Change: the word brings apprehension to some but excitement to others. Some people want nothing to change; others want everything to change. Change is a dynamic force of its own, sometimes progressing rapidly and other times glacially. Change can be incremental in size or dramatic in scope. The one constant is that change will happen. People can choose to ignore change or embrace it. Which one will you be?
At its most basic form, Accounting Standards Codification Topic 606 (ASC 606) can be boiled down to this five-step process:
- identify contracts with customers;
- identify performance obligations in each contract;
- determine the transaction price;
- allocate the transaction price to the performance obligations; and
- recognize revenue when or as performance obligations are satisfied.
ASC 606 is much more complex than a simple checklist; the rules are more than 1,000 pages long, after all. Yet most people do not understand why ASC 606 is being implemented, what problems it is intended to fix, who it really affects, what the impact will be financially and operationally, and what benefits are possible.
ASC 606 is the most significant change to generally accepted accounting principles (GAAP) in the United States in the last 20 years. That may not seem important to many people, but GAAP is the language that is most often used in the United States for financial reporting today. When a language changes, its users need to adapt or risk not understanding the environment around them. Building codes, environmental regulations, and tax rules at federal, state, and local levels are evolving all the time. We may not always like those changes, but unless we can get a court to back us up, we still need to comply with them. GAAP is no different. As the primary financial language in the United States, it is how most companies are likely communicating with their investors, financial institutions, bonding agents, and sureties through monthly, quarterly, or annual financial statements. They are the lens through which everyone else sees the company. When that lens gets fogged up, decision-making slows down or grinds to a halt. Companies cannot afford an unnecessary slowdown when the rest of the world is speeding up.
Why the change?
Under the current GAAP, revenue is basically earned when the risk and reward of a good or service is transferred from the provider to the customer. That concept is now changing from transfer of risk and reward to transfer of control. Control might mean physical possession, but it can also mean economic control. When a work crew leaves a jobsite each day (assuming the customer owns the site), a little bit more of the project's completion is being transferred each day. That example represents physical control. However, what if a specialty concrete mix is being created or specific steel panels are being fabricated that cannot be sold to another customer? While the customer may not physically control these items, they may have economic control because it would be very difficult to find anyone else to purchase them.
That is the primary operational reason revenue recognition is changing. Transfer of control is deemed to be a better measure of performance than the right to receive the reward or responsibility for the risk. There are other reasons for the change from a financial perspective. The Financial Accounting Standards Board (FASB), which sets GAAP in the United States, wants to be on the same playing field with its international counterpart, the International Accounting Standards Board (IASB). The FASB and IASB have been working for several years toward a long-term goal of converging their standards. The intended result is to improve comparability across countries and markets as the world's economy becomes more closely linked.
The other goal is to make revenue recognition and financial statements more comparable across industries. There are currently many inconsistencies when comparing construction companies to manufacturers, health care entities, technology companies, or others — the list goes on. It is often asked why comparability is necessary for companies across industries when the primary goal is out-performing companies within one's own industry. Here is why it matters: Users of a company's financial statements have opportunities every day to invest their capital in that company, in competitors in that industry, or in entities in other industries. The top two users on the list from that perspective are financial institutions and investors. They do not have to provide a company with loans for working capital and equipment or put equity into a company. They can choose a competitor in that industry or a completely different industry that they might view as more stable or more likely to pay a higher return through income and dividends. That is why GAAP matters. A company needs capital, and these financial statement users have it.
Facing the unknown
The upcoming changes to revenue recognition are still unknown to many people. Despite the FASB's issuance of ASC 606 in 2014, implementation guidance from the FASB has been slower than anticipated. Thankfully, the deliberation on the front end of the rulemaking process was well publicized, and the engineering and construction industry (E&C) voiced numerous concerns and successfully pushed for changes to the initial standard that are favorable to E&C entities. Public companies have already started implementing ASC 606 because it was effective for them starting with periods beg inning after December 15, 2017 (including interim periods). Nonpublic entities still have a little time, as it is effective for them starting with periods beg inning after December 15, 2018 (interim periods are not required to be reported under ASC 606 until after December 15, 2019). Despite the long runway from 2014 to 2018, two of the seven topics raised by the American Institute of Certified Public Accountants' (AICPA's) E&C Task Force are still unresolved by the FASB. That uncertainty is making implementation more difficult.
Who do the changes affect?
As noted earlier, any entity that issues GAAP-based financial statements will need to implement ASC 606. It does not matter whether the entity obtains any assurance (compilation, review, or audit) from a CPA or what level of assurance is provided. Entities that do not report their financial activity using GAAP, such as cash basis, income tax basis, and others, may not be impacted. However, if an entity is required by a user of their financial statements to change to GAAP-based reporting in the future, ASC 606 will apply.
External users of the financial statements, such as investors, financial institutions, sureties, and bonding agents, have already been mentioned. Obvious internal users include a company's owner or owners and its accounting personnel. However, this will also affect other users, such as project managers, estimators, and salespeople. Not only will the revenue numbers possibly change, but assets, liabilities, and expenses may change as well. Legal counsel will also see changes due to contract language likely changing.
The five steps
As noted earlier, a major change was made to ASC 606 in its infancy that is extremely beneficial to E&C entities. That change made over time (OT) revenue recognition the default method rather than point in time (PIT) revenue recognition. This issue was a major concern to the AICPA’s E&C Task Force because most contractors already use percentage of completion, which is similar to the OT method. Because of this, E&C entities may see a less drastic impact than certain other entities in industries for which PIT is the current common practice. However, this is also leading to the false sense of complacency among many E&C entities. These entities assume that, because this major change may have a smaller impact than originally expected, it will not affect them at all. This is not true, as there are many other issues to consider. Determining the method of revenue recognition is actually the fifth step of the process, so the first four steps still need to be considered.
Step one of the process is identifying the contracts with customers. This seems like a simple step until some digging is done. The definition of a contract under ASC 606 is an agreement between two or more parties that creates enforceable rights and obligations. Contracts that lack commercial substance (i.e., the risk, timing, or amount of the E&C entities’ future cash flows is expected to change as a result of the contract) are not contracts from an accounting perspective at all. If an E&C entity does not technically have a contract, then the OT method cannot be used, and all revenue for that project must be recognized only upon completion of the project and payment is not refundable. A common trap for lacking commercial substance is that each party has the unilateral right to terminate without a significant penalty (a significant penalty must be at least the recovery of cost plus a markup). This type of clause is often known as a termination for convenience clause.
Step two is to identify distinct performance obligations, which can be boiled down to two questions: Is the good or service capable of being distinct, and is the good or service distinct within the context of the contract? Integration, dependence, and interrelation all suggest the good or service may not be distinct. Many construction contracts will have only one performance obligation because the various phases are integrated, dependent upon, or interrelated with each other. However, the concept of distinctness must be considered from the project owner’s perspective as well. Were all the phases bid separately? Is the project owner acting as the de facto general contractor? Who controls the payment for work performed? These are all necessary questions that could dictate whether there are one or more performance obligations. Why does this matter? Performance obligations are measured individually and can have very different profit margins and completion dates. This will affect how and when the revenue is recognized for each of those performance obligations.
Determining the transaction price is the third step. This may seem obvious, and most E&C entities are already familiar with this process. E&C entities must know their contract terms or risk missing completion dates, and they must know their billing deadlines or face potential disputes with project owners and subcontractors. However, the way in which contract changes will be accounted for will be much less focused on periodic updates to total estimated costs (although this will still be important) but will instead shift to focus on changes in the transaction price. The concept of variable consideration is any portion of the transaction that can shift upward or downward. Examples include backcharges, penalties, retentions, incentives, profit sharing, liquidated damages, and performance bonuses. ASC 606 says that all of these items need to be considered at the beginning of the contract and throughout the contract’s duration. How likely is it that the performance bonus for meeting an early completion date will be achieved? Was the contract accepted because it should have a very high margin even though there will likely be penalties for late completion? What is the likelihood that shared cost savings will be achieved? Each of these types of scenarios needs to be accounted for at the beginning of the contract and then reevaluated throughout.
Step four probably has the least amount of ambiguity. Allocating the transaction price to the distinct performance obligations is straightforward if there is only one performance obligation. When there are multiple performance obligations, the allocation should be based on what the standalone price for that specific good or service would be if sold separately. If a standalone selling price is not directly observable, a reasonable estimation is acceptable.
Step five is where most E&C entities are focusing. As noted earlier, the OT method is the default method of ASC 606, so many E&C entities may see little change here. However, there is still some uneven terrain to navigate. The OT method can be used if one of three statements is true (if none are true, then the PIT method must be used).
First, the customer simultaneously receives and consumes the benefits of the good or service. This is often the case for maintenance contracts or other continuous services. Second, the E&C entity’s performance creates or enhances an asset that the customer controls. Common examples of this are infrastructure projects for governmental units or commercial building projects when the property is already owned by a third party. An exception for which the PIT method might be required occurs if the E&C entity owns the property and is developing the site for another party. Careful reading of the contract will be required to determine when control of the project site is truly transferred. Only when control is transferred can revenue be recognized.
The third statement is perhaps the most difficult to understand and states that an E&C entity's performance does not create an asset with an alternative use to the E&C entity, and the E&C entity has an enforceable right to payment for performance completed to date. Two earlier examples of a specialty concrete mix being created and specific steel panels being fabricated were briefly discussed. Those are two common situations in the E&C industry. If the asset being created has an alternative use (i.e., it can be sold to another customer with minimal costs incurred for modifications) or the E&C entity does not have an enforceable right to payment for performance completed to date, then the PIT method must be used. This means that revenue is not recognized until the good or service is transferred, and the payment is nonrefundable. That can provide a very different result than most E&C entities are currently getting from using percentage of completion or what they would get using the OT method.
The principles of ASC 606 could change how quickly or slowly revenue is recognized even if the method (OT or PIT) does not change. ASC 606 is not just a one-time adjustment, either, especially for E&C entities. ASC 606 is not an overall revenue policy but must be applied to each contract. Due to the uniqueness of each contract, it is possible that one contract might recognize revenue more quickly than the current pace, and another contract might dictate a slower recognition pattern. In addition, changes to contracts should be continuously evaluated and reflected in the company's financial reporting. Some entities do a good job of this; others wait until the end of the contract to true-up their financial statements.
Ratios used to calculate bonding may result in different answers in the future than when calculated today. A company’s earnings before interest, taxes, depreciation, and amortization could change as earnings are recognized on a faster or slower basis. Equity could be higher or lower. Entities that have not carried inventory on their financial statements because the materials were immediately expensed to a contract may now need to list inventory on their balance sheet. Mobilization costs and bond premiums may not be an immediate expense item either, but instead may be capitalized as an asset on the balance sheet and then amortized over a certain period of the contract.
Due to the potential timing change for recognizing revenue, the timing of tax payments might change too. Increased revenues could mean additional net income to be taxed, which can impact an entity’s cash flows when those payments are due. Changes in tax estimates also sometimes impact other items, such employee bonuses, distributions or dividend payments to owners, and even capital expenditures to take advantage of accelerated depreciation to offset tax due. The IRS has been largely silent on how ASC 606 will work with income tax reporting. To date, their sole communication has been to provide proposed guidance that suggests an automatic change in accounting method will be accepted for all entities rather than an individual evaluation by the IRS of method change requests. Also undetermined is how sales and use tax reporting and submission will be reported, as transaction prices for contracts may be different than currently calculated.
Financing relationships may change as well. As an entity’s financial statements change, so too can the results of its debt covenant calculations. A company that was meeting its debt-to-equity ratio in the past may see its equity decrease if revenue recognition is slower overall on its contracts. Conversely, debt may increase more quickly if capital expenditures are increased for accelerated depreciation purposes. Borrowing base calculations may change as well if a company has not had inventor y before or has maintained lower levels of it. A company may be able to negotiate the ability to borrow against certain inventory that was never recorded in the past. Entities that are required to get financial statement audits may find themselves at risk of modified or adverse audit opinions for failure to comply with ASC 606 as part of GAAP. E&C entities that are required to provide GAAP-basis financial statements that have been compiled, reviewed, or audited by an independent CPA will have additional hurdles. They will be required to show how they have considered and implemented ASC 606. This will involve significant administrative attention to understand the new standard, to develop processes for review of contracts before they are signed to determine how and when revenue can be recognized, and to reinforce internal documentation standards for contracts, change orders, and other customer communication. This is not an optional standard for CPAs; the assurance files for the CPA will require supporting documentation about how ASC 606 was considered by the client. Those GAAP-based financial statements will change as well and require additional time and effort on both the E&C entity’s and the CPA’s part, especially in the year of implementation. There will be additional disclosures about both qualitative and quantitative items with the goal of allowing financial statement users to understand the nature, amount, timing, and uncertainty of revenues and cash flows that result from contracts with customers.
ASC 606 was intended to simplify the process of recognizing revenue. Nevertheless, it has complicated matters for most entities. Despite this, there are also some significant benefits to it. The greatest benefit is probably that it shifts revenue recognition to a principles-based model. Put simply, it allows for greater flexibility to recognize revenue based on an entity’s specific situation. An entity can craft a set of revenue policies that best suits it as long as they fit within the newly broadened principles. It will be necessary to consistently apply these principles to similar situations and then disclose in the financial statements how and why revenue was recognized the way it was. Entities may have the opportunity to rewrite their general contracts or sub-contracts on a go-forward basis in a way that is more beneficial to them and their operations. While most contracts are unique to a certain extent, a template is often used. This change to accounting standards affords the rare opportunity to make changes to those templates without causing alarm on anyone’s part. Entities need to be aware, though, that they may be on the other end of this scenario as well and take the time to review new contracts in detail for changes that they may not have seen before.
Another benefit to ASC 606 is that some entities are taking the time to revisit their internal flow of contract administration. They are considering who should be reviewing contracts before they are signed, how much involvement is necessary by legal counsel, what information should be summarized and presented to the project manager and work crew, how frequently project reports should be updated, when accounting personnel should be consulted (this should be early), and how much additional transparency is necessary with outside users of the financial statements.
There are effectively two transition methods available: retrospective and cumulative catch-up (CCA). The retrospective method requires restatement of the entire year’s results that occurred immediately preceding adoption of ASC 606. The CCA method requires that only the results of adoption be flowed through an entity’s equity section for the year immediately preceding adoption.
A retrospective transition method may sound difficult, but there are significant benefits. First, an entity can be implementing ASC 606 as the year goes along rather than needing to flip a switch at the beginning of the reporting year. This allows entities to better understand what will change financially because the old and new methods are being performed at the same time. In addition, changes to the new method can be done with less or no external reporting impact if unforeseen consequences arise. In addition, a lot of the administrative work around the adoption can be done outside of peak operational periods.
The CCA method sounds simpler than the retrospective method, but that simplicity only carries over to the presentation of the financial statements. The same work needs to be done, but because the amount of numbers changing on the financial statements for the preceding year is relatively low, there is a danger that ASC 606 will not be given the attention it needs in the year preceding adoption.
E&C entities should not take ASC 606 lightly. Many are doing so, and this will be to their detriment. However, there are reasons for optimism for the E&C industry as well. Since many E&C entities already use the percentage of completion method of accounting and the OT method is the new default method, there is already less impact. Each performance obligation needs to be evaluated individually, but the OT method is still the likely answer for most contractors. Most E&C entities already have a solid grasp of how their contracts are written. Cash flow can be choppy in the E&C industry, so entities need to know exactly when they can bill and expect to be paid. In addition, disputes are common in the E&C industry, so meeting specifications on a large, integrated project is of greater importance than it is for some other industries in which the size of the good or service may be much smaller and failure to pass the quality control process may potentially be less impactful.
Contract disclosures are already quite robust. Many entities are providing significant revenue recognition verbiage in the accounting policies of their financial statements. The concepts of costs and estimated earnings in excess of billings and billings in excess of costs and estimated earnings are very similar to contract assets and contract liabilities, new terms provided by ASC 606. Estimated losses on uncompleted contracts are already required to be accrued when they are material. Backlog disclosures of future known revenue are required and often include expected costs and margins on work that is already started or not started yet at all. Some contractors will even break out self-performed versus sub-contracted costs. Changes in estimated profitability from the prior year are required to be reviewed and potentially disclosed if they are material. Details about each contract are typically disclosed in a completed-contracts schedule and a contracts-in-progress schedule. In many ways, E&C entities are ahead of the curve for financial reporting relative to ASC 606.
At first, many entities may believe that ASC 606 will have little applicability to them and will want to brush it off as something that either does not need any attention or can be pushed back until the last minute, but that is not a smart move. ASC 606 is not likely to be delayed or substantially changed, and the impacts are going to be significant, as already noted.
What should be done now? Companies need to work with their accountants to start getting a handle on how this will impact them. The second call that is needed is to the entity’s software provider to make sure the accounting software being used can handle ASC 606. Attempting to comply with ASC 606 manually will be painful and very difficult if the accounting system is not capable.
 Mercado, R. and Miller, J., Nuts and bolts of the new revenue recognition standards for E&C, Construction Accounting and Taxation 27, no. 6 (2017):26–33.