Revenue Recognition for Government Contractors: The Basics

At a glance:

• The main takeaway: Even after the Financial Accounting Standards Board (FASB) issued additional guidance, many federal contractors are still unclear about the new Accounting Standards Codification Topic 606 (ASC 606), Revenue from Contracts with Customers. 
• The impact on your business: Understanding the new revenue recognition standard and assessing how it will affect their revenue recognition model will be necessary for every federal contractor to ensure they appropriately record revenues for all their contracts, as many federal contracting entities still inappropriately recognize revenues based on billings. 
• Next steps: While this article outlines the five steps of ASC 606 and the critical factors that federal contractors should know about, your understanding of the intricacies and best practices associated with ASC 606 can be strengthened with the help of the experienced professionals in Aprio’s Government Contracting team.

Need further guidance or information on ASC 606? Schedule a consultation with an Aprio advisor today.

The full story:

When ASC 606 went into effect in 2019, it significantly transformed the revenue recognition landscape by introducing the Five Step Framework, which was used to determine whether the core principle of Topic 606 had been achieved. As a federal contractor, have you encountered difficulties understanding the nuances of this new standard? Are you trying to learn more about how these changes will affect your financial reporting and contracts? You’re not alone.

This article is the first in a series of articles that we will publish on government contracting entities’ revenue recognition. Each of the five steps discussed below will be expanded and elaborated in the subsequent series of articles.

An Overview of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606/ASC 606)

• ASC 606’s definition of Revenue:

“Revenue: Inflows or other enhancements of an entity’s assets or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.”

In plain English: Revenue is the total amount of money a business produces from its ongoing major operations over a predetermined period. It is a company’s gross income before any expenses are deducted.

• ASC 606’s revenue recognition principle (i.e., When do you recognize/record revenues?):

ASC 606 directs entities to recognize revenue when or as the promised goods or services are transferred to the customer. The amount of revenue recognized should equal the total consideration an entity expects to receive in return for the goods or services.

In plain English: ASC 606 is the universal framework for companies to recognize revenues from the sale of goods or services. It impacts customer contracts and pricing, and lays down how and when to recognize revenue from those contracts.

• ASC 606’s fundamental principle:

Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

This fundamental principle is reflected in ASC 606’s 5-step framework below:

ASC 606’s steps	In plain English	Application to government contracting entities (The following issues/nuances below will be covered in detail in the subsequent series of articles that we will publish on government contracting entities’ revenue recognition.)
Step 1: Identify the contract.	Customer contracts must fulfill EVERY requirement listed below to satisfy ASC 606’s first step: Both parties have agreed to and are committed to the deal (approvals have been obtained from both parties). Each party’s rights regarding the goods and services that will be transferred are specified (the rights of both parties have been identified). The contract terms of payment for the transferred products and services are specified. The agreement has commercial substance. The collectability of consideration is probable (generally “75% or greater likelihood of occurrence or more likely than not”).	COMMON ISSUES: Inconsistent accounting of similar contracts, improper accounting of contract modifications, and ignoring the specifics of non-standard and commercial contracts. Determining the contract term is crucial because it will impact how the following steps in the five-step revenue recognition are applied to the contract. For instance, Step 2, which identifies the promised goods or services (performance obligations), and Step 3, which determines the transaction price, are both significantly influenced by the contract term (Step 1). This underscores the interconnectedness of the revenue recognition process. A typical government contract usually satisfies the requirements for contract existence. An entity’s business practices may create written, verbal, or implied agreements. NUANCES TO CONSIDER: The contract term is affected by customer termination provisions/termination for convenience clause of the government. Unfunded change orders, “working at risk”, options and claims, and notice to proceed may or may not meet the requirements to be considered a contract. When signing IDIQs (Indefinite Delivery/Indefinite Quantity), MSAs (Master Service Agreements), or BPAs (Blanket Purchase Agreements), federal contractors should carefully review the contract combination guidance. Depending on the specifics, each work order under these arrangements might be eligible for a contract combination. Understanding what constitutes a contract modification is crucial. This refers to when the parties to the contract agree to add or modify enforceable rights and obligations, such as a change in the contract scope or price. This understanding is essential because changes that are not enforceable do not give rise to changes in the accounting for the contract.
Step 2: Identify the performance obligations.	The unit of accounting for revenue recognition is known as a performance obligation. Put simply, an entity needs to determine its contractual obligations and deliverables to customers. An entity must identify each performance obligation in a contract to allocate the transaction price to the performance obligations (Step 3) toward revenue recognition. A performance obligation is a promise to a customer to transfer either: (a) a good or service (or bundle of goods or services that are distinct) (b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer A good or service is deemed distinct if the customer can derive benefit from it alone or in combination with other readily accessible resources. It must also be separately identifiable from other promises made in the contract. This principle applies to individual goods and services, as well as those combined into a bundle.	COMMON ISSUES: Revenue recognition issues may arise from misidentifying distinct performance obligations or incorrectly bundling or separating goods and services (i.e., accounting for multiple promises of goods or services as one integrated performance obligation). Both the explicit and implied promises in the contract need to be considered. Principal vs. Agent considerations: Improper evaluation of whether a company is a principal or agent in a transaction each time a third party participates in providing products or services could lead to improper revenue recognition for the performance obligation, either on a gross or net basis. NUANCES TO CONSIDER: Customer options are notable for government contracting companies because they usually involve an opportunity to purchase additional products and services. Option years or renewal periods are also notable for government contracting companies. When customer options give the customer a material right they would not have obtained had they not entered into the original contract, they are frequently regarded as a distinct performance obligation. Contracts with the Federal government commonly have multiple Contract Line Item Number (CLINS), multiple option years, or numerous tasks within the scope of work throughout the performance, such as project management, operations and maintenance, and other support services. While each task could be considered independent and executed independently of one another, the tasks may NOT be considered distinct within the context of the contract due to their high interrelationship and dependency to achieve a single, critical objective. Each task will tend to lead into another or will be provided concurrently, share resources, and are viewed by the customer as more of “inputs” into the entire project objective. Therefore, although there are multiple tasks/inputs outlined in the contract, there is likely a single performance obligation for this contract. The critical aspect of Step 2 in identifying performance obligation is to view the contract from the customer’s perspective. When promised goods or services are not distinct, ASC 606 requires the federal contracting entity to account for all the goods or services promised in a contract as a single performance obligation. Principal vs. Agent considerations: Generally, a principal in an arrangement with another third party provides goods or services directly to the end-user or customer. On the other hand, an agent arranges another party to provide its goods or services to the end-user or customer. Put another way, a principal will have control of the goods or services before they are transferred to the end customer, which is not the case for an agent. There are general indicators to consider in determining who has control: Who has the primary responsibility in fulfilling the promise to provide or deliver the goods or services Who has the inventory risk Who has the discretion in making the pricing for the goods or services The indicators above are meant to aid in an assessment of control. The existence of one or more of these signs shouldn’t be the basis for concluding control. Furthermore, according to the revenue recognition rules, a company does not always have control over a specified good if it only temporarily acquires legal title to it before transferring it to a client. The application of principal versus agent considerations has been made easier by the additional guidance provided by the revenue recognition rules, although making this conclusion can still be challenging. The most important thing to remember is that, depending on your contractual arrangement, you need to ascertain whether your business is acting as an agent or a principal when a third party is involved in providing goods or services to your customers.
Step 3: Determine the transaction price.	The transaction price is the expected amount to be received for transferring goods or services, excluding amounts collected on behalf of third parties (such as sales taxes). Transaction price encompasses fixed amounts and variable consideration. Variable consideration includes parts of the transaction price contingent on future events’ outcome (i.e., discounts, price concessions, rebates, claims, incentive fees, penalties, award fees, performance bonus, rate variances for cost-plus type contracts, among others, contingent consideration on the occurrence or non-occurrence of a future event such as funding). Variable consideration is a non-fixed consideration in a contract that: (i) requires estimation which are either the expected value method or the most likely amount method (ii) requires the application of constraint to ensure that amount of revenue recognized is limited to the extent that it is probable that there will not be a significant revenue reversal in the future	COMMON ISSUES: Reliance on accurately estimating variable considerations and ensuring the reliability of the underlying data (which may be subject to bias, risk of management override of controls and fraud risk). Under ASC 606, variable consideration is assessed and adjusted depending on the probability and size of possible reversals rather than being recognized until 100% known or until it is billed to the customer. Failure to appropriately consider significant financing component in the transaction price (i.e., significant implicit or explicit benefit of financing to either the entity or the customer). NUANCES TO CONSIDER: In federal government contracts, variable consideration can take many different forms which all requires estimation and constraint, the most common of which are award fees, provisions for penalty/claims and incentive payments, reimbursement for expenses up to a specific threshold, performance and cost-target incentives, and reimbursement for other costs. The degree of variability in the consideration could influence the amount that the customer will ultimately have to pay, such as the performance bonus that an entity will be entitled to, which depends on the project’s results. It could also determine whether the entity is entitled to the consideration, for instance, meeting or not meeting a cost savings threshold to which a performance bonus is tied. An estimate of the variable consideration to which an entity expects to be entitled should be included in the transaction price to the extent that it is probable that its inclusion will not subsequently result in a significant reversal of cumulative revenue already recognized once the contingency that gives rise to the variability is resolved. This is known as the application of constraint.
Step 4: Allocate transaction price to performance obligations.	Once the performance obligations are determined, the transaction price is allocated to each performance obligation based on its standalone selling price. Allocating transaction price is straightforward if there is only one performance obligation. However, if there are multiple performance obligations, the transaction price needs to be allocated based on the observable price of goods or services (i.e., the price at which the entity sells the good or service on a standalone basis, if it is not bundled with other goods or services). Without a directly observable price, estimates should be made using one of the three estimation methods provided by ASC 606.	COMMON ISSUES: Risks include improperly relying on list prices without analysis, misallocating discounts, and failure to identify and account for variable considerations. NUANCES TO CONSIDER: Performance obligations could be for each unit on a purchase order (PO) or the entire PO/CLINS/Subline Item Number or SLINS/Accounting Classification Reference Number or ACRNS/work ticket. In a situation where no stand-alone selling price is available, which is generally common for customized goods, the selling price has to be estimated using either the adjusted market assessment approach or the expected cost-plus margin approach. Typically, a stand-alone selling price exists for the government contracting industry since contractors tend to adhere to competitive pricing practices (e.g., the GSA schedule or equivalent). Federal contractors often use the estimated cost-plus margin approach due to its consistency with the process of submitting bids and proposals for new government contracts. This approach aligns with the cost accounting requirements set forth by the Cost Accounting Standards (CAS) and Federal Acquisition Regulations (FAR).
Step 5: Recognize the revenue when/as performance obligations are satisfied.	Revenue is recognized when control of the good or service transfers to the customer, which can happen over time or at a specific point in time. It’s important to understand that the criteria for “over time” recognition involve the customer receiving and consuming benefits as the entity performs or the entity creating an asset that the customer controls. Under the old revenue recognition standards, revenue recognition occurs upon the “transfer of risks and rewards to the customer.” Under the new revenue recognition standards, revenue recognition occurs upon “the transfer of control of the goods or services to the customer.” Control is transferred to the customer at a point in time or over time.	COMMON ISSUES: Improper or inadequate documentation supporting transfer of control occurring over a period of time resulting in incorrect revenue recognition. Inaccurate measure of progress toward completion by the Company. The Company defaults to a revenue recognition method that does not accurately reflect how control of a good or service transfers to the customer, such as: Recognizing revenue based on billings when such billings do not depict the Company’s performance towards the complete satisfaction of the performance obligation. Recognizing revenue based on a straight-line or ratable monthly amount over the contract term when such a pattern may not represent when benefits are received by the customer based on the nature of the work. NUANCES TO CONSIDER: Percentage of completion (POC) is known as the “Cost to Cost” method under ASC 606.

The bottom line:

ASC 606 implementation calls for close consideration of every element of a contract and the specific obligations outlined within. For federal contractors to recognize revenue in a compliant and efficient way, they have to understand and apply the concepts into practice correctly.

Get help from a trusted advisor in Aprio’s Government Contracting team about implementing proper revenue recognition accounting practices into place.

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