Revenue Recognition for the Government Contracting Industry
June 11, 2018
With the 2018 effective date for the new revenue recognition standard issued by FASB quickly approaching, SC&H Group has pulled together a comprehensive series of industry specific resources. The following blog post summarizes revenue recognition concepts specific to Government contractors that must be considered to ensure their accounting policies are aligned with the FASB’s new standard.
Privately-held companies, including government contractors, are required to adopt and implement the new revenue recognition standards effective January 1, 2019, with retroactive treatment for comparative financial statements as of January 1, 2018.
The general consensus is that the impact of this new revenue recognition standard should not have a drastic impact on how government contractors recognize revenue depending on the nature, type and mix of contracts under which the contractor performs work. The impact will also depend on the mix of purely commercial work/contracts versus contracts with the Federal government as prime or subcontractor. Each contractor will need to have an understanding of the new standard and take steps to evaluate the impact to the contractor’s revenue recognition model.
The new revenue recognition standard focuses on the agreed upon deliverables of goods and services under the contract. Accordingly, there may be instances where a contractor will combine two or more separate contracts to identify the deliverables and determine the transaction price.
It is important to remember the government contracting industry is comprised of numerous types of contractors that provide services, goods, and a combination of both with very diverse product and service offerings. In addition, the types of contracts with the Federal government range from Firm-Fixed-Price (FFP), Firm-Fixed Unit Price (FFUP), Firm-Fixed-Price Level of Effort (FFPLOE), Time & Materials, to a variety of Cost Plus arrangements (Cost-Plus Award Fee, Cost-Plus Fixed Fee, Cost-Plus Incentive Fee). Another consideration is the fact multiple task orders are typically issued under one contract.
Identifying Contracts, Performance Obligations (Deliverables) and Transaction Price
Arrangements to provide goods and services to the Federal government as either a prime or subcontractor should always be written, even though in the commercial contracting world arrangements can also be verbal or implied by an entity’s ordinary business practices. On the rare occasions work is performed for the Federal government as a prime or subcontractor prior to receiving an executed contract, a company should consider any history of entering into amendments, side agreements, or modifications to existing or previous contracts with the customer (as prime or subcontractor), as these all have specific implications for revenue recognition. Additionally, entities are required to assess whether collection of the consideration is probable which includes consideration of any price concessions expected to be provided to the customer.
Government contractors, especially contractors that specialize in information technology services and products, often provide multiple products and/or services as part of a single arrangement, including, but not limited to hardware, software, implementation services, customer support, maintenance, and upgrades. If there are multiple deliverables in a contract, the contractor will have to assess whether each deliverable is a distinct and separate performance obligation, requiring revenue to be measured and recognized for each deliverable, or whether the deliverables are homogenous and inter-related and thus a single performance obligation for which revenue is recognized. Management must determine whether a product or service is distinct by assessing if the customer can benefit from the product or service with resources that are readily available to the customer.
After a contract has been entered into, any subsequent contract modifications that have been approved as to change in scope and price must be evaluated to determine whether a modification constitutes a completely separate contract with new deliverables, or merely an amendment to the contract. Unpriced contract modifications should be considered as variable consideration. The contractor will have to estimate the most likely amount to be recognized, provided that it is probable there will be no significant reversal in the amount of cumulative revenue recognized when the price of the modification is approved. Government contractors often enter into arrangements with variable consideration such as milestone payments, award fees, incentive fees, and other performance type arrangements.
Allocating the Transaction Price and Recognizing Revenue
Once the contractor has identified its performance obligations and the transaction price, the proper method to allocate the transaction price and recognize revenue should be determined. The biggest impact to government contractors will be on contracts under firm-fixed price arrangements with multiple deliverables or one single deliverable at the end of the contract. Under current standards contractors recognize revenue using the percentage of completion method based on inputs such as labor hours or dollars, or current costs to total estimated costs at completion. Under the new standard, revenue can be recognized when a performance obligation is satisfied when the control of the product or service is transferred to the customer. The new guidance states the customer obtains control when they 1) can direct its use and 2) obtain substantially all remaining benefits from the product or service. For intellectual property (IP), control may transfer when the customer takes possession of the software by physical receipt, download or receipt of a license key or access code. Management also needs to evaluate if the products or services are transferred over time or at a point in time which then determines if revenue is recognized over time or at a point in time. Typically control is transferred over time on long-term contracts with the federal government, accordingly the revenue recognition methodology under the new standard should not be significantly different from current methodology. Regardless, management should evaluate the transfer of control from the customer perspective.
Disclosures in the Financial Statements
The new standard requires new disclosures in the financial statements, including description of revenue type and source, customers, performance obligations, economic factors affecting uncertainty of realization of revenue and cash flow, methods and judgment used to recognize revenue. Some of these disclosures may already be made in a contractor’s financial statements, but may have to be re-formatted or edited for presentation with new disclosures.
The most significant impact will be on contractors that perform on a mix of contracts that involve both products and services, especially in the information technology area providing software implementation and ongoing maintenance and support, or any contracts that provide for multiple deliverables with milestones and customer acceptance provisions.
Nonpublic entities are required to adopt the new standard for annual reporting periods beginning after December 15, 2018 (December 31, 2017 for public entities). Implementation is to be done on a retrospective basis, so organizations should understand and account for revenue under the new standard at least a year in advance.
As a result of these standards entities need to reassess their current revenue accounting and determine whether changes are necessary. SC&H Group is here to help as you are navigating the best next steps to pursue. If you have any questions about revenue recognition specific to the government contracting industry please Contact Us.