Authored by Tom Sheahan and Erik Schuchardt
The first step in applying Accounting Standards Codification (ASC) 606 is to identify the contract(s) with the customer. To do so, you must evaluate indicators of the existence of the contract. These contract requirements are usually already evident in written contracts in the construction industry; however, the new accounting standard requires additional judgment, evaluation and documentation related to the collectability and the commitment to satisfy the customer’s obligations.
One of the necessary elements of a revenue contract under ASC 606 is that the consideration specified in exchange for the goods or services be collectible. Contractors will be required to perform an assessment of the customer’s ability and intent to pay the agreed upon consideration at the inception of the contract. The collectability requirement is applied through the lens of the probability concept, which means the future event (payment) is likely to occur. Under U.S. GAAP, the likelihood of the future event occurring must be at least a 75 percent chance of occurring.
Contractors with well-designed and implemented internal controls, policies and processes related to granting credit to customers should be able to apply the new standard without significant changes. Potential policies and processes related to assessing the collectability of consideration could include obtaining, reviewing and analyzing a project owner’s financial statements, financing commitments or proof of funds.
A scenario in construction
A contractor enters into a construction contract to build-out tenant space for a start-up company. The consideration agreed to under the construction contract is $1 million. The company does not have historical financial statements and is in the process of raising capital to fund its operations and the cost of construction. The company has a financing commitment from a financial institution totaling $500,000. The company has prepaid $200,000 to the contractor. The balance of the consideration to be paid under the construction contract is planned to be funded from capital raised by the company. The contractor has agreed to commence with construction with an understanding that the full amount of consideration may not be received until such time the start-up company has raised sufficient capital, which is potentially inconsistent with the transferred control of goods or services.
In this situation, the contractor is likely to conclude that there is too much uncertainty about the start-up company’s ability to pay the full amount of the consideration agreed to under the construction contract. As such, there is not a valid contract. The amount of the prepaid deposit of $200,000 should be recorded as deferred revenue and costs of construction should be recorded as prepaid construction costs until such time that future collection becomes probable and the collectability threshold has been met.
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