Understanding the Impact on Government Contracts

Key Takeaways:
  • Many have encountered challenges given the complexity introduced by ASC 606.
  • Misclassification of costs (either capitalization or expensing) and failure to accurately assess the recoverability of capitalized costs are potential pitfalls. 
  • Implementing ASC 606 requires careful attention to each element of a contract and the specific obligations therein.

 

The 2019 implementation of the Accounting Standards Codification Topic 606 (ASC 606), titled “Revenue from Contracts with Customers,” heralded a significant transformation in the landscape of revenue recognition. As a government contractor, have you found yourself wrestling with the intricacies of this new standard? Are you seeking clarity on how these changes impact your contracts and financial reporting? You’re not alone. 

Many have encountered similar challenges, especially given the complexity introduced by ASC 606 and the nuanced guidance subsequently issued by the Financial Accounting Standards Board (FASB). 

ASC 606 Five-Step Model 

1. Identify the Contract with the Customer 

For a contract to exist under ASC 606, it must be approved, have clear terms about rights and payment, possess commercial substance and the collection of payment must be probable. This includes written, oral or implied agreements. Special considerations apply for combining contracts, modifications and contracts like IDIQ (Indefinite Delivery/Indefinite Quantity) or MSAs (Master Service Agreements). 

Previous GAAP Contrast: Earlier guidance lacked clarity on contract combination outside of construction or production contracts. ASC 606 standardizes these principles across all contract types. 

Key Risks: Be cautious of inconsistently treating similar contracts, mishandling contract modifications and ignoring the specifics of commercial and non-standard contracts. 

2. Identify Separate Performance Obligations 

A performance obligation could be a distinct good or service or a series of similar items transferred over time. Determining whether a good or service is distinct involves assessing if the customer can use the item on its own or with readily available resources and whether the item is separately identifiable within the contract. 

Key Risks: Failure to properly identify distinct performance obligations or incorrectly bundling services can lead to revenue recognition issues. 

3. Determine the Transaction Price 

The transaction price is the expected amount to be received for transferring goods or services. This can include fixed amounts and variable consideration like discounts or incentives. Estimation methods such as the expected value or most likely amount are used depending on the number and variability of outcomes. 

Previous GAAP Contrast: Under former guidelines, the price needed to be fixed or determinable. ASC 606 allows for revenue recognition even when the price is not yet finalized, using estimates for variable considerations. 

Key Risks: The challenge lies in accurately estimating variable considerations and ensuring the reliability of the underlying data. 

4. Allocate Transaction Price to the Performance Obligations 

The transaction price is allocated to each performance obligation based on its standalone selling price. This can be directly observed or estimated using approaches like the adjusted market approach, expected cost-plus margin or the residual approach. 

Previous GAAP Contrast: Previously, discounts were often allocated to the first item delivered. Under ASC 606, the residual method estimates the selling price and helps in proper allocation. 

Key Risks: Risks include improper reliance on list prices without analysis and the incorrect allocation of discounts and variable consideration. 

5. Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation 

Revenue is recognized when control of the good or service transfers to the customer, which can happen over time or at a specific point. The criteria for “over time” recognition include the customer receiving and consuming benefits as the entity performs or the entity creating an asset that the customer controls. 

Key Risks: Errors can arise from inadequate documentation of control transfer, defaulting to inappropriate recognition methods and inaccurate measurement of performance progress. 

Additional Considerations 

Principal vs. Agent Determinations 

Determining whether an entity acts as a principal or agent remains challenging and significant judgment is required. Factors such as inventory risk and pricing discretion help guide these decisions. 

Contract Costs 

Costs to obtain a contract are capitalized if they’re expected to be recovered. However, costs like bid and proposal expenses are expensed as incurred unless they directly result in a contract. 

Key Risks: Misclassification of costs (either capitalization or expensing) and failure to accurately assess the recoverability of capitalized costs are potential pitfalls. 

Conclusion 

Implementing ASC 606 requires careful attention to each element of a contract and the specific obligations therein. For government contractors, understanding and applying these principles is crucial for compliant and effective revenue recognition. If you would like to discuss how to implement sound revenue recognition accounting processes, contact an Adams Brown advisor.