INSIGHT

ASC 606 revenue recognition: What government contractors need to know

Jeff Dietrich • October 27, 2025

If you’re a government contractor, you already know that revenue recognition isn’t straightforward. Between multi-element deliverables, variable fees, and the maze of FAR and DFARS regulations, applying ASC 606 (Revenue from Contracts with Customers) requires careful attention to detail.

Whether you’re working on U.S. federal contracts, Direct Commercial Sales (DCS), or Foreign Military Sales (FMS), understanding how ASC 606 applies to your specific situation can prevent costly missteps. Here’s what you need to know to get it right.

Why government contracts make revenue recognition complicated

Government contracts rarely fit into neat boxes. You’re often dealing with bundled products and services, option years, contract modifications, and funding that arrives in phases. Each of these elements affects how and when you recognize revenue under ASC 606’s five-step model.

The stakes are high. Misidentifying a performance obligation or incorrectly estimating variable consideration can lead to misstated financials, audit findings, and compliance issues. Let’s break down the key complexities you’ll face.

Bundled deliverables require careful analysis

Consider a defense contract that provides for the delivery of an aircraft, along with the initial setup efforts and training activities. Is this one combined performance obligation or three separate ones? The answer depends on whether these components are “distinct within the context of the contract”—a critical ASC 606 criterion.

If the customer could benefit from the training services on their own, especially when those services could be provided by another 3^rd party provider, you may have separate obligations. If the components are highly interrelated and integrated (e.g. this is training provided for the initial operation of the aircraft), they may constitute a single obligation. Getting this determination wrong leads to revenue misallocation across your contract timeline.

Customer options can create hidden performance obligations

Government contracts frequently include option years or follow-on purchase rights for additional units or services. Under ASC 606, if an option provides a material right—such as a significant discount the customer wouldn’t receive without the original contract—you must treat it as a separate performance obligation.

This effectively creates a deferred revenue component that you’ll recognize when the customer exercises the option. Contract modifications add another layer of complexity. Each change order or supplemental agreement requires analysis to determine whether it:

Adds new performance obligations
Alters the existing contract scope
Changes the transaction price

How you account for the modification (as a separate contract, cumulative catch-up adjustment, or prospective change) depends on this assessment. Auditors regularly flag inconsistent handling of similar contracts as a red flag.

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Variable consideration is the rule, not the exception

If your contracts include award fees, incentive fees, penalties, cost reimbursements, or funding contingencies, you’re dealing with variable consideration. ASC 606 requires you to estimate these amounts, but with an important constraint: only include amounts when it’s probable that recognizing them won’t result in a significant revenue reversal later.

Award and incentive fees demand careful estimation

Department of Defense programs often tie award fees or bonus incentives to performance metrics like quality, delivery timing, or cost savings. A contract might offer up to 5% additional fee for meeting specific targets, or impose liquidated damages if you fall short.

These are textbook examples of variable consideration. You need to estimate the amount you’ll earn and assess whether it’s probable you won’t have to reverse that revenue when the uncertainty resolves. This requires judgment based on your historical performance, current project status, and contract-specific factors.

Cost reimbursement structures introduce transaction price uncertainty

In cost-type contracts, your revenue equals allowable costs incurred plus a fee. While the fee may be fixed, the costs themselves are variable. Some contracts include incentive fees that share cost underruns or overruns, or impose caps on reimbursements.

Even fixed-price contracts can have escalation clauses or economic price adjustments tied to published indices. All of these elements must factor into your transaction price estimate, and you’ll need to update that estimate as circumstances change.

Unfunded contract portions create unique challenges

U.S. federal contracts often come partially funded at inception. You might sign a multi-year agreement, but Congress appropriates funds annually. The unfunded portion lacks guaranteed funding, which raises a fundamental question: Does it meet ASC 606’s definition of a contract?

The standard requires enforceable rights and obligations with collectible consideration. Until you receive or have reasonable assurance of funding, the unfunded portion may not qualify for revenue recognition. If it is determined that both the funded and unfunded portions meet the contract existence criteria, the unfunded portion becomes variable consideration, and the contractor would then need to evaluate whether any variable consideration is constrained.

The practical implication: Significant judgment is necessary in evaluating contracts with these characteristics, and the probability of receipt of payment for the unfunded portion will drive the contract existence determination. Continuous reassessment is necessary unless or until funding is appropriated.

Recognizing revenue over time versus at a point in time

Most U.S. government contracts qualify for over-time revenue recognition, typically using the cost-to-cost method. This makes sense because you’re usually creating custom products or services specifically for the government’s needs.

When over-time recognition applies

ASC 606 allows over-time recognition when your performance creates an asset with no alternative use to you, and you have an enforceable right to payment for work completed to date (Representing the third of three criteria which, individually, allow for over-time revenue recognition under ASC 606-10-25-27). Government contracts typically meet these criteria through termination-for-convenience clauses (like FAR 52.249) that require payment for work performed even if the contract terminates early.

For cost-reimbursable contracts that allow billing as costs are incurred, ASC 606 offers a practical expedient. If your invoices correspond directly to value delivered, you can recognize revenue in the amount you have the right to invoice. This invoice-based method is common for straightforward cost-plus contracts, essentially matching revenue to billable amounts each period.

The cost-to-cost method requires robust forecasting

If you’re using the cost-to-cost method to measure progress, your forecasting capabilities become critical. Unexpected cost growth may distort your percentage complete and can trigger loss provisions under ASC 606’s requirement to record the full amount of an anticipated loss when you identify it.

You need robust processes to update total cost estimates frequently and flag situations where estimated costs exceed contracted consideration—a common scenario in fixed-price development projects.

Some contracts require point-in-time recognition

Not every government contract qualifies for over-time treatment. Short-term product sales (like off-the-shelf items) or certain foreign contracts without strong termination clauses may require point-in-time recognition upon delivery or acceptance.

For example, a DCS transaction with a foreign government might be structured so title transfers only on final delivery. If you don’t have a guaranteed right to payment until that point, you recognize revenue at delivery based on when control passes to the customer.

Understanding FMS versus DCS transactions

The distinction between Foreign Military Sales and Direct Commercial Sales significantly impacts how you apply ASC 606. While both use the same accounting framework, the contract structures and risks differ substantially.

FMS: The U.S. government as intermediary

In FMS transactions, the U.S. Department of Defense acts as an intermediary. The DoD (through agencies like DSCA) contracts with you, then sells or transfers the product to the foreign government under a government-to-government agreement.

From your perspective, your customer is the U.S. government. This means:

U.S. FAR and DFARS requirements apply
DCAA audits and FAR/CAS compliance are required
Payments flow through the U.S. government to the contractor
Credit risk is expected to be minimal, given U.S. government is the counterparty
Foreign exchange risk is minimal
Revenue timing typically follows over-time recognition patterns (assuming applicable FAR clauses)

DCS: Direct engagement with foreign customers

In DCS arrangements, you contract directly with the foreign government or its agencies, without U.S. government intermediation beyond export licensing requirements.

This creates a different risk and accounting profile:

Foreign customer’s contract terms govern (FAR clauses don’t apply)
Payments made directly by foreign government(s) to the contractor
Foreign audit standards may apply instead of DCAA
Credit risk is likely a greater factor given direct remittance by the foreign government(s)
Foreign exchange risk becomes significant
Revenue timing depends entirely on your specific contract terms

The accounting model remains consistent, but FMS arrangements behave more like standard U.S. government contracts with predictable terms and protections. DCS arrangements require case-by-case contract analysis. You should maintain separate procedures for FMS versus DCS to capture these important distinctions.

Key risks and how to mitigate them

Government contractors face several recurring challenges when applying ASC 606. Understanding these risks helps you build stronger processes and controls.

Performance obligation identification errors

The risk: Failing to identify all distinct performance obligations (like embedded training, warranties, or offset obligations) or incorrectly combining separate obligations into one.

Mitigation approach: Develop a standardized checklist for contract review that covers common government contract features. Include cross-functional review involving contracts, engineering, and accounting teams before finalizing your revenue recognition position on significant new awards.

Variable consideration estimation issues

The risk: Being too aggressive in estimating award or incentive fees, leading to revenue reversals when actual results differ from estimates.

Mitigation approach: Build historical data on your actual award fee realization rates by contract type and customer. Apply the constraint principle conservatively—only include variable amounts when reversal is improbable. Document your estimation methodology and update it quarterly based on current performance indicators.

Unfunded contract treatment

The risk: Recognizing revenue on unfunded contract portions before funding is probable, creating receivables that may never materialize.

Mitigation approach: Establish clear policies defining when unfunded portions enter your contract scope for ASC 606 purposes. Track funding status separately and create controls to prevent revenue recognition on work performed against unfunded contract line items unless specific criteria are met.

Inadequate cost forecasting

The risk: Poor cost estimates may distort your percentage of completion under cost-to-cost methods, causing revenue swings and potentially triggering loss recognition requirements.

Mitigation approach: Implement formal Estimate at Completion (EAC) processes with monthly or quarterly updates. Require program managers to document assumptions and risks. Create escalation procedures for contracts approaching or exceeding budget, and consider independent cost reviews on high-risk fixed-price development contracts.

Contract modification accounting inconsistency

The risk: Applying different accounting treatments to similar contract modifications, creating comparability issues and potential audit findings.

Mitigation approach: Create decision trees or flowcharts for common modification types based on ASC 606’s guidance. Document the rationale for your treatment of significant modifications, including why you classified them as separate contracts, cumulative catch-ups, or prospective adjustments.

FMS versus DCS confusion

The risk: Applying U.S. government contract assumptions to DCS arrangements that have different terms, or vice versa.

Mitigation approach: Maintain separate revenue recognition policies and templates for FMS and DCS contracts. Train your accounting team on the distinctions and require explicit identification of contract type during the setup process.

Building a sustainable ASC 606 compliance framework

Getting ASC 606 right isn’t a one-time exercise. You need ongoing processes that keep pace with your contract portfolio’s complexity and evolution.

Start by documenting your significant judgments and estimates. When auditors or stakeholders question your revenue recognition positions, you’ll need clear documentation showing how you arrived at your conclusions. This includes your performance obligation assessments, variable consideration estimates, cost forecasts, and contract modification analyses.

Invest in cross-functional collaboration. Revenue recognition decisions for government contracts require input from contracts administrators, program managers, engineers, and accountants. Create regular touchpoints where these groups review new awards, modifications, and performance issues together.

Monitor your key estimates quarterly at minimum. Your award fee assumptions, cost forecasts, and funding probability assessments should reflect current information. Building this into your close process prevents surprises and ensures your financial statements reflect your best current knowledge.

Finally, stay current with evolving guidance. The AICPA’s Aerospace and Defense Contractors guide, FASB updates, and industry practice developments all affect how you should apply ASC 606. Your contract structures evolve, and your accounting positions should evolve with them.

Get your government contract revenue recognition right

ASC 606 creates real challenges for government contractors, but it also provides a consistent framework for addressing those challenges. The key is applying the framework thoughtfully to your specific contract terms and risk profile.

Your contracts are unique. Your customer relationships, performance obligations, variable consideration structures, and risk allocations all require careful analysis under ASC 606’s principles. Generic approaches lead to errors that can affect your financial reporting, audit results, and stakeholder confidence.

BPM’s accounting and advisory professionals work with government contractors to navigate ASC 606’s complexities. We can help you assess your current revenue recognition policies, address specific contract accounting questions, and build sustainable processes that scale with your business. Contact your BPM advisor or visit bpm.com to discuss how we can support your revenue recognition requirements.