How The New Five Step Revenue Material

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LeMoyne Construction Company signed a contract on January 1, 2019, to build an office building for Franklin Corporation for a total consideration of $10 million. The payment schedule includes an initial payment of $1 million upon signing, $5 million upon completion of the foundation and exterior components, and $4 million upon final project completion. An additional $100,000 is contingent upon the project’s completion by July 31, 2020. The task involves applying the five-step revenue recognition model to determine when LeMoyne should recognize revenue from this contract, considering the progress and performance obligations involved.

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The case of LeMoyne Construction Company's revenue recognition offers an insightful example of applying the five-step revenue recognition model under current accounting standards, primarily ASC 606. This model requires a systematic approach to determine the timing and amount of revenue that an entity should recognize from contracts with customers. Accounting for construction contracts is particularly complex due to the long-term nature of the work and the need to accurately match revenue with expenses over the duration of the project. This analysis explores each step of the model within the context of LeMoyne’s contract and discusses the implications for revenue recognition timing.

Introduction to Construction Revenue Recognition

Revenue recognition in construction projects has historically been complex owing to their long-term and performance-based nature. Under the current accounting standards (ASC 606), revenue is recognized as control of goods or services is transferred to the customer, reflecting the entity’s performance obligation completion. For construction companies like LeMoyne, understanding the five-step model ensures compliance with accounting principles while providing relevant financial information. Applying this model requires careful assessment of each contract’s specific terms, progress milestones, and performance obligations, which significantly influence revenue timing.

Step 1: Identify the Contract with the Customer

The contract between LeMoyne Construction and Franklin Corporation qualifies as a legally enforceable agreement that creates enforceable rights and obligations. It clearly stipulates the scope of work, payment terms, milestones, and conditions for additional payments. The contractual terms specify the consideration of $10 million, payment schedule, and conditions for the $100,000 bonus, establishing a solid foundation for revenue recognition. Recognizing the contract’s existence is straightforward in this case, given the formal agreement and contractual obligations.

Step 2: Identify the Performance Obligations

LeMoyne’s contractual work involves several distinct performance obligations. Primarily, these include the construction of the office building, which encompasses various tasks and milestones. The initial obligation is to construct the foundation and external components, followed by completing the full building. Each milestone corresponds to a performance obligation that is satisfied when the specific work is completed. The contractual language indicates that the client’s payments are tied to these completed milestones, signaling the need to split the contract into separate performance obligations for revenue recognition purposes.

Step 3: Determine the Transaction Price

The transaction price of $10 million is specified in the contract, with an additional $100,000 contingent on early completion. Given the conditional nature of the bonus, the expected value approach should be employed to recognize the likelihood of earning this bonus. Since the $100,000 bonus is contingent upon completing the project by July 31, 2020, and the likelihood of this condition being met is high based on project plans, LeMoyne can include this amount in the transaction price. Therefore, the total transaction price is estimated at $10.1 million, incorporating the expected bonus payment.

Step 4: Allocate the Transaction Price to the Performance Obligations

Allocating the transaction price involves distributing the $10.1 million to each performance obligation based on their relative fair values or standalone selling prices. The primary obligation is the construction of the building, which likely represents the bulk of the contract value. The milestone-based payments suggest each milestone’s value corresponds proportionally to the work completed. The initial payment of $1 million relates to the signing and initial work, while subsequent payments align with construction progress. The bonus, being contingent, is deferred until the performance is achieved. Hence, the allocation focuses on placeholding the earnings across the project timeline, with revenue recognized proportionally as work progresses.

Step 5: Recognize Revenue When the Performance Obligation is Satisfied

The fundamental criterion for revenue recognition under ASC 606 is the transfer of control to the customer. For LeMoyne, control over the work progresses as the construction advances, allowing revenue to be recognized proportionally to the completion of contractual milestones. Given the nature of the construction project, a percentage-of-completion method aligns best with the model, where revenue is recognized based on the percentage of work completed at each reporting period. Specifically, upon completion of the foundation and external structures, LeMoyne can recognize the corresponding revenue portion; similarly, upon full completion, the remaining revenue, including the bonus if earned, is recognized.

Additional Considerations: The Timing of Revenue Recognition

The initial payment of $1 million at signing can be recognized immediately as a liability transfer if control has passed, or as revenue if LeMoyne has performed its obligations. As each milestone is achieved—such as foundation work and external completion—revenue is recognized proportionally. This process ensures that revenue recognition reflects actual progress, preventing premature recognition that could distort financial statements. Moreover, the bonus contingent upon early completion is only recognized when the probability and the event of completion by July 31, 2020, are assured, aligning with the realization principle.

Implications for Financial Statements

This systematic approach ensures that LeMoyne's financial statements accurately depict its financial health and performance. Proper application of the five-step revenue recognition model enhances comparability, transparency, and compliance with accounting standards. Recognizing revenue in alignment with work progress also provides stakeholders with meaningful insights into the company's operational efficiency and project management capabilities.

Conclusion

Applying the five-step revenue recognition model to LeMoyne Construction’s contract involves detailed evaluation of contractual terms, milestone progress, and contingency conditions. By systematically identifying the contract, performance obligations, transaction price, allocation, and timing of revenue recognition, LeMoyne can ensure compliance with ASC 606 while providing a true representation of its financial performance. The proportionate recognition of revenue based on project milestones reflects the ongoing transfer of control, aligning financial reporting with economic reality, and supporting informed decision-making.

References

  • FASB (2014). ASC 606: Revenue from Contracts with Customers. Financial Accounting Standards Board.
  • Income Recognition in Construction Contracts, Deloitte (2019). Deloitte Accounting Research Tool.
  • Kieso, D.E., Weygandt, J.J., & Warfield, T.D. (2020). Intermediate Accounting. Wiley.
  • PS 6060: Revenue Recognition, PwC (2021). PricewaterhouseCoopers.
  • Accounting Standards Codification, FASB (2014). Revenue Recognition Topic. FASB.
  • NPR 6000: Construction Accounting, EY (2020). Ernst & Young.
  • Chitkara, K. (2018). Construction Business Management. Routledge.
  • Bernard, S. (2022). Financial Reporting for Long-term Construction Contracts. Journal of Accountancy.
  • Houghton, K. (2018). Revenue Recognition and Construction Contracts. Journal of Construction Engineering and Management.
  • Healy, P. M., & Palepu, K. G. (2018). Business Analysis & Valuation: Using Financial Statements. Cengage Learning.

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