OUR THOUGHTS ON:

Topic 606 and Claim Recognition - What Changes for Construction Contractors?

Audit|Construction

By Ryan Deatrick

In May of 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), which will completely overhaul the existing revenue recognition guidance for any entity that enters into contracts with customers.   Since the FASB intended to streamline revenue recognition principles across industries, much of the existing industry-specific guidance will be superseded.  Included within that industry-specific guidance are the requirements that a construction contractor needs to meet in order to recognize additional amounts of revenue from a claim or unapproved change order.

Claims and unapproved change orders have always been a hot-button issue in the construction industry due to their high level of subjectivity.  Claims are defined in the existing guidance as “amounts in excess of the agreed contract price that a contractor seeks to collect from customers or others for customer-caused delays, errors in specifications and designs, contract terminations, change orders in dispute or unapproved as to both scope and price, or other causes of unanticipated additional costs.”  Furthermore, the existing guidance permits the recognition of claims only when it is probable that the claim will result in additional revenue and the amount can be reliably estimated.  These criteria are satisfied if the construction contractor can demonstrate the following:

  1. The contract or legal counsel provides a legal basis for the claim
  2. Additional unforeseen costs were incurred that were not the fault of the contractor
  3. The additional costs are identifiable and reasonable in light of the contract and
  4. The evidence of the claim is objective and verifiable 

The explicit terminology above will not be a part of Topic 606, which begs the question, how will construction contractors recognize claims in the future?  To some degree, that answer will depend on the implementation guidance expected to be released by the AICPA’s Construction Contractors Revenue Recognition Task Force.  The Task Force was created to provide the construction industry with hints and illustrations for application of the new standard.  The Task Force has already identified claims and change orders among the potential implementation issues relevant to Topic 606, but to date, no guidance has been issued on any of the issues. 

While we wait for further guidance from the AICPA’s Task Force, the Standard itself does include one example that provides guidance on claim recognition.  The example introduces two important phrases in the new guidance “contract modification” and “variable consideration,” but also makes reference to some familiar concepts like assessing legal basis, identification of specific direct costs, and enforceable rights. 

Contract modifications refer to approved or disputed changes in the scope or price of a contract (or both) that alters or creates new enforceable rights and obligations for the parties of the contract.  An entity must consider all relevant facts and circumstances related to the contract and all available evidence in assessing contract modifications.   An entity must then consider whether or not the modification creates a new contract.  For construction contractors, the contract modification typically represents a modification of the existing contract.  In this case, the contract value and the measure of progress towards completion are adjusted for the contract modification through an adjustment to revenue.

The uncertainty of the contract modification in claim status makes the potential adjustment subject to the guidance related to the concept of variable consideration.  The key point here is that the transaction price should only be adjusted to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty is resolved.  Furthermore, an entity must evaluate the facts and circumstances relevant at the end of each reporting period to determine if the estimated contract value is still represented accurately.

The effective date of Topic 606 is approaching soon!  For more information on how to prepare, contact an advisor in the Schneider Downs Construction Industry group.

 

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