Authored by Tom Sheahan and Erik Schuchardt
Once a construction contractor has determined that it has a contract with a customer, as defined by ASC 606, the second step in applying the new accounting standard is to identify the performance obligations within the contract(s). The identification of separate performance obligations under the new accounting standard requires additional judgment related to the concept of a distinct good or service, the identification and evaluation of promises in contracts with customers, and the evaluation of principal versus agent considerations.
A performance obligation, as defined in ASC 606, is a promise to deliver a good or service (or a bundle of goods or services) that is distinct, or a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. To identify performance obligations, a contractor needs to determine whether or not the goods or services are distinct. The complexity arises in evaluating the promise(s) in the contract and determining whether they should be accounted for separately or together. This process directly affects the timing of revenue recognition.
A good or service is distinct if the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct) and the contractor’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the good or service is distinct within the context of the contract).
A good or service is not distinct if it is highly interdependent and interrelated, and the contractor will combine that good or service with other promises until it identifies a bundle that is distinct. This may result in the contractor accounting for all the goods or services promised in a contract as a single performance obligation.
The majority of construction contracts provide goods or services that are highly interdependent and interrelated, which would result in the contract being a single performance obligation; however, customer options for additional goods or services that provide material rights to the customer and service-type warranties are likely to be separate performance obligations.
A scenario in construction
A contractor enters into a contract with a customer to install an HVAC system. The contractor manufactures the ductwork for the system and purchases additional HVAC equipment from other vendors. The contractor does not design or manufacture the purchased HVAC equipment, but it does install the equipment in the customer’s facility. The construction contract includes a one-year preventive maintenance agreement at no additional charge to the customer. The contractor regularly contracts with other customers to provide preventive maintenance services.
The contractor evaluates the contract terms and determines that there are four goods or services that are capable of being distinct: the installation services, the manufacturing of ductwork, the purchase of HVAC equipment and the maintenance agreement. The contractor concludes that the installation services, manufactured ductwork, and purchased HVAC equipment should be combined into one performance obligation because the contractor provides significant services of integrating the three items into the customer’s facility. The contractor would also conclude that the maintenance agreement is a separate performance obligation since the customer can benefit from this service separately and it is not highly integrated with the installation services.
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The ASC 606 transition for construction contractors
- Identifying the performance obligations – Promises in contracts with customers
- Identifying the performance obligations – Principal versus agent considerations