Revenue Recognition in the Construction Industry
In the ever-evolving business world today, more and more complex transactions are happening, and it is important that we fully understand how to account for such transactions. From deciding whether to expense or capitalize, to understanding the implications of leasing vs buying, businesses today have a high need for accountants to help them navigate such transactions. While most people probably think of banking or finance when they imagine complicated accounting procedures, construction accounting can also be complex. One of the biggest issues in construction concerns revenue recognition and the timing of it.
Construction projects can be massive and last weeks or even years. This is this reason why the timing of revenue becomes so imperative. If a project spans multiple accounting periods, in which period would we recognize the revenue? Should we wait till the very end, when the project is complete, or should we spread it out over the length of the project? If we spread it out over the length of the project, at what points do we recognize revenue, and how much? The percentage-of-completion method is a way to recognize revenue over the life of the project, and there are several steps involved. Can all this be settled in the initial contract? As you can see, there are many issues that need to be addressed when thinking about long-term construction projects. Thankfully, ASC 606 provides us with some guidance, and we will examine the steps involved in applying this percentage-of-completion method to the construction industry.
The first step in recognizing revenue from contracts is identifying the contract with a customer. A contract is defined as “an agreement between two or more parties that creates enforceable rights and obligations” (FASB). Contracts can be oral, written or implied. A contract must also meet the following criteria:
• It is a substantive agreement.
• The payment terms and each party’s rights can be identified.
• The parties plan to enforce their rights. (Journal of Accountancy, 2014)
For the construction industry, the substance of the contract is very important. Significant time and financial resources are involved in construction and failing to spell out the terms of the contract in a fair and considerate manner can be very detrimental for a firm. Contract modifications are allowed, but all parties need to approve. For example, say a construction company signs a contract to tear down a building, and when work starts, discover there is asbestos contamination. This would require significantly more resources than originally anticipated. If the construction company failed to outline this in the original contract, and the other party does not agree to a modification, the construction company could be out a lot of money. As you can see, the creation and identification of the contract is a very important step.
After we have identified the contract, we can now identify the performance obligations that exist in the contract. FASB defines performance obligations as “A promise in a contract with a customer to transfer the customer either: A good or service that is distinct; or, a series of distinct goods or services.” For a construction company, there can be many performance obligations. For example, when tearing down and constructing a new building, one performance obligation may be to tear down the old building. The next performance obligation would be to construct the new building. This is a very vague example, and there may be many more obligations identified in an actual contract. It is crucial that each performance obligation is clearly identified, however, as we will discuss later on.
The third step is to determine the transaction price. When determining this price, the company “assumes that the goods or services will be transferred to the customer based on the terms of the existing contract.” (KPMG, 2016). There are many considerations to take into effect in this step. Variable items such as discounts, incentives and concessions need to be taken into consideration when determining price. For a construction company, this could be something like performance bonuses, where they are paid more if it is completed at a sooner than later date. The likelihood of this event occurring is also taken into consideration from an accounting perspective. There may also be noncash factors to consider in determining the price. For very large projects, such as a skyscraper, a construction firm might be offered stock in the company as a part of the compensation package. Another consideration that would affect long-term construction projects is financing considerations. For example, contacts that have long term payment arrangements, or pay a significant amount upfront, need to account for the time value of money or interest expense involved.
The fourth step involves allocating the transaction price that we just calculated to each separate performance obligation. For example, a small construction company that does floors and cabinetry may have identified performance obligations of 1) tearing out the current floors and cabinetry, 2) laying the new floors, and 3) installing the new cabinetry. One way of doing this is by determining stand-alone selling prices. For example, the cabinetry company may look at what it costs to perform each individual performance obligation on a stand-alone basis, then apply the price that way. If there is no observable stand-alone price, an estimate would need to be made. KPMG has a very helpful framework broken down into steps for estimating stand-alone selling prices:
1. Gather all reasonably available data points
2. Consider adjustments based on market conditions and entity-specific factors
3. Consider the need to stratify selling prices into meaningful groups
4. Weigh available information and make the best estimate
5. Establish processes for ongoing monitoring and evaluation (KPMG, 2016)
This should help most firms develop a process in which estimating prices becomes more accurate and less of a burden. It will also help to make financial statements more accurate, as prices will be allocated to the correct period on a more consistent basis.
Finally, the final step is to recognize revenue when the company satisfies a performance obligation. This step seems almost redundant to step 4, but there are some details that need to be considered. At the contracts inception, the construction company should determine whether each performance obligation will be satisfied over time or at a point in time. Revenue can be recognized over time if one of the following occurs: the customer 1) simultaneously receives and consumes the benefits, 2) the customer controls the asset as it is created or enhanced, or 3) the contractor has no alternative use of the asset and has an enforceable right to payment for performance completed to date (FASB). A construction project seems to satisfy requirement number 3 above. Since the flooring contractor that installs floors has no use for the floors, it should recognize revenue over time.
One other way to recognize revenue for construction projects is the completed contract method. Under this method, all revenues and expenses are deferred until the project is finished and complete. Once complete, the final accounting is done, and the company can recognize revenues and expenses. One may wonder why anyone would ever use this method when compared to the percentage-of-completion method, but “the principal advantage of the completed-contract method is that it is based on final results, whereas the percentage-of-completion method is based on estimates” (Bragg, 2010). Another area this method could be advantageous is with short-term projects that are done within the same accounting period.
Overall, there is a lot to consider for a construction company in deciding which revenue recognition method to use. One has to take into consideration the increased cost of having a more complex accounting system such as what the percentage-of-completion method would require. However, given the much more accurate financial statements and records that are a result of the percentage-of-completion method, I believe it is worth it This increased accuracy related to costs and revenues will provide the company with much more insight going forward in terms of cost control, time management and resource management. The percentage-of-completion method also paints a more accurate picture for outside investors, something that could be invaluable to any business. I think that all sizable construction companies should consider using this method.