Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers, was intended to enhance comparability of revenue recognition across all industries.1 While adopting the new guidance under Topic 606, many in the construction industry discovered that there were often only minor changes in the amount of revenue recognized as compared to the amount recognized using the legacy percentage-of-completion method (PCM) under ASC 605-35, Revenue Recognition – Construction-Type and Production-Type Contracts.
While some circumstances do result in more significant differences, many in the construction industry experienced little or no material impact to the amount of revenue previously recognized as a result of adopting Topic 606. However, while Topic 606 focused primarily on revenue recognition, it also impacted two additional key areas of the balance sheet:
- Classification of retainage
- Contract assets and contract liabilities
Classification of Retainage
In long-term construction contracts, retention provisions are common – generally as a form of security by which the customer withholds a portion of the consideration billed by the contractor for work completed until certain construction milestones are reached or the project itself is completed. Retainage provides a financial incentive to help ensure the contractor completes their work appropriately and in accordance with the contract terms.
Prior to the adoption of Topic 606, retainage was typically classified by many contractors as a receivable; however, in addition to the significant focus of Topic 606 on how much and when to recognize revenue, it also clearly states in ASC 606-10-45-4 that “a receivable is an entity’s right to consideration that is unconditional. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due.”
On the other hand, Topic 606 defines a contract asset 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 passage of time (for example, the entity’s future performance).”
Accordingly, to determine proper classification of retainage, it’s critical to determine if the right to consideration is conditional or unconditional upon something other than the passage of time.
Careful evaluation is required in determining whether retainage should be classified as a receivable or as a part of the related contract’s asset (or netted with the related contract’s liability when the contract is in a liability position). In long-term construction contracts, retainage is generally subject to conditions other than the passage of time, such as:
- The completion of future obligations under the contract
- Meeting certain milestones
- Performance metrics
In these situations, retainage shouldn’t be classified as a receivable as it is subject to conditions “other than the passage of time” and should be included in the contract asset or contract liability, which is determined at the individual contract level.
While under certain circumstances it may be appropriate to classify retainage as a receivable, this will be limited to situations in which the right to payment of retainage is solely contingent upon the passage of time. Generally, this is appropriate after the conditions upon which the retainage was contingent have been satisfied and before the customer has paid the retained amount.
In making this determination, it’s critical to carefully assess the contract terms and legal provisions. When concluding retainage represents an unconditional right to payment, it’s recommended to consult with your legal advisors to ensure that the contract’s terms and provisions have been evaluated appropriately and the retained amount isn’t contingent upon anything except the passage of time. This evidence of a thorough analysis and potentially a legal opinion may be necessary to support a company’s classification of retainage as a receivable.
Additionally, when retainage is believed to be meeting the requirements to be classified as a receivable (not conditional upon anything but the passage of time), consideration should be given to whether the retainage payment provisions result in a significant financing component in the contract, as described in paragraphs 15 through 20 of ASC 606-10-32 and further discussed in the section titled “Other Considerations.”
Financial Statement Presentation Overview
Contract asset and contract liability positions should be determined on a net basis at the individual contract level and not at the performance obligation level, which is where the amount of revenue recognition is determined. This means that a company should net each position in a contract so that an individual contract is included entirely in either the contract asset or the contract liability section – but not both – on the balance sheet.
Contract Asset
A contract asset represents a company’s right to consideration in exchange for goods or services that a company has transferred to the customer. A contract asset should be recorded when a company has transferred goods or services to the customer prior to receiving consideration and when payment of consideration is contingent upon anything other than the passage of time (e.g., future performance by the company).2
Contract Liability
A contract liability represents a company’s obligation to transfer goods or services to a customer. A contract liability should be recorded, prior to the transfer of the good or service to the customer, when a company has received consideration or when the company has a right to an amount of consideration that is unconditional.3
Accounting Policy
It’s common in the construction industry to have an operating cycle that extends beyond 12 months. While the guidance in Topic 606 requires the net contract asset or contract liability balance to be bifurcated between current and noncurrent if the company presents a classified balance sheet, many in the construction industry have elected and disclosed an accounting policy to classify all contract-related assets and liabilities as current due to their operating cycle commonly extending beyond 12 months.4
Such an accounting policy follows more specific guidance for the classification as current vs. long term for other assets and liabilities, which is further described in Chapter 6 of the AICPA’s Audit and Accounting Guide: Construction Contractors and is consistent with guidance in Topic 210 – Balance Sheet.5
Terminology Shift
While the guidance in Topic 606 uses the terms contract asset and contract liability, the guidance doesn’t prohibit the use of alternative descriptions in financial statements. If alternative descriptions are used, it’s required that sufficient information is provided for users of the financial statements to distinguish between receivables and contract assets.6
ASC 605-35: Alternative B
Under legacy generally accepted accounting principles (GAAP), unbilled revenue – or the near equivalent of Topic 606’s contract asset – was commonly referred to in financial statements as costs and estimated earnings in excess of billings on uncompleted contracts, and deferred revenue – or the near equivalent of Topic 606’s contract liability – was commonly referred to as billings in excess of costs and estimated earnings on uncompleted contracts. This terminology was closely aligned with the PCM of recognizing revenue under Alternative B of ASC 605-35-25 paragraph 84, where revenue recognition was calculated as displayed in Exhibit 1.
As seen from the first of the two equations in Exhibit 1, Alternative B adds together costs and estimated earnings to arrive at revenue. This is where the costs and estimated earnings portion of costs and estimated earnings in excess of billings on uncompleted contracts and billings in excess of costs and estimated earnings on uncompleted contracts comes from.
Determining Revenue Under Topic 606
However, Alternative B from ASC 605-35-25 isn’t consistent with the process of recognizing revenue under Topic 606, which states that revenue should be recognized when or as a company satisfies a performance obligation. While there are various methods that may be used to determine progress toward satisfaction of a performance obligation when recognizing revenue over time, the cost-to-cost input method (ASC 606-10-55-20) is commonly used for long-term construction contracts. Under this method, the key inputs are the total estimated transaction price allocated to the performance obligation, total estimated costs of the performance obligation(s), and actual cost incurred representing progress toward completion of the performance obligation.
Regardless of the method used to measure progress toward satisfaction of a performance obligation, Topic 606 doesn’t include a concept of recognizing revenue based on the amount of gross profit earned on a contract for a period plus the costs incurred on the contract during the period in the manner that legacy GAAP did. Instead, Topic 606 determines revenue as shown in Exhibit 2.
Additionally, under legacy GAAP, the amount classified as costs and estimated earnings in excess of billings on uncompleted contracts generally excluded retainage, regardless of whether the retainage was subject to conditions other than the passage of time or not. Generally, retainage associated with amounts being billed was reflected on the progress billings presented to the customer and recorded as a receivable. Accordingly, since billings is a term that doesn’t clearly indicate whether the amount includes more than just receivables – a company’s right to consideration subject only to the passage of time under Topic 606 – it can create confusion and is not recommended for describing a company’s contract asset or contract liability.
Transitioning to New Terminology
Due to the elimination of ASC 605-35’s Alternative B approach to revenue recognition, the introduction of the clearly understood terminology of contract assets and contract liabilities in Topic 606 and the change resulting from the more restrictive definition of a receivable (which results in retainage subject to more than just the passage of time being included in the contract’s asset or liability), it is recommended that companies transition from using the phrase costs and estimated earnings in excess of billings and billings in excess of costs and estimated earnings when describing their contract assets and contract liabilities.7
Within the construction industry and across nearly all industries, simply using contract assets and contract liabilities to describe such amounts on a company’s balance sheet is the most clearly understood description. Now that we’re well past the transition to Topic 606, using other terms to describe such amounts may create more confusion for financial statement users than it might clarify. However, if a company desires to use terms other than contract assets and contract liabilities, Exhibit 3 presents a few alternatives considered acceptable by many.
Presentation Examples
There’s some flexibility with how to present and disclose retainage, receivables, contract assets, and contract liabilities in a company’s financial statements in accordance with Topic 606. The following are a couple of options we’ve seen that provide the desired transparency for financial statement users in the construction industry. Exhibit 4 provides significant information about retainage on the face of the balance sheet, while Exhibit 5 provides more detailed information in the footnotes.