have a significant effect on your financial statements—which means they could affect your credit and bonding capacity.
When and How the Rules Are Changing
The Financial Accounting Standards Board (FASB) developed the new standard—Accounting Standards Codification (ASC) Topic 606, “Revenue from Contracts with Customers”—with the goal of making revenue recognition practices more consistent across various industries and jurisdictions.
For publicly traded companies, ASC 606 went into effect for annual reporting periods (including interim reporting periods) that began after Dec. 15, 2017. For all other entities that produce GAAP-compliant financial statements, the new standard goes into effect for annual reporting periods beginning after Dec. 15, 2018 and interim reporting periods beginning after Dec. 15, 2019.
Because the new standard could cause significant changes in a contractor’s financial statements, the FASB requires companies to present a retrospective application of the standard for comparison. You may use one of two methods to do this:
1) A full retrospective would apply the new guidance as if it had been in effect as of the earliest contract reflected in the current financial statements.
2) A modified retrospective (the more likely choice for most contractors) would apply the new guidance to only the current period in the financial statements and make a one-time adjustment to retained earnings to account for the difference.
The retrospective method you choose could affect how (and how much) your revenue and profits fluctuate.
Issues for Contractors to Watch
The core principle driving ASC 606 is that an entity “should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects consideration to which the entity expects to be entitled in exchange for those goods and services.”
But putting that broad principle into practice can raise complications, particularly where the new standard’s requirements differ from the traditional percentage of completion (PoC) methodology. Some of the more significant differences include the following:
• Specific performance obligations. The new standard requires you to break down contracts into specific performance obligations and identify them individually on the job schedule. For example, contractors who provide design, engineering, and construction services would be required to differentiate them and recognize the revenue from these elements separately.
• Variable consideration. This includes items such as unpriced change orders, claims, incentive payments, and penalties. You will need to determine when and how to incorporate these amounts into the transaction price.
• Other variables. Any financing you provide must be factored into the transaction price. The standard also spells out how to factor in retainage and amounts collected on behalf of a third party, such as sales tax, which no longer will be included in the transaction price.
• Uninstalled significant materials. Under traditional PoC accounting, contractors recognize the costs of these materials when they receive them at the job site, which results in a simultaneous recognition of revenue and profit related to these materials. The new FASB standard says costs such as these should not be used for revenue calculations but instead should be reported elsewhere on the financial statements. Job acquisition and preparation costs, and the costs of wasted materials and labor, are also treated differently.
These are only a few of the many changes you will encounter in the new standard. With implementation imminent, it’s important to work closely with your surety, lenders, and accounting team to review the changes and anticipate potential complications in order to make the transition as smooth as possible.