The new revenue recognition standard (ASC 606) which significantly changes the revenue recognition model for contractors is here, and many firms have yet to evaluate the impact the new rules will potentially have on their company’s financial statements.
How to account for fulfillment or upfront costs
A substantial change required by ASU 2014-09 Revenue from Contracts with Customers (Topic 606) is how to account for fulfillment or upfront costs. Fulfillment costs are costs directly related to a specific contract that generate or enhance a resource that is used to fulfill a performance obligation, and are recoverable under the contract. The situation becomes more complex when it comes to pre-contract costs incurred prior to the transfer of control of goods or services to the customer. Such costs may include, but are not limited to:
- Insurance premiums and surety bonds
- Mobilization costs of equipment and labor to a job site
- Engineering and design
- Scheduling of workflows and costs of production equipment
- Materials related to a specific contract
These costs must be deferred and amortized to the contract as transfer of control occurs. Revenue recognition will not occur for these costs, since there is no transfer of control of any goods or services. Amortization will be based on a systematic and consistent basis, such as the percentage of completion.
Aside from fulfillment costs, we would like to address incremental costs. Incremental costs are costs incurred in obtaining a contract that would not have been incurred if the contract had not been obtained. These costs are recognized as an asset. Similar to fulfillment costs they will be amortized to the contract as goods and services are provided. Costs to obtain a contract, such as a bid or estimate, will be expensed as incurred unless the contract explicitly states they are chargeable to the customer. Sales commissions may be an example of an incremental cost.
Cost of waste & inefficiencies
The new standard also addresses the cost of waste and inefficiencies. When a cost incurred does not contribute to progress in satisfying a performance obligation, the costs would be excluded from input measurement used to recognize revenue, and instead be directly expensed, because these costs do not represent the transfer of goods or services to the customer. Inefficiencies in the contractor’s performance that are not reflected in the contract price will also require consideration. Theoretically, these costs should be segregated and charged directly to expense, rather than used as an input in the calculation of revenue. It seems unlikely that a contractor will be able to quantify these costs in any meaningful way.
Compliance with the new rules
Questions have been raised about how contractors will comply with the new rules. Current construction cost accounting software will unlikely be able to modify its programming to account for these items differently than current practice. A contractor may continue to account for upfront costs as it does now, but total its costs incurred up to the point goods or services begin to be provided to the customer. At year end, these costs for all contracts would be adjusted to the balance sheet, net of amortization, presented separately on the contract schedule by contract, and then subsequently reversed back to contract costs at the start of the new year.
The new standard requires contractors to account for certain costs differently. With a lack of software modifications, contractors will have to find alternative strategies to properly account for, and present, these costs.