Revenue Recognition Changes in the Construction Industry: More Than Just Terminology
When ASC 606 took effect in January 2018, it redefined many accounting standards. Within the construction industry, there were key changes to revenue recognition standards.
Since the changes were implemented, there has been widespread confusion and inconsistency regarding revenue recognition for construction contracts. The confusion is caused by misunderstanding the ASC 606 changes, where contract revenue recognition was changed from “overbilling” and “underbilling” to “contract assets” and “contract liabilities.” While some may use the two terms interchangeably, it is not enough to swap contract assets/contract liabilities for overbilling/underbilling. The post-ASC 606 results for the same financials should be different since the formulas are different.
ASC 606 Changes to Contract Revenue Recognition
The old calculation for underbilling/overbilling was (Total Billings - Earned Revenue). It was labeled overbilling when the result was positive and underbilling when negative.
However, retainage receivable per job must be added to underbillings (if that job is in an underbilled position) or netted against overbillings (if that job is in an overbilled position) to determine if each job is in a contract asset or contract liability position.
Misconception of Risk
Although the two have entirely different calculation formulas, there are many examples where the only change was to the label in the report. This misrepresents the risk presented in the financial documents.
Users of the financial statements often view underbillings as a higher risk than overbillings because underbillings may be indicative of inflated estimated profit margins and eventual job fade. However, as the previous calculation shows, a job may be overbilled but in a contract asset position if the retainage receivable on the job is more than the overbilling. Therefore, if the users believe that contract assets are the same as underbillings, they may believe that a job is underbilled when it is actually overbilled. As a result, they may believe a business is operating under high-risk estimates, which may not be the case.
Consistent processes and clear, accurate reports are crucial to the accounting profession. Auditors need to use the correct terminology AND calculation to accurately present data in their reports.
There are several steps firms can take to catch errors in their current processes and prevent more in the future.
- A firm should start by assessing their team’s current level of understanding regarding ASC 606 and calculating contract assets and contract liabilities.
- If there is a misunderstanding, the firm should implement training to educate the entire team on the latest processes and accurately execute calculations for these audits.
- Once internal misunderstandings have been addressed, the firm should also review any financial documents for clients to ensure that they are using the correct terminology and calculation standard for contract assets and contract liabilities.
- If any issues are found, the firm should formulate a plan for communicating with clients on this issue.
This action plan will ensure a quality deliverable, which gives clients and the entity receiving the financial information reliable information to make informed financial decisions.
Matthew J. Boland
Matthew J. Boland, CPA, CCIFP, is the director of accounting and assurance at McCarthy & Company, PC.
This article appeared in the Summer 2022 issue of New Jersey CPA magazine. Read the full issue.