This is Part II of a two part series. In the last article, we outlined the five-step model under the new standard of revenue recognition for construction. In this article we will discuss specific accounting changes to how your company should measure job progress to completion.
A significant change in the new standard of revenue recognition for construction is the measurement of progress to completion. The general concept of the new standard is that revenue is recorded as performance obligations are satisfied. Assuming the contract is eligible for revenue recognition over time, a basis for the measurement of progress must be chosen. The two general options are output measurements (quantities of work performed, milestones reached) and input measurements (costs incurred, labor hours utilized). Time elapsed may be either an output or an input measurement.
Costs will be the most practical measurement basis for contracts due to the complexity of typical construction projects and the integration of goods and services performed by the contractor. However, the use of costs as a measurement basis is only allowed if it is a reasonable approximation of the transfer of control of goods and services to the owner. Revenue, not gross profit, is measured through the percentage of completion calculation. Changes to estimated total costs are recognized throughout the contract performance period, just as with current GAAP.
The new standard requires contractors to evaluate the nature of costs incurred to determine if the specific costs incurred accurately reflect the fulfillment of the performance obligation(s). Certain project costs do not directly represent the transfer of goods and services to the customer. These are costs that relate directly to the contract, generate or enhance resources of the entity that will be used in the future to satisfy contract performance obligations and are expected to be recovered. Examples of these costs that require special consideration are:
- Contract procurement and fulfillment costs (incremental bidding, engineering, design, mobilization, bonds etc.)
- Materials/equipment not installed
- Wasted costs not anticipated at bid (e.g. costs due to rework or abnormal inefficiencies)
Costs to fulfill a contract incurred prior to the transfer of control to the customer are subject to review for capitalization. The costs must be material to the contract as a whole and while this is not defined in the standard, it could be 10% or more of total anticipated contract costs.
Only incremental contract procurement (bidding) costs are considered – i.e. costs that would not have been incurred had the contract not been awarded. Contract procurement costs (bidding costs) are often directly expensed by contractors and this policy is required if the costs are not recoverable in the bid. However, a sales commission is an example of an incremental cost that would qualify for capitalization.
Bidding, engineering and design costs prior to award should be expensed unless they qualify as recoverable contract costs. Post award engineering and design costs that are recoverable will likely be attributable to one or more performance obligations and considered in measuring progress to completion. If mobilization is recognized as a bid performance item, they may represent a transfer of control relative to the contract performance obligation and would not be capitalized.
Amortization and Capitalization
Capitalized bond costs, commissions, design/engineering and mobilization costs should be treated as prepaid expenses and amortized over the initial time period of the contract if material to the contract. The amortization may be straight-line unless the work supported by the costs varies on some other basis such as seasonality or the unequal loading of the related revenue.
The adoption of a policy of not recognizing profit on a job until a certain level of completion is still acceptable and could mitigate the need to capitalize and amortize costs incurred early in the contract performance period that do not represent the direct transfer of goods and services to the customer.
Stored materials are materials purchased for a contract but not yet customized and incorporated into the project. Note that the rules regarding inventory still apply and if title to the goods has not passed to the customer, the proper treatment is to exclude the costs from project costs and capitalize them instead. The key issue in accounting for uninstalled materials is determine when control of the asset passes to the customer. The following are considerations when evaluating control:
- The entity has a present right to payment for the asset (the costs are billable to the owner)
- The customer has legal title to the asset (usually upon approving a billing)
- The entity has transferred physical possession of the asset
- The customer has the significant risks and rewards of ownership
- The customer has accepted the asset
If control has transferred under the above or other criteria, the entity must then make a determination as to whether costs of materials represent a proportionate measure of progress towards satisfying the performance obligations. The evaluation of stored material costs is performed at inception and throughout the contract performance period. Most stored material costs will be non-customized supplies that could be used on other contracts.
When stored material costs are significant, the contract is in effect segmented into a “performance” segment and a “material supply” segment. No margin is attributed to the material supply segment and the contract amount is split accordingly.
Significant equipment purchases potentially create issues with contract revenue recognition similar to stored materials unless the equipment is specifically tailored for the job and the contractor believes the delivery of the equipment represents proportional progress to fulfilling a performance obligation. The costs of offsite construction such as a pre-fab operation of a plumber or the fabrication of customized gates by an iron contractor may be treated as progress towards a performance obligation even if not delivered to the job site on the measurement date as they represent the delivery of goods or services towards the fulfillment of a performance obligation.
Wasted costs are abnormal costs incurred that do not represent progress towards fulfilling a performance obligation and were not anticipated at bid. The determination of whether costs are “wasted” is subject to a great degree of judgement. Many cost overruns are not wasted costs as they represent progress towards the performance objective and the fact that over/underruns are expected in any bid. Wasted costs could be characterized by the need to remove and re-work or re-build a portion of the work and therefore clearly did not result in progress towards a fulfilling a performance obligation. Wasted costs are expensed currently against revenue and are excluded the measurement of progress toward completion.
Implementing Revenue Recognition for Construction Firms
We know there may questions as you begin to implement the new standard. The Aldrich Construction team is here to help!
Gary Alongi, CPA, CCIFP®
Aldrich CPAs + Advisors LLP
Gary Alongi brings over two decades of experience helping his clients reach their highest level of success. His extensive knowledge of the construction industry allows him to provide value-added services that save clients money, helps them comply with regulations and requirements, and take advantage of opportunities helping them grow their business. American Institute of Certified…
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- Certified Public Accountant
- Overhead rate (FAR 31) audits and compliance
- Certified Construction Industry Financial Professional (CCIFP®)
Director, Construction Accounting
Eric Krystad, CPA
Aldrich CPAs + Advisors LLP
Eric Krystad has focused his accounting and consulting practice on serving the construction industry for 30 years in the greater Los Angeles area. Eric is a frequent speaker at seminars and conferences for underwriters, bankers, attorneys and others involved in the construction industry. His industry knowledge includes accounting, tax planning and compliance, acquisitions, partnerships, international…
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- International contracts