Financial Accounting Standards Board (FASB) Accounting Standards (ASC) Codification Topic 606, Revenue from Contracts with Customers (ASC 606) introduced new qualitative and quantitative disclosure requirements for entities that issue financial statements in many sectors, including construction. ASC 606 addresses both public and private entities and includes additional disclosure requirements for both, but the disclosures for public entities are more robust.
Contract assets and liabilities
One of the most significant impacts of ASC 606 on contractors is the redefinition of contract assets and liabilities and their presentation and disclosure in financial statements and footnotes.
Under ASC 606, contract assets and liabilities are accumulated and presented on a net basis from the individual contract level. ASC 606 states that a contract asset arises as an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passing of the time. Contract assets include:
- Estimated costs and revenues in excess of billings on unperformed contracts (i.e. unbilled receivables)
- Retention receivables
- Materials uninstalled
Contract liabilities represent an entity’s obligation to transfer goods or services to a customer. Examples include:
- Billing in excess of cost and revenue (i.e. deferred or unearned revenue), net of contingent holdback receivable
- Deductions payable
Classification of deductions: debtors/payables vs contractual assets/liabilities
In the area of withholding, ASC 606 differs from older generally accepted accounting principles (GAAP). Under previous GAAP, holdbacks receivable were presented and disclosed with contractual receivables and holdbacks payable were presented and disclosed with contractual payables. ASC 606 defines a claim as the right of an entity to consideration that is unconditional, although only the passage of time is necessary before payment of that consideration is due.
In the construction industry, retention clauses in construction contracts are a common form of security where the customer retains a portion of the consideration charged by the contractor when the contractor completes its work in a proper manner and in accordance with terms and specifications of the contract. Generally, payment of the holdback is subject to the performance of future obligations under the contract, such as meeting certain milestones. This is called conditional deduction. A careful assessment of the correct classification of holdbacks is essential to the proper accounting treatment, presentation and disclosure of these items.
The contingent holdback should be included in the contract asset (or contract liability) and determined at the individual contract level. At each reporting date, issuers accumulate their contract assets and liabilities in their balance sheet accounts, separating and presenting between current and non-current amounts in accordance with the entity’s accounting policies and operating cycle.
Applying these new definitions and classifications under ASC 606 requires reporting companies to revise their footnotes to financial statements in the following areas:
- Significant accounting policies footnote (revisions to redefining contract receivables, contract assets and contract liabilities)
- Disclosure of contract assets and liabilities
- Additional schedule of changes to contractual information
All construction contractors must disclose and present separately on the balance sheet the opening and closing balances of contract receivables, payables, contract assets and contract liabilities. There is some flexibility in how to present and disclose in the footnotes to the financial statements contract receivables, contract payables, contract assets, contract liabilities, and additional disclosures in accordance with ASC 606.
The following examples are options to consider in providing the desired information to users of financial statements in the construction industry.
Understand the impacts of correct classification
The classification of assets, liabilities and contract holdbacks may affect performance measures, debt covenants, borrowing base determinations or financial ratios included in the company’s financial instruments. Reviewing these financial instruments is important to determine how their classification affects the company’s ability to meet its financial commitments. It is important for users of financial statements to understand the difference in classification of the retention included in contract receivables versus their inclusion in contract assets.