Topic 606, Revenue from Contracts with Customers, also known as the revenue standard, has been a hot topic in the construction world since implementation. The standard established a five-step process for companies to evaluate their revenue with customers. While all steps are important in this five-step process, none are as important as step three which is determining the transaction price.
Step three of the revenue standard tends to revolve around variable considerations and estimation of the monetary value associated with these considerations. The amount of consideration, otherwise known as transaction price, that the company may get after performing a service can be either fixed or variable. This variable method requires estimations to be done before the end of the contractual period. Multiple forms can affect variable consideration, like change orders, incentives or claims, and liquidated damages. Liquidated damages are often overlooked because they are amounts needed to be paid to customers as opposed to what is received. The new revenue recognition standard has determined that transaction price includes both the amount to be received from the customer along with the amount to be paid to them, which includes liquidated damages. Oversight of this variable consideration has led to revenue being overstated.
There are two standards allowed when estimating variable consideration, the expected value method, and the most likely amount method. The main difference between the two being the number of outcomes there may be, the expected value method having more possibilities and the most likely amount method having a small number of possibilities. Once the transaction price is estimated, the company must make sure the amount of revenue to be received by the company is probable. This is typically viewed under U.S. GAAP as 75% or greater. However, when considering variable considerations or more so liquidated damages, companies should be asking themselves if there is a 25% or more likely chance this will need to be paid. If the answer is yes, then they need to exclude that balance from revenues as the likelihood of payment of this balance is probable.
As an example of this, a company is contracted to build a road, with contractual consideration of $200 million. $190 million of that is fixed consideration, while $10 million of it is variable consideration to cover liquidated damages on a “per day late” basis. $10 million was the amount determined that would be the maximum amount the company would pay for being late in completing the job. The company uses the information they have available like their history with the owner, the type of project, the geographical area, and their past practices to avoid having to pay liquidated damages. Based on history, they conclude that they are 25% or more likely (not 75%) to have to pay $7 million in liquidated damages. The transaction price at contract inception is therefore set to $93 million.
Correctly applying the variable consideration model will result in a decrease in time for cash outflows and along with it, a decrease in the amount of revenue recognized sooner than expected. Companies should put more care in making sure liquidated damages or other cash outflows are being applied correctly. Companies should consider liquidating damages prior to heading into annual financial statement engagements with their CPA.
Please feel free to reach out to one of our construction accounting specialists on this important topic.