A new website or updated software “goes live” when it’s launched for widespread use. This, too, will soon be the case with an important accounting change for construction businesses that follow Generally Accepted Accounting Principles (GAAP).
For privately held companies, Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, is due to go live with annual reporting periods beginning after December 15, 2018. The new rules will most affect contractors with substantially valuable contracts carried out over considerable lengths of time, transitioning these big-money deals away from a strict percentage-of-completion method to a revised revenue recognition model.
As its name indicates, ASU 2014-09 sprung to life in 2014, when the Financial Accounting Standards Board (FASB) in May originally published the update. Although it’s been subject to a number of comment periods and updates since, the objective remains to converge revenue recognition rules under GAAP with accounting rules published by the International Accounting Standards Board (IASB).
Indeed, the new rules are the result of over a decade of work with the IASB to establish one clear reporting method for businesses across the globe. In the process, roughly 180 parts of business- transaction-specific guidelines under U.S. GAAP were eliminated as the two accounting organizations took a more principles-based approach to revenue recognition.
The result: Under ASU 2014-09, companies must follow a five-step procedure for recognizing revenue:
- Identify a contract with a customer.
- Separate the contract’s commitments.
- Determine the transaction price.
- Allocate a price to each promise.
- Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.
The updated rules may cause some businesses to recognize revenue much differently from what they’re accustomed to under current GAAP practices. So, it’s critical to be prepared for the change and to know just how it will affect your construction company.
You’ll note the second of the five steps listed above is “separate the contract’s commitments.” Doing so will be key for contractors. More specifically, you’ll have to divide your contracts into “performance obligations,” which the FASB defines as “promised goods or services that are distinct and should be accounted for separately.” For a good or service to be separately recognizable as revenue, the customer must be able to:
- Benefit from that good or service as a standalone item, or
- Use that delivered good or service with only the customer’s existing resources (and not be required to receive future goods or services in order to use that good or service).
ASU 2014-09 is likely to have the biggest impact on new construction. Currently, you probably report a variety of common line items separately as recognizable revenue because you sell these goods and services separately. Examples include site clearance, foundation work, construction of a structure, piping and wiring, and installing equipment and finishing.
But, for new construction, contractors must provide a significant level of service to integrate these items (and others) into an overall project for a customer’s use. So, in the case of, say, electrical wiring and foundation work, you’ll no longer recognize these items separately under ASU 2014-09. Rather, they’ll be considered components of revenue that you’ll report later.
To be clear, you may be able to bill for them separately, but you won’t be allowed to account for them separately as revenue under the new rules when these line items are billed or paid.
An important concept in following the new rules will be the “bundling” of goods or services. In an update to ASU 2014-09, the FASB directs businesses to aggregate building components until a distinctly deliverable and usable bundle of goods or services is identifiable. This could result in a contractor accounting for all of the goods or services under a new-construction contract as just one performance obligation. If this happens to your company, you may initially report much less income under the new rules than you have in previous years.
If your construction company typically works on installation or renovation projects, ASU 2014-09 will affect your accounting procedures differently. You should focus primarily on whether you can recognize revenue from materials or equipment separately from the installation work.
Making this determination won’t always be easy, as specifics will vary based on the project. But, in a nutshell, you’ll need to look at whether the materials or equipment has a standalone value to the customer.
To do so, ask yourself: Could the equipment be installed without customization by other contractors? Also, does it have retail sales value to the customer by itself? If the answers are yes, you’ll likely be able to record the revenue separately. On the contrary, if you’re performing specialized integration services that transform equipment or materials into a usable form, you probably won’t be able to recognize the revenue separately.
Assuming your company follows GAAP, ASU 2014-09 will challenge you with its detailed approach to revenue recognition. (Also note: Additional disclosures may be required under these rules.) Work closely with your CPA to prepare for the change and to navigate the new rules thereafter.
We welcome the opportunity to put our construction industry expertise to work for you. To learn more about how our firm can help advance your success, please contact Dave Wolfenden at (302) 254-8240.