New Accounting Standards for Long-Term Projects
The Financial Accounting Standards Board (FASB) issued ASC 606, a new standard on recognition of revenue from contracts with customers. The new standard will have major implications on construction companies’ internal accounting. While ASC 606 will only apply to construction companies that enter into contracts greater than one year, it would benefit all owners to familiarize themselves with the New Guidance.
The new standards’ effective date for private companies begins after December 15, 2018 (calendar year 2019). Companies will have two options for complying with the new accounting standard: (1) restate all periods as if they had been accounted for under ASC 606 originally, or (2) apply the new standards to current contracts as of the effective date and contracts moving forward.
The core principle in ASC 606 is that a construction company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the payment to which the company expects to be entitled to in exchange for the goods/services. Fortunately, FASB provided five steps to achieve this core principle:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
Construction contractors will need to pay specific attention to change orders and contract modifications to ensure internal accounting procedures satisfy the new standards. Contract modifications may be accounted for as either (1) a separate contract, (2) termination of the existing contract and formation of a new contract, or (3) as included in the existing contract.
If a contract modification or change order includes goods or services that are distinct from the goods or services provided for under the original contract, the contractor must treat the modification as terminating the original contract and creation of a new contract. The revenue that has already been recognized under the original contract will not be adjusted, rather, the remaining amount of the original contract is combined with the amount of the modification to create a new contract.
If a contract modification or change order includes goods or services that are not distinct from the goods or services provided for under the original contract, the modification is treated as included in the existing contract. The contractor must adjust the recognized revenue on a cumulative catch-up basis at the time of the contract modification. An example of a situation where the change order results in a modification of the original contract, which will be accounted for as a change in estimate, is a slight change in the roofing plan that will not require different goods or labor to be provided on the job site.
If a contract modification or change order is a combination of goods or services that are both distinct and similar to the original contract’s scope of work and price, the modification is to be treated as the creation of a separate contract that is distinct from the original contract. This situation will typically occur when a change order requests a large amount of additional work, at a different price or rate, and the original contract scope has not been completed. The new work is considered a distinct service and the price will reflect the contractor’s separate selling price.
In sum, construction contractors will need to exercise significant judgment when deciding how to treat contract modifications and change orders on internal accounting procedures. Experience and advice will lend contractors the greatest help when dealing with the new ASC 606.
Disclaimer: The information contained in this article is for general educational information only. This information does not constitute legal advice, is not intended to constitute legal advice, nor should it be relied upon as legal advice for your specific factual pattern or situation.