Common ASC 606 Issues: Aerospace & Defense Entities

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition is effective for fiscal years starting after December 15, 2017 for public companies and affects almost every industry. This article provides a quick review of the key issues aerospace and defense companies are likely to face when applying this new standard.

The contractual arrangements between aerospace and defense (A&D) contractors and the United States Federal Government and foreign governments create many difficulties with revenue recognition. Due to the size and complexity of A&D contracts, there may be significant gaps of time between contract initiation, receipt of payment, and delivery of goods, which can impact when revenue may properly be recognized under ASC 606. The AICPA and the major accounting firms have assembled industry task forces to research the accounting issues with ASC 606, and we will draw from those guides to give you an idea of the issues you should expect. For more information on any of these guides, see:

We will also provide references to other RevenueHub articles for more detailed explanations of ASC 606 topics.

The following are issues that A&D companies commonly face:

1. Contract existence and related issues for foreign contracts with regulatory contingencies

There are two primary ways by which A&D entities do business with the United States Federal Government and foreign governments: (1) foreign military sales (FMS) and (2) foreign direct commercial sales (DCS). FMS contracts are conducted between the US and foreign governments, and the entity is brought in only after the governments have satisfied regulatory requirements. For FMS contracts, the existence of the contract is never in question because work does not begin until regulatory requirements are satisfied.

In contrast, DCS contracts between an A&D entity and a foreign government(s) are unusual in that they require regulatory approval—which is not guaranteed, and normally takes place after work on the contract has already commenced. This uncertainty surrounding contract approval could suggest that the criteria in ASC 606-10-25-1 for contract existence are not met. Judgment is needed to determine if the likelihood of regulatory approval is high enough to merit the recognition of a contract on a contract-by-contract basis.

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2. Unfunded portions of US Government contracts

A&D contracts depend heavily on the US Federal Government’s annual budget process, which often results in projects that are funded incrementally rather than all at once. Consequently, within one long-term A&D contractual agreement, it is very likely that a portion of the contract has already received funding from the government, while the rest is subject to budgetary reviews in subsequent years. Multiple applications of ASC 606 may be appropriate, depending on the situation, but the unfunded portion of a contract is normally treated as variable consideration.

Per ASC 606-10-32-11, an entity should only include the amount of variable consideration for which it is probable that a significant reversal of revenue recognized to date will not occur. Consequently, the A&D entity would need to evaluate the unfunded portion of its government contracts to determine the likelihood of that portion being funded in the future (and thereby not reversing any present recognition of revenue). If the A&D entity considers it probable—based on prior experience, lobbyist interactions, etc.—that all, or some, of the unfunded portion of the contract will be funded in the future, that amount should be included in revenue.

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3. Contract modification, unpriced change orders, claims

It is not uncommon in large A&D contracts for changes in product specifications to be issued before a change in pricing has been approved (even when it is likely that the contract will be finished before the final pricing can be approved). Under ASC 606, a contract modification is only treated as a separate contract if it results in a new performance obligation, with a price that reflects the standalone selling price of that new obligation. If a modification does not create a new performance obligation, it is treated as an adjustment to the original contract. This means that in typical A&D arrangements, the modification may create a new performance obligation or change an existing performance obligation without a commensurate increase in the overall transaction price of the contract.

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4. Impact of customer termination rights and penalties on contract term

A&D contracts with the US Federal Government often contain a “termination for convenience” clause that, per Federal Acquisition Regulations (FAR) 52.249-1, allows the Federal Government to “terminate [the] contract, in whole or in part, when it is in the Government’s interest.” This unilateral right to a contract termination creates some uncertainty regarding the existence of a legally binding contract. However, the FASB/IASB Transition Resource Group (TRG) determined that the legally enforceable contract period should be considered the contract period, thus suggesting that it is permissible to have a contract even when a termination for convenience clause exists.

After a termination for convenience takes place, FAR 49.201(a) directs that “[a] settlement should compensate the contractor fairly for the work done and the preparations made for the terminated portions of the contract, including a reasonable allowance for profit. Fair compensation is a matter of judgment and cannot be measured exactly.”

The enforceable right to payment for work completed plus profits helps to validate the existence of a contract because, according to ASC 606-10-20, a contract is defined as “[a]n agreement between two or more parties that creates enforceable rights and obligations.” ASC 606-10-55-11 explains that the profit margin paid in the event of a contract termination “need not equal the profit margin expected if the contract was fulfilled as promised.”

5. Accounting for offset obligations

As part of A&D contracts, it is not uncommon to have offset obligations between the seller (the A&D contractor) and the buyer (often a foreign government). These offset obligations often represent performance obligations from the contractor to the buyer, and do not necessarily have to be directly related to the main product or service produced in the A&D contract. For example, the A&D contractor may agree to work with a company within the foreign buyer’s country as a condition of the original contract.

The parties to the transaction will need to identify if the offset obligation represents a distinct performance obligation in accordance with ASC 606-10-25-14 and ASC 606-10-25-19. If the offset is found to be distinct, then the A&D contractor would allocate an appropriate amount of revenue to that obligation. Comparatively, if the offset is not found to be distinct, it should be bundled with other obligations within the contract until it forms a distinct bundle.

For many A&D contracts, the offset obligations come with an associated penalty if the contractor fails to comply. If the contractor decides to pay the penalty, it would be a consideration payable to the customer.

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6. Variable Consideration and constraining estimates of variable consideration

A&D contracts often include incentives for effective project cost management as well as timely production of the contracted goods. These fees are contingent upon the performance of the contractor, and do not represent guaranteed consideration at the time of contract signing. As such, these incentives are considered variable consideration.

Examples of A&D specific variable considerations are: award fees, claims, cost incentives or penalties, economic price adjustments, billing rate adjustments, performance incentives or penalties, price adjustment or redetermination clauses, and unpriced change order.

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7. Significant financing component

A&D contracts often include a significant financing component because the A&D entity receives payment in advance of the transfer of the finished good to the customer. When a significant financing component exists, the entity is required to adjust the transaction price for the time value of money. However, a practical expedient does exist that would permit an A&D contractor not to account for a significant financing component if the entity expects to transfer the good and receive payment within one year.

The following factors may suggest that a significant financing component exists: (a) there is a difference between the amount a customer would pay for the good/service (i.e., the performance obligation) in cash versus what the customer promises to pay, (b) there is a large time difference between when the good/service is delivered and when the customer pays, or (c) it is the contractor’s intent to provide a financing component in the agreement. These conditions require judgment on the part of the A&D contractor, as certain timing differences in payment may not actually reflect a significant financing component. For example, if a contract is written such that the customer provides payment as progress is made on the performance obligation, this would generally indicate that there is not a significant financing component.

8. Allocating the transaction price

ASC 606 puts forth many different acceptable methods by which the transaction price may be allocated to distinct performance obligations within a contract, depending on the situation. ASC 606-10-32-32 states that, “the best evidence of a standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers.” However, in many A&D contracts, the Federal Government may be the only customer for the goods and/or services being provided, which necessitates a different way of determining the standalone selling price.

Some of the alternative ways to determine the standalone selling price that may be appropriate are the expected cost-plus-margin approach, the adjusted market assessment approach, and the residual approach. Each of these methods is explained in detail in the RevenueHub article Case Study: Estimating Standalone Selling Prices.

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9. Acceptable measures of progress

ASC 606-10-25-33 specifies two ways to measure progress in a contract: the output method and the input method. A&D contracts are unique in that often, especially with the US Federal Government, they contain termination for convenience clauses, which allow the customer to cancel a contract whenever it is deemed necessary. As previously stated, termination for convenience clauses usually specify that the contractor will recover all incurred costs as well as an allowance for a profit. Additionally, the Federal Government usually retains the right to all goods—both complete and in process—that were part of the contract.

In these circumstances, with a termination for convenience clause, an output method based on units produced or delivered would not accurately measure the progress in the contract, because the customer may have effective control of all the goods in progress as well as those that are finished. As such, an input method would be more appropriate—such as the cost-to-cost method.

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10. Transfer of control to non-US Federal Government contracts

A&D contracts can vary greatly from custom system manufacturing to ongoing maintenance service agreements. Consequently, it is possible that the performance obligations in an A&D contract may be satisfied at a point in time or over a period of time (assuming the obligation meets the qualifications in ASC 606-10-25-27 for over-time recognition). This determination depends, in large part, on whether the entity or the customer controls the assets that are produced throughout the life of the contract. Some A&D contracts create assets that are controlled by the A&D contractor, and have alternative uses, but others—due to regulatory restrictions, or extensive customization—do not. If control resides with the contractor, revenue is typically not recognized until that control passes to the customer. If, however, the customer does retain control over assets during the manufacturing process, revenue is typically recognized throughout the manufacturing process.

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11. Accounting for contract costs

An A&D entity can incur many costs to obtain a contract with the US or a foreign government. Under the new standard, companies are required to capitalize and amortize the incremental costs to obtain and fulfill a contract (e.g., sales commission). The costs of obtaining a contract are recognized as an asset if the entity expects to recover them, but a practical expedient exists that allows entities to immediately expense the costs if they would have been fully amortized in one year or less. The A&D entity should only capitalize and amortize the costs to fulfill a contract if the costs (1) relate directly to a specific contract, (2) generate or enhance resources that will be used to satisfy performance obligations in the future, and (3) are expected to be recovered by the entity. The costs that the entity capitalizes should be amortized as the entity transfers goods or services to the customer.

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Conclusion

It is likely that many other issues and questions will arise within the A&D industry as entities transition to the new revenue recognition standard. This article has provided a starting point for your research into some of the common issues anticipated by industry experts, but you should check back for updates as they become available. Feel free to reach out with any questions that you have. Additionally, see our other industry-specific RevenueHub articles for more information about the complexities of transitioning to ASC 606.

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Author Jeff Wilks

Professor Wilks is the Director and EY professor of BYU’s School of Accountancy. From 2006 to 2008, he worked as an academic fellow at the Financial Accounting Standards Board in Norwalk, Connecticut. While there, he led the development of the new international standard on revenue recognition, a standard that was released in May 2014. Professor Wilks also served from 2008-2009 as an academic advisor to the International Accounting Standards Board in London, England. He has also served as a technical advisor to Connor Group, which provides technical GAAP review, IPO services, and SEC reporting guidance to firms preparing for IPO. In January 2014, the US Financial Accounting Foundation appointed him to the Financial Accounting Standards Advisory Council.

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