When the Financial Accounting Standards Board (FASB) issued Revenue from Contracts with Customers (Topic 606),¹ some of the accounting practices commonly used by contractors under ASC 605-35, which codified the previous guidance known as SOP 81-1, were no longer allowed. One such item of interest was the accounting for materials purchased or allocated to a project that was not yet installed — commonly referred to as uninstalled materials.

What Qualifies as Uninstalled Materials?

Since contractors can, for the most part, recognize revenue under Topic 606 in a manner that is largely consistent with the percentage-of-completion method (PCM) of accounting under Topic 605 (reporting contract revenues based upon the ratio of the cost incurred on the project to the total estimated cost), some of the changes to revenue recognition addressed by Topic 606 have been occasionally overlooked. One of those changes relates to materials that have been purchased for a specific project but have not yet been installed.² When examining the intricacies of Topic 606, it is easy to see how there can be a lack of understanding among construction contractors regarding what specifically qualifies as uninstalled materials.

One reason some contractors may not view uninstalled materials as a pertinent issue is because they typically buy materials as they use them. So when they apply the concepts of Topic 606, the amount of time it takes to install the material after it is received is so limited that the risk of a significant amount of uninstalled materials included in the cost-to-cost method is low. Also, most small- to mid-sized construction companies or independent contractors buy materials on a project-by-project basis and may view the uninstalled material guidelines as something that does not have a meaningful effect on their business since they already incurred the cost of the material.

However, in ASC 606-10-55-21, FASB specifically noted that a shortcoming of the PCM of accounting was that there may not be a direct relationship between the entity’s inputs (cost incurred) and the transfer of the good or service to the customer (satisfaction of the performance obligation). Certain types of contractors are more prone to this shortcoming than others.

A GC that subcontracts all the tasks in a project probably didn’t lose a lot of sleep thinking about Topic 606 and how to apply uninstalled materials in the PCM calculation; however, the contractor hired to build the elevator system probably did. While the purchasing agent who was able to get a deal on all the drywall isn’t thinking about the accounting ramifications, the financial professional should be thinking about whether the procurement of the drywall is:

• Cost incurred, which is considered progress toward satisfying the performance obligation under Topic 606;
• Cost incurred but uninstalled materials to exclude from the PCM calculation; or
• Inventory to be used on future backlog and not yet a cost of the contract.

Therefore, it is important to thoroughly understand the details surrounding the material used to complete any construction project. When assessing how to account for this material, the financial professional should understand the contract specifications — that is, whether the contract is unique and how this uniqueness can affect the timing of the revenue recognition.

The financial professional and project manager should be able to answer where the material is located and who owns it. The material may be earmarked for a certain job, but if it’s sitting in a warehouse (or even on the jobsite), then who technically owns the material and is responsible for it at that point in time? Has the customer already paid for the material and taken control? Is the material being used on the job highly specialized, of a higher cost, or have any other unique specifications that can change how revenue may be recognized?

Sometimes the project’s contract clarifies these details, but many times it does not. In fact, it’s possible to have the same exact material and amounts on two different jobsites, yet the material needs to be handled differently for each scenario.

Uninstalled Materials: Who Is Affected?

Any contractor that needs to purchase substantial materials for projects could potentially be affected by the intricacies of Topic 606 relating to uninstalled materials. Subcontractors may especially be affected due to the amount of materials they have on hand to assist contactors on jobs.

Consider the case of an electrical contractor that buys a significant amount of wire or a mason who purchases a large volume of bricks. Contractors that purchase more material than they need at the moment could potentially have to make adjustments to the cost-to-cost calculations due to having uninstalled materials. Those contractors that purchase limited quantities of materials for a specific, short-term project are less likely to be impacted.

The Intricacies of Uninstalled Materials: How Revenue Changes

Previously, when determining revenue recognition under Topic 605, a contractor would use all the costs incurred on the project, which ran through its job cost records and made progress to the extent the contract was complete. The uninstalled materials are not part of this cost and therefore excluded in revenue. However, under Topic 606, more information must be considered to determine how much progress has been made toward completion. In other words, how much of the contract value can be recognized as revenue? Sometimes the calculation is not as easy as it used to be.

Recognizing Uninstalled Materials in Calculations

In order to calculate revenue under ASC 606-10-55-189 and 190, it’s critical to understand that the amount of revenue to recognize is a combination of the progress completed and the uninstalled material. First, the contractor must identify the costs incurred but not yet installed and carve out the amount of uninstalled materials from the cost-to-date amount to determine costs incurred for the portion of revenue to recognize based upon the measurement of progress toward completion. Second, the cost of the uninstalled materials is added to determine the total amount of revenue recognized. Therefore, revenue recognized on uninstalled materials is recognized at a zero margin.

For a contractor with a significant amount of uninstalled materials, its work-in-progress (WIP) schedule can present job-to-date gross profit percentages that do not match the final estimated profit amount; this may take some getting used to. Some contractors may look at how to present their WIP schedules in a way that easily depicts the effects of uninstalled materials. Work with your accountant on the best way to present uninstalled materials on the WIP schedule.

A presentation that allows the users to recalculate the revenues earned on each project is recommended. Surety and banking relationships may have input on the presentation as well. And, overall, it is better to be upfront with the users than to explain at the last hour.