1. Identify the Contract with the Customer
The first step for contractors is to identify all the legal agreements or contracts that they expect to perform for the customer to receive payment. Contractors may have several contracts with the same client that could be treated as one contract or multiple contracts, depending on the structure of the agreement.
According to ASC 606, whether a contract is considered a single legal obligation or must be treated separately as multiple contracts depends on identifying the various and distinct performance obligations. Following the same logic, change orders could be considered as an amendment to an existing contract or as a completely new contract, depending on the scope of the performance complication.
2. Identify the Performance Obligations
The first thing to understand is that a performance obligation and a contract aren't necessarily the same thing. Contracts must have at least one performance obligation, but they could have many more.
For example, suppose a contractor had a contract to renovate an office space for a client. The work could include flooring, framing, putting up partitions, installing an electrical system and low-voltage communications, installing the ceiling, and constructing a gym with workout equipment for employees.
Most of the work, such as flooring and framing, could be considered interrelated and treated as integral to the project. It could therefore be viewed as a single performance obligation. However, the gym could be considered a separate performance obligation since it would not necessarily be integrated with the completion of the entire project.
3. Determine the Transaction Price
In most cases, the transaction price is the value or amount of the contract that the customer pays for goods and services. However, the final transaction price could vary if the contract contained performance incentives for early completion, penalties for missed delivery dates, or pending change orders. Any financing provided by the customer for the contractor, or vice versa, could affect the timing and recording of contract revenue or interest on financing.
4. Allocate the Transaction Price
After the contractor has identified the performance of obligations required under the contract, they can now determine a transaction price for each performance obligation. ASC 606 states that contractors can make these price allegations based on the "relative standalone prices of each distinct good or service." This means that price allocations are made as if the goods or services provided were performed as separate operations.
5. Recognize Revenue
Contractors record revenue after satisfying the performance obligation. However, this doesn't mean that you cannot recognize revenue until the performance obligation is complete. The issue hinges on the principle of "transfer of control."
The new standards for revenue recognition per ASC 606 fall into two categories:
- at a point in time
- recognition over time
The question is, when does control transfer from the contractor to the client?
If the contract terms state that the contract is only recognized as complete at a specific point in time, the contractor does not have the right to receive payment until the project is complete. If the agreement is for a point in time, the contractor retains legal title and physical possession until the project is complete and a transfer of ownership is made to the customer.
If the contract allows recognition of revenue over time, then the contractor has the right to receive payments at various stages of the project. The customer then receives title with the use and benefit of the contract's stage of completion. For example, in an office renovation project, the customer might receive a transfer of control after the framing is complete. This is because the customer could possibly sell the office space in its uncompleted state since they have use and benefit.
Therefore, a contractor could recognize revenue over time as the project progresses, even though the entire performance obligation might not be complete.
