The new revenue recognition has been discussed extensively for the past few years and while most discussions focus on the technical issues, I like to discuss application of the standard, particularly on how it affects the construction industry. On a previous blog, I discussed contract fulfillment costs and how these costs are treated under the new standard.
For contractors, the changes in revenue recognition are primarily in determining which costs can be used to drive revenue (and profit) under the new standard. Specifically, some costs, which were commonly charged to jobs, need to be excluded from the cost to cost calculation because 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
- Contract fulfillment costs
- Uninstalled materials
- Wasted or unproductive costs
What is considered uninstalled materials?
Materials that are purchased with extended lead times or are held due to delay of installation, may arrive on the job site significantly in advance of the contractor’s ability to install them.
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 should consider whether the inclusion of uninstalled materials would result in recording revenue prematurely.
The prior standard allowed for uninstalled materials that were specifically produced or fabricated for a job to be treated as normal costs in the POC calculation. The new standard (new GAAP) allows us to recognize revenue only to the extent of costs incurred (i.e. no markup) for uninstalled materials when control of those materials has been transferred to the customer. The markup on those materials is then recognized as they are installed. Consequently, uninstalled materials that are not costed to a job are capitalized and included on the balance sheet as a contract asset.
So, how does this affect your company?
To apply the no-markup treatment on uninstalled materials when control has passed to the customer, or for these costs to be capitalized as a contract asset when control has not passed to the customer, all of the following factors should be present:
- Materials are not specific to the particular job.
- Materials are delivered to a site, but they have not yet been integrated into the overall project
- Materials cost is significant
- Materials are from a third party without design or manufacturing involvement by the contractor.
As a financial manager, you must establish internal controls and procedures that demonstrate you have considered uninstalled materials on a contract by contract 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.
Stay tuned for my upcoming blogs as I discuss the other contract costs outlined above.
Abel Coronel, CPA