After years of refinement, the Financial Accounting Standards Board (FASB) had issued ASC 606, Revenue from Contracts with Customers back in mid-2014. Because of a number of implementation issues, the effective date of the new standard was pushed back as the issues were addressed. Well, the day of reckoning is finally here for accounting and finance departments at Architecture and Engineering (A/E) firms who have been reluctant to deal with ASC 606. For non-publicly traded entities, the new revenue standard must be accounted for by all calendar-year 2019 companies.
The effect of ASC 606 is far-reaching. The implementation of the new standard will not only impact a company’s accounting, but also financial reporting, systems, processes, internal controls, debt covenant ratios, and contracts.
Application of these principles will necessitate greater judgment and advance preparation. This broad, new standard establishes a uniform revenue recognition model for substantially all industries; however, the extent of the industry-by-industry impact will vary dramatically.
Below, we answer some of the most frequently asked questions and answers regarding the implementation of ASC 606 in the engineering and design industries.
Nonpublic entities are required to apply the new standard for annual reporting periods beginning on or after December 15, 2018, including interim periods therein. Public entities are required to adopt ASC 606 in reporting periods beginning after December 15, 2017 (including interim periods therein). Thus, for most A/E firms which are privately-held companies with a December year-end, calendar year 2019 is the first year that this new standard will take effect.
ASC 606 establishes the following core principle: recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This replaces the current focus on recognizing revenue when risks and rewards are transferred, with an emphasis on when a change in control occurs.
To apply that core principle, an entity should follow these steps:
Step 1: Identify the contract with a customer.
A ‘contract’ does not mean a legal document; it is essentially an agreement between you and your customer that creates enforceable rights and obligations. Engineering and design firms will need to pay particular attention to change orders and determine if it creates a new and separate contract or simply modifies the existing contract.
Step 2: Identify the performance obligations in the contract.
The contract may contain more than one distinct good or service, so some judgment will be required to determine whether all of the promises in a contract should be accounted for as a single combined performance obligation or not.
Step 3: Determine the transaction price.
Variable elements will require up-front estimation and careful consideration. Be aware of special incentives and bonus payments within contracts, or alternatively, penalties associated with a delay in completion of a project. Estimating variable consideration for unpriced change orders that should be included in the transaction price may involve the use of significant judgment.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Allocate using the relative ‘standalone selling price’ of each good or service, or an estimate if that is not available.
Step 5: Recognize revenue when or as the entity satisfies a performance obligation.
This may occur at a point in time, or over a period of time. Most engineering and design firms will use an input method based upon labor hours spent.
While none of the above sounds radically different from how we had been accounting for revenue for many years, applying the steps in certain industries may be challenging and produce different outcomes than current practices.
ASC 606 is a principles-based standard, requiring judgment in its application. Accordingly, at a minimum, all entities will be subject to more disclosure requirements. However, the amount of enhanced disclosures will vary according to industry, and the extent of management’s judgments.
Based upon information currently available, we believe the impact on the engineering and design industries will be moderate. Since the engineering and design industries are governed by legal contracts, it is easy to default to the thinking that the changes will be profound, but when contracts are evaluated in terms of the guidance above it is unlikely that revenue will be recognized in a substantially different manner than it is now.
The “cost-to-cost” method of revenue recognition that largely prevails now will generally continue, only under the auspices of new terminology. Much design work, specifically in the fields of civil, municipal and survey, create value to the customer as a function of time incurred, subject to agreed-upon pricing. This will yield revenue recognition that is very parallel, if not identical, to the current methods.
Some engineering and design entities may have revenue streams that contain variable elements, such as incentive payments, awards, or penalties. For example, a $500,000 contract may contain a penalty of $40,000 if the work is not completed before a specified date. The $40,000 penalty is considered variable consideration under ASC 606. The new standard requires variable consideration to be estimated as part of the transaction price (Step 3) as long as it is probable that a significant revenue reversal will not occur (this is referred to as a constraint). ASC 606 provides guidance on how to estimate this. Further, any estimated variable consideration not subject to the constraint will then be evaluated for when to recognize it as revenue (Step 5). Generally, the revenue will be recognized as the related performance obligation is satisfied, subject to the constraint. Returning to our example, the entity will assess, based upon its experience with similar contracts, whether it is probable that the penalty will be incurred (not subject to a significant revenue reversal). ASC 606 discusses factors to consider in this assessment, such as if the entity has a long history of performing this type of work on time, is it within their control to complete the work on time, and will the uncertainty be resolved within a relatively short period of time.
Given the swing from a risks and rewards approach to an emphasis on change in control, it is possible that engineering and design entities may recognize certain variable revenue streams sooner than they are today.
Companies are concerned about how much internal effort, external help, and time they need to address implementation questions. And they should be because this will take some effort as there remains no time for further procrastination. Therefore, we recommend the following: