Continuing a six-part series, MorganFranklin’s Government Contracting Advisory Services (GCAS) team examines key considerations for government contractors as they navigate complying with federal contracting regulations. We also focus on establishing, evaluating, and enhancing internal controls within the confines of maintaining compliance.
In article five of our six-part series, we move on to one of the most important topics to both government contractors and their investors: the order-to-cash process from contract kick-off to revenue recognition. We will discuss the importance of an effective and efficient contract kick-off process, which must , ensuring contracts are appropriately set up within the accounting system, and how to handle contract modifications as they are issued to ensure an accurate and efficient revenue recognition process.
Key Compliance Consideration #1: Contract Kick-Off
Once a new contract award is won, this sets into motion a wide array of activities within an organization. These activities can range from administrative in nature (i.e., setting up a contract repository for the new award to ensure all important documents are stored together) to making key accounting decisions regarding the amount of performance obligations present within the contract and the appropriate timing of revenue recognition per ASC 606 and U.S. GAAP. Depending on the complexity of the contract awards, they can sometimes include multiple project setup and kick-off meetings broken down by Contract Line Item Numbers (“CLINs”), task orders (“TOs”), or option years. Decisions regarding the appropriate number and division of kick-off meetings should be made by program management and the contract should be examined from an ASC 606 perspective on a contract basis before being bifurcated into smaller projects. To ensure a successful contract kick-off and subsequent setup, an organization must ensure all relevant stakeholders are notified when a new award is won and further, all stakeholders are working together during this process.
Problems arise when there is a disconnect between the program and accounting point of views, which can result in inconsistent setup decisions being made across the organization.
How can the risk of an incorrect contract setup be mitigated?
A well-defined contract kick-off process which includes relevant decision makers within the set-up process is key to reducing the risk of incorrect contract setup. Typically, a successful contract kick-off and subsequent setup includes a kick-off meeting where members of the program team, accounting team, IT team, and administrative team, are present as deemed necessary by the program manager assigned to the new award. There are multiple inputs that are prepared prior to this meeting including:
- Contract Brief: A form that includes all pertinent data from the original contract document such as name, customer, period of performance, contract type, summary of goods and/or services to be provided, billing terms, etc.
- This form is typically completed by the program manager.
- ASC 606 Revenue Recognition Checklist: A checklist which goes through all five steps of the revenue recognition process per U.S. GAAP and concludes on the appropriate accounting treatment for each.
- This form is typically completed
- Contract Setup Form: A form which outlines the specific setup of the contract within the organization’s ERP system. This form will often include each individual contract line and the appropriate revenue and billing formulas for each.
- This form is typically completed by the Contracts Department.
It is imperative that organizations establish robust review and approval processes for the above-mentioned forms to ensure they are completed correctly. Often, these forms will shape the overall setup of a new contract within the Company’s systems and the revenue recognition pattern for multiple years.
Key Compliance Consideration #2: Contract Setup and ASC 606 Conclusions
After the initial contract kick-off meeting, special care needs to be taken to ensure the setup of the contract within the Company’s operating system aligns with the conclusions reached for revenue recognition in accordance with ASC 606 and follows the Company’s revenue recognition policy. Often, the individual inputting the contract information into the system and the individual reviewing and approving the ASC 606 conclusions are not the same. As such, setup decisions such as which revenue formulas and how many separate project lines to utilize can alter the way in which revenue is recognized each period.
For example, let’s say a new contract award is won and the following facts are present:
- The contract award is Firm Fixed Price (FFP) with six unique CLINs.
- The ASC 606 Checklist concludes that in the initial period of performance of the contract (for example, 1 year) there are two distinct performance obligations, both of which should have revenue recognized over time.
- The contract setup form indicates each CLIN will be set up in the system as a separate project line item and given a separate revenue formula.
In the example above, because the conclusion within the ASC 606 checklist notes two distinct performance obligations, the entity must apply a single method of measuring progress for each. However, if each CLIN setup within the system has a unique measure of progress, then the setup of the contract is in contradiction with the conclusions reached within the ASC 606 Checklist. Thus, revenue recognized on the contract from the system calculations may not be in accordance with U.S. GAAP.
How can the risk of misalignment between system setup and U.S. GAAP be mitigated?
It is imperative during the review and approval of the contract setup form and ASC 606 Checklist that all parties involved work to understand and evaluate the implications of the ASC 606 conclusions and how that must be applied to the contract system setup. A quality internal control that would help prevent this issue from arising is requiring the program finance lead or similar equivalent to review both the ASC 606 Checklist and the Contract Input Form. This individual should have a working knowledge of both U.S. GAAP and system setup to be able to evaluate whether the two forms are completed correctly and working in tandem to ensure appropriate revenue recognition. Further, for more complex contracts that require multi-level CLIN setup in the system and have multiple performance obligations, an additional level of review should be required which could include either the Director of Program Finance or the CFO of the Company depending on company size and contract complexity.
Key Compliance Consideration #3: Appropriate Accounting for Contract Modifications
Once a new contract award has been successfully set up within the system and all relevant revenue recognition conclusions have been reached, it can seem like all that is left to do is perform quality work and recognize hard-earned fees. However, contract modification accounting is a complex area of ASC 606 and needs to be given careful consideration, particularly for Government Contractors which often have long-term contracts with numerous modifications over their period of performance.
Contract modifications can range from simple funding or administrative modifications, which have no impact on revenue recognition, to complex expansion of scope and period of performance, which will require analysis including performance considerations, staffing levels, budgets and supply chain to conclude how the modification should be handled. Depending on the nature of the modification, ASC 606 may require an adjustment to revenue based on a change in an existing estimate-at-completion (“EAC”) or it may require an entirely new contract be set up with its own unique revenue recognition conclusions. Mistakes regarding the accounting for contract modifications are most often made when companies assume each modification is simply an extension of their existing work and do not perform the required analysis using proper accounting guidance to ensure the correct answer in accordance with U.S. GAAP, government contract rules & regulations, and contract terms and conditions adherence to avoid non-performance or non-conformance risks, potential additional liabilities, or potential false claims issues.
How can the risk of incorrect treatment of contract modifications be mitigated?
The easiest way to avoid incorrect treatment of contract modifications is to establish a detailed review process which requires a contract modification form to be prepared, reviewed and approved each time a modification is received. These forms can be created as a template to facilitate the numerous funding or administrative modifications that have no bearing on revenue recognition or impact on performance. On the other hand, they should also provide valuable guidance to program finance individuals on how to account for more complex contract modifications.
Another good tool for a company to employ is the creation of a decision tree for treating contract modifications. A decision tree is an easy-to-follow visual aid process flow that leads the preparer of the form through a series of questions that will help guide them to the correct answer from a U.S. GAAP perspective. These questions could include the following:
As shown above, the decision tree easily guides the preparer to the correct ASC 606 conclusion based on asking probing questions which get to the true nature of the contract modification.
Ensuring a process is in place for evaluating contract modifications when they are received will help prevent incorrect ASC 606 conclusions as it relates to contract modifications.
Revenue recognition is one of the most heavily scrutinized areas of accounting for all businesses. The consequences of incorrect revenue recognition can sometimes be severe as they usually result in adjustments and changes to forecasts moving forward.
From initial contract award and contract setup to each time a modification is received, to contract close out, it is important for a company to have the correct individuals involved to ensure all facets of the contract are being considered and appropriately set up within the business. Employing a variety of training, visual aids, and review type internal controls is vital in ensuring ASC 606 is applied correctly throughout a company’s complex contract portfolio.
How MorganFranklin Can Help
The MorganFranklin Government Contracting Advisory Services (GCAS) practice work with our clients to provide guidance to successfully contract with the Federal Government. We provide comprehensive and customized solutions including identification of the government contract risk profile; audit readiness assessments and ongoing audit support; DFARS business system compliance reviews; drafting, reviewing, and updating policies and procedures; and implementation of system transformation compliance controls to help businesses efficiently and effectively execute government contracts. MorganFranklin’s technical accounting solution center (TASC) assists our clients with conducting contract reviews for ASC 606 compliance, developing standardized forms for internal control use, and reviewing contract system setup to ensure consistency with revenue recognition conclusions. We have a portfolio of subject matter experts, most with over 20 years of relevant experience including former DCAA auditors, industry, and consultancy experience, that are ready to help you solve the most complex problems when contracting with the Federal Government.
Senior Manager, Accounting Advisory Services