Companies in the engineering and construction (E&C) industry frequently execute contracts that extend over multiple years and have various incentives or penalties for the speed and quality of performance. These long-term contracts require E&C entities to choose an appropriate way to measure progress and recognize revenue. Additionally, long-term contracts are often modified—sometimes before pricing has been adjusted—to accommodate different situations and goals of the customer. These issues, and others, can create complexity for recognizing revenue. The AICPA and the major accounting firms have assembled industry task forces to research the industry-specific accounting issues with ASC 606. This article will draw from the guides they have published on the E&C industry to give you an idea of some of the issues you should expect. For more information on these issues, see:
- AICPA: Revenue Recognition: Audit and Accounting Guide, Chapter 11
- EY: Technical Line: Engineering & Construction
- PwC: In depth: Implementation in the engineering and construction industry
We will also provide references to other RevenueHub articles for more detailed explanations of related ASC 606 topics. For general information on the basics of revenue recognition, see our RevenueHub article, The Five-Step Method.
The following are the issues that entities in the E&C industry commonly face:
1. Changes to E&C contracts
In the E&C industry, contracts are frequently modified as circumstances and needs change. At times, these changes may be minor adjustments to the existing contract, but in other cases, the changes may represent substantial modifications in contract scope, price, or both. According to ASC 606-10-25-10, a “contract modification could be approved in writing, by oral agreement, or implied by customary business practices.” However, ASC 606-10-25-11 states that a modification can exist for accounting purposes even before it has been approved and that if a change in scope has been approved before the final pricing has been agreed upon, the E&C entity will need to estimate the change in the transaction price using the same principles as those for estimating a variable consideration (see our article on Variable Consideration and the Constraint).
After verifying that a contract modification has occurred, the E&C entity must determine if it should account for the contract as a separate contract. For more information about the relevant issues to consider regarding contract modifications, see our series of articles Contract Modification Part I – Separate Contracts, Contract Modification Part II – Contract Modification Treatment, and Contract Modification Part III – The Hindsight Expedient.
EY’s Technical Line provides an example of some of the contract modification contracts that are commonly seen in the E&C industries, citing a building construction project in which a customer requests a change order to add an additional floor. Normally, such a contract—installing a floor—would be considered a distinct service, but because the construction company is already contracted to construct the building, this additional service would likely be combined within the existing bundle as a single performance obligation. These change orders are common for E&C entities, and they can create challenges in estimating a standalone selling price because the pricing for an add-on to an existing contract will likely be different than that for a standalone sale. Judgment is required to assign appropriate values and properly account for the modification under the 606 framework.
2. Determining what elements of a contract are distinct
ASC 606-10-25-19 states that a good or service must meet two criteria to be distinct:
- It must be capable of being distinct
- It must be separately identifiable or distinct within the context of the contract
In the E&C industry, long-term contractual arrangements can create many situations in which it may be difficult to determine if a performance obligation is truly distinct within the context of the contract. For example, many construction contractors integrate multiple services together while maintaining a managerial role. Under ASC 606, this bundle of services may be accounted for as a single performance obligation; this arrangement would alter when revenue could be recognized across the lifetime of the contract.
Toll Brothers, Inc. (SEC Correspondence Mar. 2019): Analysis of Distinct Performance Obligations in Construction
- Toll Brothers, Inc is a construction company for residential and commercial properties. Occasionally, Toll Brothers is unable to complete certain outdoor features of a home before the closing of the home. Toll Brothers considers the outdoor features a separate performance obligation and thus defers the portion of the revenue related to the outdoor features.
In March 2019, the SEC inquired as to the nature of the outdoor features and why the company considered the service a separate performance obligation under ASC 606-10-25-19. In response, Toll Brothers explains:[This section is tabbed out] Our conclusion is supported by the following findings: (i) the obligation to complete the outdoor features is separately identifiable within the contract and is not highly interdependent or interrelated with the obligation to deliver the home; and (ii) our customers realize significant benefits from accepting delivery of a fully constructed and habitable home notwithstanding that certain outdoor features may be incomplete, as evidenced by their willingness to close on the home and make full payment of the purchase price at closing.
Just as many of the goods and services provided in constructing a house are capable of being distinct (as seen by the numerous independent contractors available for these goods and services), so to can landscaping services fall in this category.
Relating to the second requirement of ASC 606-10-25-19, Toll Brothers reasons that everything that is part of the home provided to the customer (excluding the landscaping services) is not distinct in the context of the contract because they “…are providing a significant service of integrating the goods and services to deliver a completed home to the home buyer in accordance with the sales agreement.” Additionally, the contract specifies that the home buyer must accept the home even if the landscaping is not complete—there is no such caveat for any other part of the home.
Toll Brothers then concludes that, as outlined in ASC 606-10-25-21, the landscaping service is separately identifiable from the home because:
- There is no significant service provided to integrate the landscaping with the home.
- Neither the landscaping nor the home customize or modify each other.
- The landscaping is not interdependent on the home, as the customer can use the home for its intended purpose without the landscaping.
This comment letter is an example of the reasoning required to identify distinct performance obligations in a construction contract.
3. Series of distinct goods and services that are substantially the same
In the E&C industry, it is not uncommon to have contractual arrangements that provide for a series of distinct goods or services that are essentially identical. For example, multi-year engineering contracts may provide the same type of service multiple times during the contract term and thus need to be evaluated to see if the goods or services provided are, as ASC 606-10-25-14 states, “substantially the same and… have the same pattern of transfer to the customer.” To evaluate if a series of distinct goods or services have the same pattern of transfer, ASC 606-10-25-15 gives two criteria that must be met:
- Each distinct good or service in the series meets the criteria to be a performance obligation satisfied over time
- The entity would use the same method to measure the progress toward complete satisfaction of the performance obligations
If both criteria are met, the entity will account for the goods or services as a single performance obligation.
4. Principal versus agent
In some E&C contracts, there are provisions for a customer to receive goods or services from an unrelated third party. In these situations, the E&C entity must determine if it is acting as a principal or an agent, and recognize revenue accordingly. For example, if an E&C entity were constructing a bridge for a client and procured materials so that it could complete the bridge, it would likely be appropriate to recognize the gross amount of revenue, because the E&C entity is acting as a principal in the overall bridge construction.
Comparatively, if an E&C entity were acting as a procurement manager that works to identify and purchase materials for its client, any handling of materials would likely be as an agent. Therefore, if the E&C entity made a purchase for its client and received the materials from a third party on the client’s behalf, it would not be appropriate to recognize the payment from the client to the third party as gross revenue. Rather, only the commission or the net amount that the E&C entity charges could be recognized as revenue. For more information on the principal versus agent determination, see our article Principal/Agent Consideration (Gross vs Net).
5. Variable considerations—awards/incentive payments/delay fees
In the E&C industry, contracts often have bonuses or penalties that are contingent upon how well (e.g., timing, quality, etc.) the E&C entity satisfies its obligations. For example, in the construction industry, it is common for a contract to include provisions for bonuses that can be earned if a project is completed by a certain day or week (with different amounts of award depending on how soon completion occurs). These potential revenues constitute variable consideration under ASC 606, and must be estimated and included in the transaction price to the extent that it is “highly probable” that there will not be a reversal of revenue recognized.
ASC 606-10-32-8 gives two potential methods by which an entity can determine how much of the variable consideration to include in the transaction price: the expected value method and the most likely amount method. For many of the types of variable consideration earned by E&C entities, the most likely amount method is recommended by the FASB as a better predictor of the potential outcomes. For more information about the treatment of variable consideration, see our article Variable Consideration and the Constraint.
Additionally, E&C entities must determine whether to allocate the variable consideration to all performance obligations or one or more, but not all. ASC 606-10-32-40 gives two criteria that must be met to allocate the variable consideration to one or more, but not all, performance obligations: (a) the terms of the variable payment relate specifically to the entity’s efforts to satisfy the performance obligation, and (b) allocating the variable consideration entirely to the performance obligation is consistent with the amount that the entity expects to be entitled in exchange for transferring the promised good or service to the customer. We expect that E&C entities will qualify for this allocation exception in some cases and will not in other situations.
6. Noncash consideration – customer-furnished materials
In some E&C contracts, the customer provides goods—such as materials or equipment—to the E&C entity to facilitate the completion of the contract. These customer contributions are considered noncash consideration(s) under ASC 606, and the fair value of the consideration should be included in the transaction price. Therefore, the E&C entity must estimate the fair value of the consideration transferred, using the principles in ASC 820, Fair Value Measurement. For more information on noncash considerations, see our article Noncash Consideration.
7. Significant financing component
Due to the long-term nature of many E&C contracts, diverse payment terms may exist in which there are differences between the timing of when work is completed/goods transferred and payment is received. These contracts need to be evaluated to see if a financing component exists as part of the payment terms; however, it is important to note that just because a long-term contract has progress payments, a significant financing component does not necessarily exist.
Either party in a contract could be found to be providing financing, regardless of whether it is intended, so both parties in an E&C contract need to assess the contractual arrangement to verify whether financing exists. Some common payment terms in E&C contracts like retainage, milestones, and progress payments could create this type of financing component.
If an E&C entity identifies that a significant financing component does exist, it will need to adjust the transaction price to account for the effects of the time value of money as consequence of the financing arrangement. According to ASC 606-10-32-16, the purpose of adjusting the transaction price is “to recognize revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer…” See our article Significant Financing Component for more information about this issue and the proper way to adjust the transaction price.
8. Determining the transfer of control within a contract
Depending on the specification and type of E&C contract, control of the goods or services produced by the E&C entity may be transferred at various times. The transfer of control must be determined to properly recognize revenue for the contract. First, the E&C entity needs to determine if the performance obligations are satisfied at a point in time or over time, which requires an assessment and understanding of how control is transferred from contractor to customer.
ASC 606-10-55-4 outlines three criteria that would suggest that the transfer of control is over time: (a) the customer simultaneously receives and consumes the benefits provided, (b) the entity’s performance creates or enhances an asset that the customer controls, (c) the entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
It is likely that E&C contracts will be satisfied over time. See our article Revenue Recognition Over Time for more information about the specific requirements for this determination.
9. Measuring contract progress
E&C entities must identify an appropriate way to measure contract progress under ASC 606. According to ASC 606-10-55-16, there are two primary methods by which this progress can be measured: an input method or an output method. Once the entity chooses how it will measure the progress for a performance obligation, it is not allowed to change. See our article Input vs. Output Methods for more information.
Input methods recognize revenue by the amount of effort or inputs put in by the entity to satisfy the performance obligation. E&C entities must analyze their contracts carefully to see what methods best apply. If an entity cannot identify a reasonable basis to measure contract progress, it would not be appropriate to recognize revenue beyond the costs incurred (zero margin revenue recognition).
Although conceptually easy to understand, using units-of-delivery (an output method)—with revenue recognized as units are delivered to the customer—may not be appropriate in many E&C contracts because it neglects to account for the work-in-progress goods. The E&C entity needs to consider the usability and control of items that have not yet been delivered when determining an appropriate progress measurement.
10. Uninstalled materials
Many E&C entities will measure contract progress by looking at the costs incurred relative to the total estimated costs, a cost-to-cost method. However, uninstalled materials can complicate the calculations, and require judgement to determine if the costs incurred accurately reflect the progress being made on the overall contract.
Uninstalled materials are significant goods made by a third party to the contract that are not created specifically for that contract. ASC 606 provides the example of an elevator in a construction project to refurbish a three-story building. The elevator costs $1.5 million in a contract with total anticipated costs of $4 million and total consideration of $5 million. When the construction contractor receives the elevator prior to installation, the costs incurred—which are significant—do not accurately reflect the proportionate progress that has been made. As such, even if the entity is using an input method of costs incurred, recognizing revenue in proportion to the costs of the elevator—which the E&C entity did not manufacture—would overstate the contract progress. The construction company would only recognize revenue for the transfer of the elevators in an amount equal to the costs to procure the elevators (zero margin). Therefore, effectively, the proportionate progress under the input method would only apply to the non-elevator costs incurred.
The contracts that are common in the E&C industry can potentially create many revenue recognition issues under ASC 606. Companies need to evaluate their contracts to verify that they are properly identifying separate performance obligations and selecting appropriate measures of progress.
This article serves as a base reference point for your research into some of the focal issues anticipated by industry experts. Similar industry-specific issues, discussions, and resources are available on the RevenueHub site for major industries identified by the AICPA. Click on the following link for a list of these articles: Industry-Specific Issues.