Looking back at the evolution of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 606 Revenue from Contracts with Customers,1 it is hard to believe that the construction industry grappled with the proposed changes for nearly a decade when considering there was generally a minor impact as to how contractors recognized revenues from contracts upon implementation as compared to “old” GAAP.
While the percentage-of-completion method (referred to in Topic 606 as recognizing revenue over time) remains the predominant revenue recognition model for long-term construction contracts, the industry perspective on how to recognize revenues from service contracts could vary. This article looks to address how revenues from service contracts should be recognized in accordance with Topic 606.
Service Contracts in the Construction Industry
It is not uncommon for a construction company to enter into a service contract, which could include activities such as project management, asset maintenance, or some other identifiable task (e.g., the weekly landscape maintenance at an office building or an electrical contractor that checks/changes light fixtures for a customer as needed).
As the nature and scope of construction service contracts varies, the pattern and timing of revenue recognition will depend on when control of the promised services is transferred to the customer, which will require knowledge of the contractual terms of the services being provided. In other words, the contractor cannot just defer to a method for service contracts.
As this article dives into some of the relevant issues that have surfaced as they relate to applying Topic 606 to service contracts, assume that the first step in the process has been satisfied — i.e., a contract with a customer has been identified.
Identifying the Performance Obligation
To recap, a performance obligation is a distinct promise, or a series of distinct promises, in a contract to transfer a good or service to the customer, which is either explicit or implied. It is known that a contract can contain multiple performance obligations, which is why they should be identified at the contract’s inception because when and how performance obligations are satisfied will directly affect when revenue is recognized.2
A more common example is when a construction contractor is awarded a new build or gut renovation project and, as a part of that contract, there is a service component to it. This raises the issue of how many performance obligations exist.
Capable of Being Distinct & Distinct Within the Contract
According to Topic 606, a promised good or service is accounted for as a performance obligation if it is both capable of being distinct and distinct within the context of the contract. Capable of being distinct essentially means that the customer can benefit from the promised good or service “on its own or together with other resources that are readily available to the customer.”3
For the performance obligation to be distinct within the context of the contract, the service must be separately identifiable; not integrated with, highly dependent on, or highly interrelated with other promised services; or does not significantly modify other promised services in the construction contract.4 Put another way, the customer can benefit from it without reliance on other phases or aspects of the scope of the contract in question.
Additionally, a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer should be accounted for as one performance obligation.
Individual vs. Multiple Performance Obligations
When contracts for engineering, procurement, and construction or design-build projects are encountered, there are multiple services that must be evaluated to determine if the goods or services represent an individual or multiple performance obligations.
The contractor must assess the following:
- If the customer can benefit from the goods or services on their own or together with other resources readily available to the customer; and
- If the goods or services are separately identifiable from the other promises in the contract.5
As an example, consider a heating, ventilation, and air conditioning (HVAC) contractor that enters a contract to design, fabricate, and install the HVAC system at a new hospital. The HVAC contractor is responsible for designing the system as a promised service, purchasing the material, and installing the system. As all of these services are not capable of being distinct (since the customer cannot beneﬁt from each good on its own), the contract would be considered to have one performance obligation because the owner of the project is beneﬁtting from a completed and installed HVAC system.
Now consider if the contract also requires the HVAC contractor to provide maintenance/service for the system over the next ﬁve years; this would need to be evaluated separately from the promises to design, fabricate, and install the new HVAC system. In this case, the maintenance/service of the system would likely be distinct from the other promises in the contract since the customer can benefit from the maintenance service without reliance on other phases or aspects of construction under the scope of the contract in question. Accordingly, this would be treated as a separate performance obligation.
While the preceding example is a good indicator that service agreements are most often a separate performance obligation from design/construction, there are a variety of other factors that may provide evidence that the customer can benefit from the good or service either on its own or in conjunction with other readily available resources.
For example, the fact that the contractor regularly provides a maintenance service separately would indicate that a customer can benefit from this on its own or with other readily available resources. Put another way, the maintenance service is distinct within the context of the contract as it is not integrated with, highly dependent on, highly interrelated with other promised services, and does not significantly modify other promised goods or services in the construction contract.