Accounting for Uninstalled Materials under ASC 606: Keeping it Simple
Uninstalled materials continues to be a topic of conversation as it relates to ASC 606 and revenue recognition. A Google search on “ASC 606 uninstalled materials” yielded us 3,600 results at the time of this article. Throughout this article we provide recommendations on the basics of identifying and accounting for uninstalled materials. The intent of this article is not to cut and paste from ASC 606, or to be overly technical, but rather provide you with foundational knowledge of accounting for uninstalled materials under ASC 606.
The varying interpretations of the guidance in financial statements of both public and private companies lead to the complexity of determining the correct approach and policy. What we have learned is there is generally not, and should not be, a one size fits all policy that can be applied. Our first recommendation is to Develop an accounting policy for uninstalled materials that is adaptive to each contract. You may have the same uninstalled materials on two different contracts that result in two different accounting treatments.
Why is the Adaptive Policy Best?
In accounting for long-term construction contracts, most contractors use costs incurred to measure progress towards completion of performance obligations. Materials are often a very significant component of this cost. All materials are not considered equal! Purchased materials should not be included in costs towards completion if they have yet to be installed on the project (i.e. uninstalled).
This leads to our second recommendation, Develop a process and controls for tracking and identifying uninstalled materials. This is critical, if you don’t already have a process in place, you may quickly determine that uninstalled materials are more significant than you may realize. You may also conclude that for many jobs, the uninstalled materials are clearly insignificant to your measurement of progress. In those cases, maintain documentation of your conclusions and focus on the jobs with significant uninstalled materials. As part of your review processes and policies, consider applying a threshold (perhaps an overall dollar amount or a portion of total job costs) below which uninstalled materials are considered insignificant to the project.
Now that you have identified your uninstalled materials, this is where the analysis begins. The most important part of this analysis is determining who has title/control of the materials on each contract (see our first recommendation above). This sounds somewhat simple, but often this is where most of your time will be spent. This process will include evaluating the transfer of control in accordance with your contract(s) and understanding state and local laws as they relate to transfer of ownership. Are you familiar with your state and local laws for transfer of ownership?
This leads to our third and most significant recommendation, Educate your entire team on how to determine when control of these materials has transferred to your customer(s). The key component of this analysis is reading and understanding each contract. Billing your customer doesn’t always indicate a transfer of control, especially if (legally) you can pick up those materials and move them to another job site. Understanding the transfer of control will be a significant determining factor in your accounting for the materials. This is not only a relevant consideration for contractor to customer considerations, but also contractor to subcontractor relationships and vice versa. We often simplify this discussion with the following question – If you were terminated as the contractor today, who would keep the materials?
Now that you have determined who “owns” the uninstalled materials you can move forward with the appropriate accounting treatment. We see three common scenarios:
- Control has transferred to the customer OR the materials are so specific to one job that they could not be used on other jobs. Under this scenario, you would typically record revenue to the extent of the costs of the materials with no margin. Materials would not be factored into progress towards completion AND contract price when calculating revenue for jobs in progress. If the materials include a significant unique design component, further analysis may be required (See #2).
- Control has not transferred to the customer AND the materials are unique and distinct. This scenario would indicate that the contractor was involved in the design and fabrication of materials unique to the contract. Under this scenario, the contractor may have a separate performance obligation and potentially the ability to recognize margin as the design and fabrication may represent progress towards completion.
- Control has not transferred to the customer AND the materials can be used on another job. We anticipate this to be a common treatment as companies stockpile materials to combat rising prices. Under this scenario, these materials are likely an asset for the company and ASC 320, Inventory would be applicable.
This may be an ongoing process, or a less frequent process. Some contractors may determine that an ongoing process is most appropriate, and others may determine that an annual evaluation is most appropriate. As discussed above, there is not a one size fits all approach. Owners and management should discuss and evaluate the most cost beneficial approach to meet the needs of users of the financial information.
Our fourth and final recommendation is Document, Document, Document. ASC 606 is principles based, not rules based, and includes judgment throughout the process. As an external auditor, we are looking to see that our clients have considered the key components of ASC 606 as it relates to uninstalled materials on each contract if amounts are significant. We are also looking for management’s decisions and basis for including/excluding uninstalled materials in progress towards completion or including the amounts in inventory.
ASC 606 recommendations summary:
- Develop an uninstalled material policy that is adaptive to each contract.
- Develop a process and controls for tracking and identifying uninstalled materials.
- Educate your entire team on how to determine when control of uninstalled materials has transferred to your customers.
- Document your analysis and conclusions reached on each contract with significant uninstalled materials, particularly over uninstalled materials at year-end for financial reporting.
If uninstalled materials are significant to your organization, we encourage you to be familiar with ASC 606 and the elements specific to uninstalled materials. We also encourage you to contact our construction team with questions. Our team is familiar with the guidance and ready to help you navigate the complexities of accounting for uninstalled materials.