August 1, 2022 Construction contractors are usually well-versed in contracts, however the new revenue recognition standard will necessitate managers to make more judgments when evaluating whether or not to recognize revenue from contracts. Accounting Standards Codification (ASC) 606-10-25-1 provides a number of criteria that must be met for an agreement to be identified as a contract. The new revenue recognition standard, ASC 606 Revenue from Contracts with Customers, contains a significant change in the way it handles variable consideration. This change will have an impact on all contractors. The following are examples of variable considerations within a contract: Claims and pending change orders Unpriced change orders Incentive and penalty provisions within the contract Shared savings Price concessions Liquidating damages Unit price contracts with variable units ASC 606 requires companies to estimate variable consideration in determining the transaction price, subject to restrictions on estimating variable consideration. As discussed in ASC 606-10-32-9: “…an entity shall consider all the information (historical, current and forecasted) that is reasonably available to the entity and shall identify a reasonable number of possible consideration amounts. The information that an entity uses to estimate the amount of variable consideration typically would be similar to the information that the entity’s management uses during the bid-and-proposal process and in estimating prices for promised goods and services.” When deciding whether or not to accept a quote, an organization must consider the possibility and scale of a revenue reversal owing to a later modification in expectations. ASC 606 discusses when to include variable consideration in the transaction price and notes that an entity should include in the transaction price some or all of the variable consideration amount estimated in accordance with ASC 606-10-32-8. The expected amount of revenue should not exceed the actual amount recognized in any given period to the extent that it is likely that a substantial reversal in cumulative revenue recognition will not occur when the uncertainty associated with the variable consideration is resolved. It’s important to note that the significance of a reversal is determined against prior revenue recognized on the performance obligation and is not a financial materiality standard. According to ASC 606-10-32-12, factors that might raise the potential and extent of a revenue reversal include the entity’s experience (or other evidence) with comparable agreements is limited, or that experience (or other evidence) has little predictive value. The significance of a future reverse is assessed at the contract or financial materiality level, rather than the performance obligation level, when a contract has several performance obligations. When events occur or uncertainty is reduced, the amount of the estimate must be updated on a regular basis. The contractor must evaluate all information (historical, present, and projected) at the start of the contract to determine the contract price. In determining the amount of variable consideration in a contract, contractors should consider the following quantities: Step 1 – evaluate all potential variables linked to a contract or performance obligation. Step 2 – determine which items, if any, can be grouped together for evaluation due to shared features. Step 3 – record the amount of the variable consideration using information that the contractor typically utilizes throughout the bid and proposal process, as well as data utilized in pricing promised products. A contractor must evaluate the amount of variable consideration to include in the transaction price and weigh both the probability and magnitude of a revenue reversal when allocating fixed costs. If the potential reversal of the cumulative revenue reversal recognized is not significant, an estimate of variable consideration is not restricted. The contractor should evaluate the contract price’s potential constraint. A 70-80% chance of occurrence is used by GAAP to designate a prediction as “probable.” The amount of the estimated variable consideration to be included in the contract price should be determined using one of two approaches: (1) the expected value method, or (2) the most probable amount. What is the Expected Value Method? If you’re using the expected value approach, it’s especially beneficial to a portfolio technique of combining client contracts. If management makes reasonable assumptions and applies them to many similar contracts, the overall amount of income should equal the total sum of all anticipated amounts for each contract. In cases like this, the expected value technique can be useful. There is a bonus for each day prior to a deadline that an entity completes a performance obligation (or a penalty for each day late), as in the example above. When the contractor expects to be entitled to one of only two possible amounts, the most likely approach is often the better predictor. The method that best predicts this amount should be used, and it should be utilized in a consistent manner throughout the contract (not an optional policy). Various techniques may be employed for various types of variable consideration under the contract. Expected value is often advised in situations with several possible outcomes (such as the number of days before a deadline) and the most likely amount for binary outcomes (such as winning an award if a milestone date is met). The contract may include general bonus/incentives that represent potential outcomes. However, if in management’s judgment the method is the better measurement, the standard does not prohibit the use of the most likely amount approach when there are numerous possible outcomes (not binary). Construction Accounting in Maryland When you need construction accounting in Maryland, you can rely on us. We’re experts in the field and we’ll make sure that your construction accounting needs are met. We have a wide range of services that we offer, and we’re always happy to help you with any questions that you might have. Make sure you have a firm like Katz Abosch, experts in accounting matters for Maryland and beyond.