ASC 606 for Construction: Percentage-of-Completion in the New World, and What the Auditor Will Test

The standard, the contract, and the documentation gap ASC 606 (Revenue from Contracts with Customers) became operative for nonpublic mid-market construction firms in fiscal years beginning after December 15, 2018, replacing the construction-specific guidance that had governed percentage-of-completion accounting since the early 1980s. The transition was nominally clean, most construction firms continued to recognize revenue on a percentage-of-completion basis using cost-to-cost as the input method, and the headline financial-statement impact was modest at adoption. The headline cleanliness obscured the more consequential change: ASC 606 restructured the supporting documentation the auditor expects to see, and the auditor's testing methodology has evolved over the seven-plus years since adoption to probe the documentation in ways the prior standard did not. The construction firms we audit, when we are engaged on a back-office diagnostic or as a third-party reviewer ahead of a sponsor-side investment, almost always have an application of ASC 606 that is mathematically reasonable and documentationally thin. The percentage-of-completion calculations are correct. The cost-to-cost ratios tie to the WIP. The earned revenue lines up with the financial statements. What is missing is the contract-level analytical workpaper, the document that walks through the five-step model for the specific contract, identifies the performance obligations, names the input method and justifies the choice, treats the variable-consideration components, and addresses the contract-modification mechanics if the contract has been modified. The auditor reads the workpaper before they read the math, and a workpaper that does not exist or is generic-template-grade produces the audit findings that show up in the management letter year after year. This guide covers the five-step model adapted to construction contracts, the single-versus-multiple performance-obligation analysis that drives most of the application complexity, the input-method justification, the variable-consideration treatment for change orders, claims, and liquidated damages, the contract-modification mechanics, and the audit-side testing that the construction CFO and controller should anticipate. The principles are familiar to anyone who has read the standard; the application discipline is what separates a clean audit from a year of follow-up requests. The discipline pairs with the WIP schedule for bonding-side review, the WIP and the ASC 606 documentation are read together, and weakness in either surfaces in both. The five-step model adapted to construction ASC 606's five-step model, identify the contract, identify the performance obligations, determine the transaction price, allocate the price to the obligations, recognize revenue as the obligations are satisfied, applies cleanly to construction once the construction-specific judgments at each step are made explicitly and documented. The construction firms whose applications survive audit are the firms whose policy memos walk through the five steps for each material contract type the firm enters; the firms whose applications produce findings are the firms whose memos treat the five steps as a checklist rather than as analyses. Step 1: identify the contract. A construction contract under ASC 606 is identified when the parties have approved the contract and are committed to performing, the rights of each party are identifiable, the payment terms are identifiable, the contract has commercial substance, and collection of consideration is probable. For most construction contracts, lump-sum, cost-plus, design-build, T&M, these criteria are met at contract execution and the analysis is brief. The complications appear with letters of intent, notice-to-proceed agreements before formal contract execution, and contracts with substantial change-order activity that effectively renegotiates the terms. The policy memo for each contract type addresses the contract-identification timing explicitly: when does the firm consider the contract to exist for ASC 606 purposes, what documentation is required, and how is pre-contract work treated if the firm proceeds at the customer's request before formal execution. Step 2: identify the performance obligations. This is where the most consequential judgment in construction-revenue accounting lives, and where the application most often produces audit findings. ASC 606 requires the firm to identify each distinct good or service in the contract, distinct meaning the customer can benefit from it on its own and it is separately identifiable from other promises in the contract, and to treat each as a separate performance obligation. The application question for construction is whether the typical construction contract represents one performance obligation (the overall delivery of a complete project) or multiple performance obligations (separately identifiable deliverables within the project). The conclusion most construction firms reach, and that is supported by ASC 606's "series of distinct goods or services" guidance and the construction-industry interpretive practice, is that most construction contracts represent a single performance obligation: the integrated delivery of a complete project. The argument is that the individual elements of a construction project, site preparation, structural work, MEP, finishes, commissioning, are not distinct in the context of the contract, because the customer cannot benefit from the structural work alone without the rest of the project, and the firm's obligation is to deliver the integrated whole. Under this conclusion, a single percentage-of-completion calculation for the whole contract is appropriate. The conclusion is not always that the contract is a single performance obligation, and the policy memo must address when multiple obligations apply. The most common multi-obligation pattern in mid-market construction is a contract that includes a distinct equipment-supply or material-supply component alongside the construction services, for example, a mechanical contractor whose contract includes both the supply of major equipment and the installation, where the equipment is separately specified, separately priced, and could be supplied by the customer or a third party. Other multi-obligation patterns include design-and-build contracts where the design is a distinct deliverable, contracts with separate phases that the customer can use independently (a campus build-out where building one becomes operational before building two starts), and warranty obligations that extend beyond standard assurance warranties. The policy memo names the criteria the firm uses to evaluate multi-obligation treatment and applies the criteria contract by contract; the memo also documents the firm's typical conclusion (single obligation) and the conditions under which the firm departs from it. Step 3: determine the transaction price. The transaction price is the consideration the firm expects to be entitled to in exchange for the performance obligations, and it includes both fixed and variable consideration. For a construction contract, the fixed consideration is the contract value as initially set; the variable consideration is the change orders, claims, liquidated damages, performance bonuses, and any other components whose amount is not fixed at contract inception. The variable-consideration treatment is the second-most-consequential judgment in construction-revenue accounting, and it deserves separate treatment in section four of this guide. Step 4: allocate the transaction price to the performance obligations. For a single-performance-obligation contract, allocation is trivial, the entire transaction price is allocated to the one obligation. For a multi-obligation contract, the price is allocated based on the standalone selling price of each obligation, with the residual or other allocation methods used when standalone selling prices are not directly observable. The policy memo for a firm that enters multi-obligation contracts addresses the standalone-selling-price methodology explicitly: how the firm determines standalone selling price for an obligation that does not have a directly observable market price, what data sources the firm uses, and how the allocation is documented in the contract-level workpaper. Step 5: recognize revenue as the performance obligations are satisfied. For most construction contracts, the performance obligation is satisfied over time rather than at a point in time, because the firm's performance creates an asset that the customer controls as it is created (real property attaches to land owned by the customer) or because the firm's performance does not create an asset with alternative use to the firm and the firm has an enforceable right to payment for performance completed to date. The over-time conclusion drives percentage-of-completion treatment; the policy memo must justify the over-time conclusion contract-by-contract or by contract type. Input method versus output method ASC 606 permits both input and output methods for measuring progress on an over-time performance obligation, and the methods produce different recognition patterns from the same underlying contract economics. The construction industry has overwhelmingly adopted the cost-to-cost input method, measuring progress as costs incurred to date divided by total estimated costs, because the method aligns with the firm's job-cost ledger, ties to the WIP schedule, and produces a recognition pattern that approximates the customer's consumption of the asset being built. The cost-to-cost input method is appropriate when costs incurred faithfully represent the firm's progress toward satisfying the performance obligation. The method's mechanics are straightforward: the percentage of completion is costs incurred to date divided by total estimated costs at completion, and the earned revenue is the percentage multiplied by the transaction price. The discipline lives in the denominator, total estimated costs, because the percentage moves with both the numerator and the denominator, and a stale or unrefreshed denominator distorts the percentage independently of the costs incurred. We treat the project-manager estimate-refresh discipline that maintains an accurate denominator in detail in our WIP schedules guide; the discipline is the same whether the WIP is read by the bonding agent or by the auditor. The cost-to-cost method has two specific application traps that the policy memo should address. The uninstalled-materials trap. Materials procured for a job but not yet installed have been paid for, are sitting in costs incurred to date, and would inflate the percentage of completion if treated mechanically. ASC 606 requires that uninstalled materials be excluded from the cost-to-cost calculation when they do not represent progress on the performance obligation, with the firm recognizing revenue equal to the cost of the materials with zero margin (a practice sometimes called the "zero-margin" or "input-method-with-uninstalled-materials" treatment). The policy memo addresses how the firm identifies uninstalled materials, when they are excluded from the percentage-of-completion calculation, and how the zero-margin recognition is documented. The mobilization and bonding-cost trap. Mobilization costs and bonding costs incurred at the start of a job inflate the percentage of completion in the early periods if treated as cost-to-cost inputs without adjustment. Some firms include them; some firms exclude them; some firms capitalize them and amortize over the contract life. The policy memo names the firm's treatment, justifies the choice, and applies it consistently. Inconsistent treatment across contracts is what the auditor catches. The output method, measuring progress based on units produced, milestones achieved, or surveys of work completed, is occasionally used for construction contracts where output is more directly observable than cost incurrence. Unit-price contracts for road construction or pipeline installation, where the contract specifies a price per linear foot or per unit and the firm bills on the basis of units installed, can support an output-method recognition. The application is rare in mid-market commercial and residential construction because the cost-to-cost method aligns better with the firm's existing operations. When a firm uses output method for some contracts and cost-to-cost for others, the policy memo justifies the differential treatment by contract type. Variable consideration: change orders, claims, liquidated damages Variable consideration is the component of the transaction price that is not fixed at contract inception. For a construction contract, the most common variable-consideration components are approved change orders, unapproved change orders and claims, liquidated damages and other penalty provisions, and performance bonuses. ASC 606 requires the firm to estimate variable consideration using either the expected-value method (probability-weighted estimate across possible outcomes) or the most-likely-amount method (single most likely amount), and to include the estimate in the transaction price only to the extent it is probable that a significant reversal will not occur when the uncertainty is resolved. The "probable, no significant reversal" constraint is the single most consequential discipline in variable-consideration treatment, and it is where most audit findings on construction revenue recognition originate. Approved change orders are the cleanest variable-consideration item. Once a change order has been approved by the customer in writing, typically via an AIA G701 Change Order or equivalent contract modification, the change-order amount is a contractually committed addition to the transaction price, and the firm includes it in the price as of the approval date. The policy memo addresses how approval is evidenced (signed change order, written email approval, owner's representative authorization) and the timing of recognition (the period in which approval is received, with retrospective adjustment to the percentage-of-completion calculation as needed). We treat the change order management discipline as a separate guide; the documentation discipline upstream of the recognition decision is what makes the recognition defensible. Unapproved change orders and claims are the variable-consideration component where most audit findings live. The firm has performed work that the customer has authorized informally or that the firm believes is owed under the contract, but the customer has not approved a contract modification. The firm's accountants must estimate whether the consideration will be received and to what extent, applying the "probable, no significant reversal" constraint. The conservative practice, and the practice that survives audit cleanly, is to include unapproved-change-order or claim revenue in the transaction price only when the firm has documented evidence that approval is highly likely (a written acknowledgment of the work, a customer's representative's authorization, a pattern of similar past approvals on the same contract) and the amount is reasonably estimable. Recognition of claim revenue at full claimed value before any documented basis for collection is the most common ASC 606 audit finding we identify in construction firms. The policy memo for unapproved-change-order and claim treatment names the documentation criteria the firm requires before any recognition, the percentage of the claimed amount the firm recognizes (often 0% until documentation criteria are met, then a probability-weighted percentage as approval becomes more likely), and the controller's review-and-approval process before any recognition is recorded. The memo also addresses how the firm handles disputed claims that have been pending for extended periods, at some point a claim becomes a contingent asset that should be disclosed but not recognized. Liquidated damages are negative variable consideration. A contract with a liquidated-damages clause for late completion creates the possibility of a price reduction that depends on the firm's performance. The firm must estimate the liquidated damages it expects to incur and reduce the transaction price by the estimate, again applying the "probable, no significant reversal" constraint. A firm that is on schedule with a strong delivery track record may estimate zero liquidated damages; a firm that is behind schedule and where the schedule recovery is uncertain must estimate the damages and reduce the transaction price accordingly. The policy memo addresses the schedule-risk evaluation that drives the liquidated-damages estimate. Performance bonuses are positive variable consideration tied to early completion, quality milestones, safety performance, or other metrics. The firm estimates the expected bonus using the same probable-no-significant-reversal constraint and includes the estimate in the transaction price when warranted. Performance bonuses are often more certain than claims because the bonus criteria are objectively measurable (completion date, safety incident rate), but the constraint still applies, and the memo addresses the supporting analysis. Contract modifications Construction contracts are frequently modified during their life. ASC 606 distinguishes between modifications that should be treated as separate contracts, modifications that should be treated as terminations of the existing contract and creation of a new contract, and modifications that should be treated as continuations of the existing contract with prospective or cumulative-catch-up accounting. The treatment depends on whether the modification adds distinct goods or services and whether the additional consideration reflects the standalone selling price of those goods or services. A modification that adds distinct goods or services at standalone selling price is treated as a separate contract. A change order that adds an entirely new building element (a separate equipment installation, an unrelated scope addition) at a price that reflects what the firm would charge for that work as a standalone engagement is a separate contract; the existing contract continues unchanged, and the new contract is accounted for from its inception. A modification that does not add distinct goods or services, or adds them at a price that does not reflect standalone selling price, is accounted for as a modification to the existing contract. The firm reassesses the contract as a whole, recalculates the percentage of completion using the modified transaction price and modified estimated costs, and recognizes a cumulative catch-up adjustment in the period of the modification. Most construction change orders fall into this category because they are integral to the project, and the price reflects the project context rather than standalone selling price. A modification that terminates the existing contract, for example, a master agreement that is replaced by a new agreement on materially different terms, is treated as a contract termination, and the new contract is accounted for from its execution date. This pattern is uncommon in normal construction practice but appears in cases of bankruptcy reorganization, owner replacement, or fundamental project restructuring. The policy memo addresses the modification framework explicitly, with examples drawn from the firm's typical change-order activity. The most common application failure we see is treating every change order as either a separate contract (which inflates revenue when the change-order price is not standalone-comparable) or as a continuation with cumulative catch-up (which can produce volatile period-over-period results when the modifications are large). Neither blanket treatment is correct; the analysis is contract-by-contract, and the memo provides the framework that lets the controller apply it consistently. What the auditor will test The audit-side testing of construction revenue recognition under ASC 606 has matured since the standard's effective date. The auditor, whether a regional firm, a national firm, or one of the larger firms, applies a consistent testing approach, and the construction CFO who anticipates the testing produces documentation that survives the testing without re-work. The testing is built around four areas. Contract sample selection and walk-through. The auditor selects a sample of contracts from the active and closed populations, weighted toward larger contracts and contracts with unusual features (multi-year terms, significant change-order activity, claims, distinct phases). For each sampled contract, the auditor walks through the five-step analysis: did the firm identify the contract correctly, did the firm identify the performance obligations correctly, did the firm determine the transaction price correctly including the variable-consideration analysis, did the firm allocate the price correctly across obligations, and did the firm recognize revenue correctly using the appropriate method. The walk-through requires the contract-level workpaper that ties to the contract document, the policy memo, the WIP schedule, and the recognized revenue in the GL. Variable-consideration estimate testing. The auditor tests the firm's estimates of variable consideration, change orders, claims, liquidated damages, performance bonuses, by examining the supporting documentation, comparing estimates to subsequent outcomes, and assessing whether the "probable, no significant reversal" constraint has been applied. The testing surfaces firms whose estimates are systematically optimistic (claims recognized at full value that subsequently settle at 30 cents on the dollar) and firms whose estimates are systematically conservative (zero liquidated damages estimated on contracts that incur penalties). The construction CFO whose estimates have a documented track record and a clear methodology produces a defensible position. Contract-modification testing. The auditor selects a sample of change orders and contract modifications and tests whether the firm has applied the modification framework correctly, separate contract, termination and new contract, or continuation with cumulative catch-up. The testing requires the change-order log, the contract-level analytical workpaper, and evidence of the controller's review of the modification treatment. Firms that treat every change order mechanically as either a separate contract or a continuation, without the analysis, produce findings. Estimate-to-complete testing. Although estimate-to-complete is upstream of the percentage-of-completion calculation, the auditor tests it because it drives the recognized revenue. The testing examines whether the project-manager estimates are refreshed monthly, whether the controller reviews material movements, and whether the prior-period estimates compare reasonably to subsequent actuals. The testing ties directly to the WIP discipline and to the job cost discipline; a construction firm whose job-cost discipline is weak produces estimate-to-complete data that the auditor cannot rely on, and the audit findings cascade. The most common findings we see across the firms we audit, in approximate frequency order: revenue recognized on uncosted change orders without variable-consideration support; claim revenue recognized at full value before any documented basis for collection; multi-performance-obligation contracts treated as single obligations because the analysis was not done; estimate-to-complete unrefreshed for multiple periods; and contract-level workpapers that do not exist or are template-grade rather than contract-specific. Each finding is preventable with the documentation discipline this guide describes. What we recommend ASC 606 application for construction is a documentation problem more than a calculation problem. The math is well-understood; the audit-side expectations have stabilized; the application failures we see are failures of the analytical workpaper, not of the underlying accounting. We recommend three actions for any construction CFO or controller who wants to evaluate whether the firm's ASC 606 documentation will survive audit. Build a contract-level analytical workpaper for the next ten contracts the firm enters. The workpaper walks through the five-step model, documents the performance-obligation analysis, justifies the input method, treats the variable-consideration components, and addresses any modifications. It ties to the contract document, the WIP, the change-order log, and the GL. After ten contracts, the firm has a template that the controller's team can apply to all future contracts; before ten contracts, the firm has a documentation gap that the auditor will keep finding. Refresh the firm's ASC 606 policy memo annually. The memo is not a one-time document. It addresses the firm's contract types, the typical performance-obligation conclusions, the input-method choice, the variable-consideration framework, and the contract-modification framework. It is reviewed by the CFO and signed annually, and it is updated when the firm enters a new contract type or when interpretive guidance evolves. The annual refresh forces the conversation about whether the firm's application has drifted, and the memo becomes the document the auditor reads first. Run a six-month look-back on variable-consideration estimates. Compare the variable-consideration estimates the firm recorded six months ago to the actual outcomes that have since materialized. Calculate the average accuracy. The look-back surfaces whether the firm's estimating discipline is systematically optimistic, conservative, or accurate, and the result feeds back into the controller's review process. A firm whose variable-consideration estimates have a documented track record produces a position that survives audit; a firm whose estimates have no track record produces a year of follow-up requests. The ASC 606 Construction Policy Memo Template paired with this guide includes the five-step framework adapted to construction contract types, the performance-obligation decision tree, the input-method justification framework, the variable-consideration estimation methodology, the contract-modification decision tree, and the contract-level analytical workpaper template. It is the reference set we install when we engage with construction firms on the Build-Construction-Back-Office Diagnostic, and it is paired with the WIP schedules and change order management guides to address the documentation set the auditor reads together. The construction firms whose audits run cleanly, whose management letters do not carry recurring revenue-recognition findings, whose auditors complete fieldwork on time, whose financial statements are issued on schedule, are not the firms with the most sophisticated accounting systems or the deepest finance teams. They are the firms whose documentation discipline is exhaustively applied to every contract, whose policy memos are refreshed and current, and whose controllers can hand the auditor a contract-level workpaper that walks through the five-step model without prompting. The discipline is not expensive. It is the difference between an audit that surfaces real issues for the firm to address, and an audit that surfaces documentation gaps the firm should have closed before fieldwork began.