The ASC 606 transition for construction contractors: Recognizing revenue
In this series, we have identified the contract, identified the performance obligations, determined the transaction price and allocated the transaction price to the various performance obligations. The final step is to recognize revenue as performance obligations are satisfied, by transferring a promised good or service to a customer. This occurs as the customer obtains control of the asset. ASC 606 requires additional consideration and documentation related to the transfer of control, including whether the transfer of control occurs over time or at a point in time.
A construction contractor has satisfied a performance obligation by transferring the promised good or service to a customer. A good or service is transferred when (or as) the customer obtains control of that good or service. Control of a good or service is demonstrated when a customer has the ability to direct its use and obtain substantially all of the remaining benefits associated with the use of the good or service. Control also means the ability to prevent other entities from directing the use of, and receiving benefit from, a good or service. A contractor must make a determination as to when it believes its customer obtains control. Some possible indicators of control passing to the customer include:
- Using the asset to produce goods or services
- Using the asset to enhance the value of other assets
- Using the asset to settle liabilities or reduce expenses
- Selling or exchanging the asset
- Pledging the asset to secure a loan
- Holding the asset
Control passes to a customer in one of two ways: either at a point in time or over time.
Transfer of control over time
The new standard requires a contractor to determine, at contract inception, whether it will transfer control of a promised good or service over time or at a point in time—regardless of the length of contract or other factors. Depending on the measure of progress a contractor applies, the accounting for a contract that meets the criteria for recognition of revenue over time may be similar to the method a contractor currently applies under existing guidance (i.e., percentage-of-completion). It is presumed that control transfers at a point in time if a contractor is unable to demonstrate that control transfers over time.
The new accounting standard provides that revenue is recognized over time if any of the following criteria are met:
- A customer simultaneously receives and consumes the benefits of the performance obligation as the work is performed.
- A contractor’s performance creates or enhances a customer-controlled asset.
- A contractor’s performance does not create an asset with an alternative use to the customer and the contractor has an enforceable right to payment for performance completed to date.
- This would apply in many recurring service arrangements for which the simultaneous receipt and consumption by the customer is readily evident; however, in circumstances where simultaneous receipt and consumption is less evident, the standard clarifies that revenue recognition over time is still appropriate when a contractor determines that another contractor would not need to substantially re-perform the work that the contractor has completed to date if the other contractor were to fulfill the remaining performance obligation to the customer.
- For purposes of this criterion, the definition of control is the same as previously discussed, in which the customer has the ability to direct the use of and obtain substantially all of the remaining benefits from the asset. This criterion would apply in many contractor arrangements where construction occurs on customer-controlled land.
- An asset created by a contractor has no alternative use if the contractor is either restricted contractually or practically from readily directing the asset for another use (e.g. selling to a different customer). In addition, if the contractor would incur significant economic losses to direct the asset for another use (e.g. a redesign or modification of an asset or an asset sold at a significantly reduced price), the asset is considered to not have an alternative use.
- A contractor has an enforceable right to payment for performance completed to date if, at any time during the contract, the contractor would be entitled to an amount that at least compensates it for work already performed. This right to payment must be present, even if a customer can terminate the contract for reasons other than a contractor’s failure to perform as promised. The amount to which a contractor is entitled must approximate the cost of the goods or services transferred to date plus a reasonable profit margin.
A contractor recognizing revenue over time also needs to determine a measurement of progress towards satisfaction of the performance obligations. Under ASC 606, measuring progress towards completion is performed using one of the following methods:
- Input method: Recognize revenue on the basis of a contractor’s efforts or inputs to the satisfaction of a performance obligation, such as labor hours, labor dollars, machine hours, costs incurred or material quantities used, relative to the total expected inputs to the satisfaction of that performance obligation.
- Output method: Recognize revenue on the basis of direct measurement of the value to the customer of goods or services transferred to date, such as surveys of goods or services transferred to date, appraisals of results achieved, milestones reached or units produced or delivered, relative to the remaining goods or services promised under the contract.
For construction contractors, the majority of performance obligations will be measured over time as control is transferred using the input method. This is consistent with the percentage of completion method under current U.S. GAAP, but the new accounting standard emphasizes that the input method may need to be adjusted when a cost is incurred that does not contribute to a contractor’s progress in satisfying the performance obligation. Therefore, costs incurred related to rework or wasted materials would be excluded from input measurement, as these costs do not represent the transfer of goods or services to a customer. In addition, the cost of uninstalled materials does not represent a contractor’s progress towards fulfilling its performance obligations and should therefore not be included in the measurement of progress towards completion calculation. While uninstalled materials are excluded from the measurement of progress, a contractor is permitted to recognize revenue equal to the cost of the uninstalled materials (excluding gross profit) under the new standard.
A scenario in construction
An elevator contractor enters into a contract to remove an existing elevator and replace it with a new elevator in a commercial building for $4 million. Due to a long lead time on the manufacturing of the new elevator, the contractor orders and incurs cost for the new elevator equal to $1 million. The new elevator is delivered to the job site six months before it will be installed. The contractor estimates that other costs of $2 million will be incurred related to the removal of the existing elevator and other labor and materials needed to install the new elevator. Based on the circumstances, the elevator contractor uses the input method based on the cost incurred to measure progress towards completion. At the end of the reporting period, the contractor has incurred other costs of $1 million and the cost of the new elevator of $1 million for total costs incurred of $2 million.
Conclusion
The contractor determines that including the costs to procure the new elevator in the measure of progress would overstate the extent of the contractor’s performance since it is uninstalled at the reporting period. As a result, the contractor excludes the $1 million incurred to procure the new elevator from its measurement of progress. The contractor’s measurement of progress includes the other costs incurred of $1 million against the total expected other costs of $2 million or 50 percent. The contractor would recognize revenue as follows:
As the new elevator is installed, the contractor would reevaluate its progress towards completion and recognize revenue and gross profit based on satisfying the performance obligation.
If a contractor is unable to demonstrate that control transfers over time, the presumption is that control transfers at a point in time.
Transfer of control at a point in time
The concept of transfer of control at a point in time is very similar to the completed contract method under existing accounting guidance. ASC 606 provides that control has transferred and revenue is recognized at a point in time if any of the following criteria are met:
- A contractor has a present right to payment for the asset
- A customer has legal title to the asset
- A contractor has transferred physical possession of the asset
- A customer has the significant risks and rewards of ownership of the asset
- A customer has accepted the asset
The above list is not all-inclusive and a contractor may determine that specific facts and circumstances enable a conclusion that control has passed to the customer.
A scenario in construction
A homebuilder enters into a contract with a customer to construct and sell a new home for $500,000. The contract stipulates that the home completion and closing are estimated to take place within nine months from the date of the contract. The homebuilder is also a land developer who will transfer title of the land and new home when the closing occurs. The homebuilder concludes that the contract to construct and sell the home on the homebuilder’s lot represents a single performance obligation where the ultimate output is the completed home.
Conclusion
The homebuilder has evaluated the new accounting standard and determined that the contract does not meet one of the three criteria outlined to recognize revenue over time based on the following:
- The customer is not simultaneously receiving and consuming the benefits of the performance obligation as the work is performed. The customer will not receive the benefits of the performance obligation until closing occurs.
- The homebuilder’s performance has not created or enhanced a customer-controlled asset. The asset is controlled by the homebuilder and the customer does not have the ability to direct the use or obtain substantially all of the remaining benefits from the asset.
- The homebuilder’s performance has created an asset with an alternative use to the customer and the homebuilder does not have an enforceable right to payment for performance completed to date until the closing occurs. The home under construction could be sold to another customer without incurring significant economic losses by the homebuilder to direct that asset for another use.
Since the contract between the homebuilder and the customer to construct and sell a new home does not meet one of the above criteria, the homebuilder concludes that revenue should be recognized at a point in time. The homebuilder determines that the point in time to recognize revenue is at the closing date when the homebuilder has a present right to payment for the asset, legal title of the asset is transferred to the customer, physical possession of the asset is transferred to the customer, the customer has accepted the significant risks and rewards of ownership of the asset and the customer has accepted the asset.
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