Understanding changes to existing business systems, processes & internal controls

With the first key effective date of Accounting Standards Codification (ASC) 606 quickly approaching, the time to understand the impact to your business and what you need to do about it is now. Most contractors earn the majority of their revenues from contracts with customers. Therefore, they will be impacted by the new accounting standard in some manner. Even if there is no change in top-line new revenue, there may be a difference in the accounting process to reach that number. For many construction companies, there will be substantial changes to business systems, daily processes and internal controls over financial reporting.

The Elements of ASC 606

ASC 606 provides a structure through which all revenue transactions must be fully assessed. The structure consists of five elements in total:

  • Identify the contract with a customer
  • Identify the performance obligations (promises) in the contract
  • Determine the transaction (contract) price
  • Allocate the transaction price to the performance obligations
  • Recognize the revenue when (or as) the reporting organization satisfies the performance obligations

Companies should approach assessment and implementation like they would any new construction project—by planning a systematic approach, assigning a project manager, managing the progress and measuring the results. Outlined below is a six-step approach to help you get started.

1. Evaluate the company’s different revenue streams & various contracts

To accurately assess the impact of ASC 606 on your company, a clear understanding of how a company recognizes revenue is important. Every revenue stream may possess different areas of risk under the new accounting revenue standard. To fully understand the scope of impact, disaggregate the revenue balance into streams with similar characteristics, bearing in mind organizational structure (subsidiaries, business units and segments), contract types, product lines and customers.

Be as precise as possible to ensure the impact assessment appropriately identifies unique implementation issues. Then, take a complete inventory of the revenue from contracts and assess the potential impact to each type of contract. The precision of this exercise will dictate the effectiveness of the overall ASC 606 assessment and implementation process.

2. Assess the impact of each contract type & inventory contracts

Once the revenue streams are identified by risk, take an inventory of the types of contracts in each revenue stream. Review a sample of contracts from each of the new revenue streams, and compare this to the five elements of revenue recognition in ASC 606. Some of the key points contracts will need to focus on include:

  • What are the goods or services being offered?
  • What is the timing of billing versus delivery of service?
  • Are there upfront costs to fulfill a contract?
  • What types of change orders are performed?
  • Are there penalties or bonuses?
  • Is the contract negotiated along with other contracts?
  • How is the good or service delivered; at a point in time or over time?
  • Does the company provide payment terms that would be considered financing?

At this point, you should be able to articulate the potential impact to the business based upon the new guidance.

3. Perform a gap analysis

Next, the organization’s current contract process, internal controls and information systems should be compared to ASC 606 compliance requirements. Use the impact assessment prepared in Step 2 to identify areas where gaps exist within the organization in order to comply with the new standard. Regardless of financial statement impact, organizations may need to also:

  • Review and refine internal control processes
  • Reconfigure information systems
  • Revisit incentives and other compensation programs
  • Review bank covenants and surety underwriting requirements
  • Use this gap analysis as a baseline roadmap for implementation. It is important to discuss the gaps and implementation strategies with additional stakeholders

4. Develop a roadmap or plan for implementation

Now it is time to confirm strategy. One of the first matters to determine is whether the company will implement restating prior periods or do a modified retrospective approach. All scenarios should be vetted, and the appropriate method selected.

Regardless of the financial impact of the new guidance, there will be changes necessary to processes and systems so your implementation plan should include focus on both areas. All of the above will result in a project plan, which should focus on a timeline, the resources needed, effort required and an overall work plan.

5. Execute the plan

As you execute the implementation plan, document its design for impacts and changes. With changes occurring, testing is necessary to ensure all appropriate processes and controls are in place and operating as planned. You should understand changes that may be necessary to business practices, as well as adjustments to contracts’ terms that may need to avoid unintended consequence.

6. Perform ongoing management & controls

With ASC 606 implemented and business practices changed, ongoing reviews of systems and controls will be important. Circumstances may arise that necessitate new practices. Companies should periodically test their processes and controls to ensure they are working effectively.

New revenue recognition changes will affect all businesses in some way. While the amounts recorded in the financial statement may not change, some controls and process will require modification. Contractors should not take implementation of this standard lightly. Each revenue stream and contract type must be assessed to understand how ASC 606 will impact it. This assessment will likely be a complex process—plan accordingly.

Scenarios Requiring New Internal Controls

Scenario 1

  • Entity submits a bid to customer on Jan. 15, 2018, for the construction of Building A for $100,000
  • Entity submits a bid to customer on Jan. 30, 2018, for the construction of Building B for $75,000
  • Bid price for Building B is contingent on customer accepting bid for Building A
  • Customer accepts bids for Building A and Building B on Feb. 15, 2018
  • Under the prior accounting guidance, each contract would be recorded as a separate contract for the price of each contract. A gap analysis identified the following controls that need to be in place to comply with ASC 606:
    • Documentation of whether to combine contracts
    • Documentation identifying the performance obligations
    • Allocation support of the transaction price to the performance obligations

As part of their ASC 606 implementation plan, this entity will have a step which develops internal controls over the three items, noted above.

Scenario 2

  • Entity enters into a contract with customer for the construction of a building for $1,000,000 on Jan. 15, 2018
  • Estimated cost of the building to the entity is $800,000
  • Costs incurred through Dec. 31, 2018, total $300,000
  • Entity and customer enter into a change order on June 1, 2018, for an additional $75,000 to enhance the finishes
  • Estimated cost of the change order to the entity is $50,000
  • Costs incurred through Dec. 31, 2018, total $750,000

Under current guidance, the change order and estimated cost would be added to the contract and revenue calculated using percentage of completion. Under ASC 606, not all change orders are accounted for the same way. The entity’s internal control structure will need to include a step that requires the contractor to determine whether the change order is distinct or not. The change order can be recorded one of three ways, depending on the nature of the promise: a new contract, continuation of the existing contract or termination of the old contract and creation of a new contract.