The impact of revenue recognition on contractors
Over the last several months, our conversations with contractors about the new revenue recognition standard have typically started with their assertion that “it’s not going to affect us.” By and large, they are correct with the overall mechanics of revenue recognition. In fact, the new standard generally brings the rest of the world onto the same revenue recognition model that construction contractors have been using for decades – percentage of completion. However, there are nuances to the new standard that must be addressed by every contractor and are very different than current practice.
Many contractors take a very conservative approach when it comes to change orders by not recognizing the change order until all approvals have been obtained and the ink is dry. However, under the new standard, change orders should be recognized once the scope of work has been agreed to, either orally or written. If the price is still under negotiation or unknown, the contractor must determine a price to assign to the change order using the methods prescribed by the standard.
Performance Bonuses/Penalties, Incentives, Liquidated Damages and Claims
Under the new standard, contract bonuses and incentives must be examined on an ongoing basis. The new standard also addresses variable compensation arrangements. Rather than waiting until the end of the job, management must estimate the project’s status and record a projected bonus/penalty at each reporting period. Claims and liquidated damages follow a similar approach under the variable compensation guidance.
Under the new standard, materials that are specific and custom to the project, but not yet installed, cannot have profit recognized on them. Only revenue up to cost (zero profit) may be recognized. This is meant to more closely follow the true project completion timeline and discourage manipulation of earnings.
Much has been said and written about performance obligations and whether one contract should be separated into multiple contracts. There is certainly quite a bit of judgment required in this area, but contracts and change orders should be carefully examined on the front end, to determine how they should be accounted for. Certain contracts call for the initial build, as well as required servicing and inspection over a defined period. In this case, the total contract price must be allocated between the two performance obligations.
Financial Statement Impacts
The new standard has updated some of the verbiage on the balance sheet and requires additional footnotes that describe and detail the revenue streams and the recognition methodologies. Retention, while still an asset, may be presented as a contract asset rather than a receivable, depending on the contingency requirements. Certain contract costs may be capitalized as a contract asset and expensed over the life of the contract should they meet certain criteria. Underbillings and overbillings will now be titled as contract assets and contract liabilities. It is important that you discuss and understand these changes with your professional advisors so that you can educate the users of the financial statements.
The standard became effective January 1, 2019, so now is the time to evaluate the contracts in progress at the end of 2018 in order to determine the impact on 2019. It is also important that new contracts are evaluated by individuals familiar with the standard in preparation for the 2019 financial statements.
You might be surprised, but the new standard will affect you. If you have questions or would like to see how the new revenue recognition rules affect you, please contact us.