Topic 606, Revenue from Contracts with Customers, of the Accounting Standard Codification has been discussed extensively for the past few years and while most discussions focus on the technical issues, I want to discuss application of the standard, particularly on how it affects the construction industry.
For contractors, the changes in revenue recognition are primarily in determining which costs can be used to drive revenue (and profit) under Topic 606. Some costs, which were commonly charged to jobs, need to be excluded from the cost to cost calculation. They don’t contribute to the contractor’s progress in completing the project. These costs, under the new standard are:
- Incremental costs of obtaining a contract (see previous blog)
- Contract fulfillment costs (see previous blog)
- Uninstalled materials (see previous blog)
- Wasted or unproductive costs
What is considered a wasted or unproductive cost?
The most challenging issue about wasted costs is to properly identify what is considered a wasted cost. A wasted cost does not contribute to the fulfillment of a contract (performance obligation). Not to say that any costs incurred above a contract estimate would be considered a wasted cost. Construction projects normally have some areas of expected inefficiencies, and contingencies are included in the original project forecast for these types of risks.
There are circumstances, however, where unexpected significant inefficiencies may occur that were not considered a risk at the time of entering into the contract. A classic example of wasted costs would be the “reperformance” of work due to construction that did not meet the required specifications. If a contractor was hired to pour concrete and the concrete did not pass inspection, the costs of tearing out the concrete and re-pouring it to specification would be considered unproductive costs.
How are these costs treated under the new standard?
As it is the case for all other costs, the new standard emphasizes that the contractor must not recognize revenue on the basis of costs incurred that are attributable to wasted or unproductive costs. These costs have to be excluded from the contract.
Under the old standard these costs would be included in the contract and the estimated costs would be adjusted to reflect the additional costs.
How does this affect your company?
As a financial manager, you must establish internal controls and procedures that demonstrate you have considered wasted costs on a contract by contact basis when implementing the new standard. The key concept is that you do not recognize revenues and costs that do not reflect the progress of the contract.
One way to do this, is to monitor your jobs schedule and identify low performing jobs (jobs with lower profit than expected). Once you identify these contracts, ask the Project Manager if there were any issues with the job that would identify significant wasted costs.
Abel Coronel, CPA