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Common ASC 606 Issues: Aerospace & Defense Entities

Implementing ASC 606 requires a substantial amount of time and expertise, with specific challenges rising in each industry. Gain a deeper understanding of the key issues that A&D entities face as they transition to ASC 606.

Jeff Wilks
Chapman Ellsworth
Published:
Feb 3, 2018
Updated:

The contractual arrangements between aerospace and defense (A&D) entities and the United States Federal Government and foreign governments create many difficulties with revenue recognition. Due to the size and complexity of A&D contracts, there may be significant gaps of time between contract initiation, receipt of payment, and delivery of goods, which can impact when revenue may properly be recognized under ASC 606. The AICPA and major accounting firms have assembled industry task forces to research the accounting issues that arise with ASC 606, and we will draw from those guides to give you an idea of the issues A&D entities should expect. For more information on any of these guides, see:

We will also provide references to other RevenueHub articles for more detailed explanations of ASC 606 topics.

The following are issues that A&D companies commonly face:

1. Contract existence and related issues for foreign contracts with regulatory contingencies

There are two primary ways by which A&D entities do business with the United States Federal Government and foreign governments:  

  1. Foreign military sales (FMS)
  1. Foreign direct commercial sales (DCS)

FMS contracts are conducted between the US and foreign governments, and an A&D entity is brought in only after the governments have satisfied regulatory requirements. For FMS contracts, the idea of existence of a contract as defined by ASC 606 is never in question because work does not begin until regulatory requirements are satisfied.

In contrast, DCS contracts between an A&D entity and foreign government(s) are unusual in that they require regulatory approval—something not guaranteed—which normally takes place after work on the contract has commenced. This uncertainty surrounding contract approval could suggest that the criteria in ASC 606-10-25-1 for contract existence are not met. Judgment is needed to determine if the likelihood of regulatory approval is high enough to merit the recognition of a contract on a contract-by-contract basis.

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2. Unfunded portions of US Government contracts

A&D contracts depend heavily on the US Federal Government’s annual budget process, which often results in projects that are funded incrementally rather than all at once. Consequently, within one long-term A&D contractual agreement, it is very likely that a portion of the contract has already received funding from the government, while the rest is subject to budgetary reviews in subsequent years. Multiple applications of ASC 606 may be appropriate, depending on the situation, but the unfunded portion of a contract is normally treated as variable consideration.

Per ASC 606-10-32-11, an entity should only include the amount of variable consideration for which it is probable that a significant reversal of revenue recognized to date will not occur. Consequently, the A&D entity would need to evaluate the unfunded portion of its government contracts to determine the likelihood of that portion being funded in the future (and thereby not reversing any present recognition of revenue). If the A&D entity considers it probable—based on prior experience, lobbyist interactions, etc.—that all, or some, of the unfunded portion of the contract will be funded in the future, that amount should be included in revenue.

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3. Contract modification, unpriced change orders, claims

It is not uncommon in large A&D contracts for changes in product specifications to be issued before a change in pricing has been approved (even when it is likely that the contract will be finished before the final pricing can be approved). Under ASC 606, a contract modification is only treated as a separate contract if it results in a new performance obligation, with a price that reflects the standalone selling price of that new obligation. If a modification does not create a new performance obligation, it is treated as an adjustment to the original contract. This means that in typical A&D arrangements, the modification may create a new performance obligation or change an existing performance obligation without a commensurate increase in the overall transaction price of the contract.

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4. Impact of customer termination rights and penalties on contract term

A&D contracts with the US Federal Government often contain a “termination for convenience” clause that, per Federal Acquisition Regulations (FAR) 52.249-1, allows the Federal Government to “terminate [the] contract, in whole or in part, when it is in the Government’s interest.” This unilateral right to a contract termination creates some uncertainty regarding the existence of a legally binding contract. However, the Transition Resource Group (TRG) of the FASB determined that the legally enforceable contract period should be considered the contract period, thus suggesting that it is permissible to have a contract even when a termination for convenience clause exists.

After a termination for convenience takes place, FAR 49.201(a) directs that “[a] settlement should compensate the contractor fairly for the work done and the preparations made for the terminated portions of the contract, including a reasonable allowance for profit. Fair compensation is a matter of judgment and cannot be measured exactly.”

The enforceable right to payment for work completed plus profits helps to validate the existence of a contract because, according to ASC 606-10-20, a contract is defined as “[a]n agreement between two or more parties that creates enforceable rights and obligations.” ASC 606-10-55-11 explains that the profit margin paid in the event of a contract termination “need not equal the profit margin expected if the contract was fulfilled as promised.”

5. Accounting for offset obligations

Offset obligations are frequently added to A&D contracts between the seller (the A&D contractor) and the buyer (often a foreign government). These offset obligations often represent performance obligations from the contractor requested by the buyer, and do not have to be directly related to the main product or service produced in the A&D contract to be accounted for as such. For example, the A&D contractor may agree to work with a company within the foreign buyer’s country as a condition of the original contract in order to supply 100 fighter jets to the country. The work with that foreign company is not directly related to the A&D contract, but it is a distinct performance obligation that must be satisfied by said contract.

The parties to the transaction will need to identify if the offset obligation represents a distinct performance obligation in accordance with ASC 606-10-25-14 and ASC 606-10-25-19. If the offset is found to be distinct, then the A&D contractor would allocate an appropriate amount of revenue to that obligation. Comparatively, if the offset is not found to be distinct, it should be bundled with other obligations within the contract until it forms a distinct bundle.

For many A&D contracts, the offset obligations come with an associated penalty if the contractor fails to comply. If the contractor decides to pay the penalty, it would be a consideration payable to the customer.

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6. Variable Consideration and constraining estimates of variable consideration

A&D contracts often include incentives for effective project cost management as well as timely production of the contracted goods. These fees are contingent upon the performance of the contractor, and do not represent guaranteed consideration at the time of contract signing. As such, these incentives are considered variable consideration and are subject to requirements outlined by ASC 606-10-32-5 through 32-14.

Examples of A&D specific variable considerations are award fees, claims, cost incentives or penalties, economic price adjustments, billing rate adjustments, performance incentives or penalties, price adjustment or redetermination clauses, and unpriced change order.

The A&D entity must determine either the expected value or most likely amount it is to collect in exchange for meeting its performance obligations.

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Curtiss Wright Corp (SEC Correspondence Nov. 2018): Variable Consideration
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Curtiss Wright Corp, an aerospace manufacturing company and service provider, engaged in dialogue with the SEC, addressing Comment 1, which queried their approach to estimating revenue involving incentives, awards, price escalations, liquidated damages, and penalties in their contracts. The SEC requested expanded disclosures, specifically seeking clarity on whether the consideration in their contracts is deemed variable and whether such consideration is typically constrained, as well as details regarding the methods, inputs, and assumptions used for estimating variable consideration, citing ASC 606-10-50-12(b) and ASC 606-10-50-20.

Comment 1:

“Given you have historically considered incentives, awards, price escalations, liquidated damages and penalties related to performance on contracts in estimating revenue, please expand your disclosures to highlight whether any of the consideration in your contracts is considered variable and whether such consideration is typically constrained. Your disclosures should also highlight the methods, inputs and assumptions used for estimating any variable consideration. See ASC 606-10-50-12(b) and ASC 606-10-50-20.”

In response, Curtiss Wright Corp acknowledged the SEC's comments and committed to enhancing future disclosures in their 2018 Form 10-K. They detailed their revenue recognition process under ASC 606, emphasizing the incorporation of variable consideration—like incentives, awards, price escalations, liquidated damages, and penalties—into the transaction price. However, such consideration would only be recognized if a significant reversal of cumulative revenue was improbable. The company outlined their methodology for estimating variable consideration, employing either the expected value or most likely amount method based on current facts, historical data from similar arrangements, and assured that variable consideration typically remains unconstrained.

Moreover, in acknowledging the responsibilities associated with the disclosure in their filings, Curtiss Wright Corp noted the SEC's comments do not preclude potential actions by the Commission under federal securities laws, asserting their accountability for the accuracy and adequacy of the provided disclosures.

7. Significant financing component

A&D contracts often include a significant financing component because the A&D entity receives payment in advance of the transfer of the finished good to the customer. When a significant financing component exists, the entity is required to adjust the transaction price for the time value of money. However, a practical expedient does exist (ASC 606-10-32-18) that would permit an A&D contractor to not account for a significant financing component if the entity expects to transfer the good or service and receive payment within one year.

ASC 606-10-32-15 and 32-16 state that the following factors may suggest a significant financing component exists: (a) there is a difference between the amount a customer would pay for the good/service (i.e., the performance obligation) in cash at or during transfer of control of the good or service versus what the customer promises to pay, (b) there is a large time difference between when the good/service is delivered and when the customer pays, or (c) it is the contractor’s intent to provide a financing component in the agreement. These conditions require judgment on the part of the A&D contractor, as certain timing differences in payment may not actually reflect a significant financing component. For example, if a contract is written such that the customer provides payment as progress is made on the performance obligation, this would generally indicate that there is not a significant financing component.

8. Allocating the transaction price

ASC 606 puts forth many different acceptable methods by which the transaction price may be allocated to distinct performance obligations within a contract, depending on the situation. ASC 606-10-32-32 states that “the best evidence of a standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers.” However, in many A&D contracts, the Federal Government may be the only customer for the goods and/or services being provided, which necessitates a different way of determining the standalone selling price.

Some of the alternative ways to determine the standalone selling price that may be appropriate are the expected cost-plus-margin approach, the adjusted market assessment approach, and the residual approach.

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9. Acceptable measures of progress

ASC 606-10-25-33 specifies two ways to measure progress in a contract: the output method and the input method. A&D contracts are unique in that often, especially with the US Federal Government, they contain termination for convenience clauses, which allow the customer to cancel a contract whenever it is deemed necessary. As previously stated, termination for convenience clauses usually specify that the contractor will recover all incurred costs as well as an allowance for a profit. Additionally, the Federal Government usually retains the right to all goods—both complete and in process—that were part of the contract.

In these circumstances, with a termination for convenience clause, an output method based on units produced or delivered would not accurately measure the progress in the contract, because the customer may have effective control of all the goods in progress as well as those that are finished. As such, an input method would be more appropriate—such as the cost-to-cost method.

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United Technologies Corporation (SEC Correspondence Sep. 2018): Acceptable Measures of Progress
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United Technologies Corporation (UTC) specializes in the design, manufacture, and service of innovative aerospace technologies, building systems, and industrial products. Through its various divisions, UTC develops cutting-edge solutions for aircraft engines, aerospace systems, elevators, HVAC systems, and security systems, contributing significantly to advancements in aviation, defense, and building infrastructure worldwide.

The SEC sought clarity in a comment letter on UTC's revenue recognition methods for specific contracts, particularly regarding the measurement of progress within these arrangements under ASC 606, highlighting a discrepancy between the disclosed percentage-of-completion basis and UTC's statements about over-time revenue recognition.

UTC responded to the SEC by explaining they recognize revenue over time for various contracts, using an input method based on costs incurred relative to total estimated costs. This method aligns with transferring control to the customer, reflecting work performed. They clarified using this method due to simultaneous receipt and consumption of services, asset creation, or specialized product production. UTC committed to enhancing future disclosures to explain their revenue recognition method and its fidelity in representing goods and services transfer. They highlighted changes due to ASU 2014-09 adoption, recording approximately $220 million in unrecognized sales related to ongoing contracts but don't anticipate significant revenue differences.

10. Transfer of control to non-US Federal Government contracts

A&D contracts can vary greatly from custom system manufacturing to ongoing maintenance service agreements. Consequently, it is possible that the performance obligations in an A&D contract may be satisfied at a point in time or over a period of time (assuming the obligation meets the qualifications in ASC 606-10-25-27 for over-time recognition). This determination depends, in large part, on whether the entity or the customer controls the assets that are produced throughout the life of the contract. Some A&D contracts create assets that are controlled by the A&D contractor, and have alternative uses, but others—due to regulatory restrictions, or extensive customization—do not. If control resides with the contractor, revenue is typically not recognized until that control passes to the customer. If, however, the customer does retain control over assets during the manufacturing process, revenue is typically recognized throughout the manufacturing process.

Kaman Corporation (SEC Correspondence Sep. 2018): Revenue Recongnition Timing
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Kaman Corporation is an American aerospace company specializing in engineering and selling helicopters, airplane parts, and other aerospace-related materials. In response to an SEC comment letter regarding its Form 10-Q for the period ended June 29, 2018, Kaman Corporation described its reasoning for recognizing revenue on K-MAX aircraft at a point in time rather than over a period of time:

The Company determined we would recognize revenue at a point in time under ASC 606 for each of our K-MAX® contracts. Based on the criteria in ASC 606-10-25-30, the Company determined that its performance obligations for K-MAX® aircraft are satisfied at the point in time that each aircraft is accepted by the customer as the customer obtains control of the asset at that point in time.

After evaluating the three criteria in ASC 606-10-25-27, Kaman determined that it would not need to recognize revenue over a period of time for the following reasons:

  1. Kaman’s customers did not receive any benefit as it completed its performance
  2. Kaman’s performance did not create or enhance an asset that the customer controls as the asset was created or enhanced
  3. Kaman does not have an enforceable right to payment for performance on a completed date, and the performance creates an asset that is not highly specialized or unique, thus giving it alternative use to Kaman.

On the third point, Kaman argued this about a customized asset:

We noted that the customization of the aircraft typically reflects certain additional equipment and services, but minimal customization to the underlying base aircraft. This would allow the aircraft to be redirected to another customer contract with minimal cost of re-work. Moreover, we are not restricted contractually from redirecting the aircraft to another customer.

Because Kaman Corporation’s operations do not meet any of the three criteria, they claimed they could recognize revenue at a point in time rather than over the period of time when the aircraft was under construction, even though Kaman has control over the asset throughout the manufacturing process.

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11. Accounting for contract costs

An A&D entity can incur many costs to obtain a contract with the US or a foreign government. Under the new standard, companies are required to capitalize and amortize the incremental costs to obtain and fulfill a contract (e.g., sales commission). The costs of obtaining a contract are recognized as an asset if the entity expects to recover them, but a practical expedient exists that allows entities to immediately expense the costs if they would have been fully amortized in one year or less. The A&D entity should only capitalize and amortize the costs to fulfill a contract if the costs (1) relate directly to a specific contract, (2) generate or enhance resources that will be used to satisfy performance obligations in the future, and (3) are expected to be recovered by the entity. The costs that the entity capitalizes should be amortized as the entity transfers goods or services to the customer.

Astronics Corporation (SEC Correspondence Oct. 2018): Capitalization of Contract Costs
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Astronics is a company based out of New York that is known for lighting and electronics integrations on military, commercial, and business aircraft and semiconductor test systems. The SEC commented on Astronics’ Form 10-K for the Fiscal Year Ended December 31, 2017, asking about the capitalization of costs to obtain a contract.

Astronics determined it should only capitalize and amortize costs to fulfill a contract if the costs meet the criteria specified in ASC 340-40-25-5, which requires that the costs:

  1. Relate directly to a specific contract,
  2. Generate or enhance resources that will be used to satisfy performance obligations in the future, and
  3. Are expected to be recovered by the entity.

Astronics capitalized mobilization, design, and engineering expenses associated with anticipated contracts because they were directly associated with specific contracts, they enhanced resources for future performance obligations, and the recoverability of those capitalized costs was deemed probable as the contracts were fulfilled. Because these expenses met the three criteria in ASC 40-40-25-5, Astronics capitalized and amortized these costs.

Although Astronics capitalized some pre-contract costs, it expensed in the period incurred costs associated with obtaining contracts with a customer, such as sales commissions, that would be fully amortized in one year or less. Astronics replied to the SEC, “The period of benefit for each commission is less than one year, and such costs are expensed as each purchase order is satisfied based on the practical expedient included within ASC 340-40.”

Astronics’ application of ASC 606 aligns well with the guidance on a company’s ability to capitalize or expense costs related to obtaining a contract.

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Conclusion

It is likely that many other issues and questions will arise within the A&D industry as entities transition to the new revenue recognition standard. This article has provided a starting point for your research into some of the common issues anticipated by industry experts, but you should check back for updates as they become available. Feel free to reach out with any questions that you have. Additionally, see our other industry-specific RevenueHub articles for more information about the complexities of transitioning to ASC 606.

Footnotes
Jeff Wilks
Chapman Ellsworth
Feb 3, 2018