Few things are cut and dry in the construction industry, and revenue recognition certainly isn’t one of them. Still, it’s a critical practice to get right because it has a significant impact on both the financial reporting and overall health of your company. How your company recognizes revenue directly affects not only how it presents its earnings, but how much ownership benefits from their stake in the business.
The way revenue is recognized has changed with the introduction of ASC 606, which introduces five principles for recognizing revenue. We’ll get into the details of ASC 606 later in this article, along with how companies should consider costs and expenses, the implications of changes in estimates, and more.
Key Takeaways
- Accurate revenue recognition is essential for the financial representation of construction companies.
- The details and progress of a construction project helps determine the right revenue recognition method.
- Construction revenue recognition requires careful consideration of costs, expenses, and contract terms.
What is Revenue Recognition in Construction?
Revenue recognition is the method construction companies use to determine when to report revenue and profits in their financial statements. While that might sound overly simple, the long-term and often complex nature of construction projects can often make the process challenging for contractors. What’s more, revenue recognition becomes even more complicated when a company uses an accrual basis for its revenue (a cash basis produces a much more straightforward number).
Revenue recognition hinges on the completion of certain criteria that signify the revenue is earned and follows specific accounting principles and standards.
Two Revenue Recognition Methods in Construction
There are two methods companies can use to properly recognize revenue, and the one you use will determine how and when revenue is recorded, which can significantly impact a construction company’s financial health.
Cash Basis
Under the cash basis of accounting, a construction company recognizes revenue when cash is received, and expenses when they are paid, regardless of when the services are actually performed or incurred.
This method is pretty straightfor iward but doesn’t give the best representation of your financial position if there’s a significant time gap between earning the revenue and receiving the cash. Most small and medium-sized construction companies will use this method for revenue recognition until they’re forced to move to the next method – accrual. If you consider when you create an accounts receivable for the billing in cash basis, you don’t earn the revenue until the accounts receivable is paid in this method.
Note: The cash basis method of accounting is reserved for small businesses that are operating under $30 million in annual revenue as of 2024 for corporations and partnerships per IRS publication 538.
Accrual
Under the accrual basis method of accounting, you record revenue and expenses during the period the work is performed, regardless of when you actually received or paid money. This method more accurately represents the economic reality of the construction processes, as it reflects a job’s financial progress, even if cash hasn’t exchanged hands yet. Most of the banks and bonding agencies you’ll work with will prefer you use this method.
A cash crunch is one of the most common financial roadblocks a construction company can hit. That’s why if you’re using the accrual basis method of accounting, you need to make sure you’re tracking your business’s cash too. This is because you’re creating an accounts receivable and revenue at the exact same moment, but you’re not being paid for the accounts receivable until later.
Before ASC 606 was passed (which we’ll get into a little later), there were two processes contractors on the accrual method would use to recognize revenue — percentage of completion and completed contract.
Percentage of Completion Method – Here, revenue is recognized based on an estimate of how far along a job is. This was the main method used by most construction contractors until ASC 606 was passed as the standard. It’s important to know that ‘percentage of completion’, or ‘percent complete’ as it is called, was favored for its ability to match revenue recognition with the costs incurred to earn that revenue as a project progressed. This allowed for revenue to be reported more evenly throughout the life of the project.
Completed Contract Method – This method defers all revenue and expense, or contract costs, recognition until a contract is completed. Completed contract accounting offers a clear picture of a project’s success after its completion, though it can lead to significant fluctuations in your income statement and balance sheet as you move from one reporting period to another.
A Note on Accounting for Uninstalled Materials
Accounting for uninstalled materials requires careful consideration, especially when you’re using the percentage of completion method. Any costs for materials that aren’t yet installed but specifically fabricated or assigned to a contract should be included in the progress calculations tied to your work-in-progress (WIP) sheets (provided these materials are expected to be used on the project). Be careful to make sure these costs don’t distort the recognition of progress.
All About ASC 606
The Accounting Standards Codification (ASC) 606 was issued by the Financial Accounting Standards Board (FASB) and outlines the new standard for how companies should recognize revenue under accrual accounting. These new standards also align closely with the guidelines set by the International Accounting Standards Board (IASB). ASC 606 replaces the percent complete and completed contract method for recognizing revenue.
- FASB – The FASB is an independent nonprofit organization responsible for establishing accounting and financial reporting standards for companies and nonprofit organizations in the United States, following Generally Accepted Accounting Principles (GAAP).
- IASB: An independent, private-sector body that develops and approves International Financial Reporting Standards (IFRSs).
Revenue recognition in the construction industry is guided by the principle that revenue should be reported when it is earned, regardless of when the cash is received, under an accrual basis. This is called the “revenue recognition principle”.
Under ASC 606, this means you’re recognizing revenue when performance obligations are satisfied, not necessarily when payment is received (like with cash basis accounting). Along with the transaction price, this determines how much revenue you can recognize in a given period of time.
Understanding these concepts is important as we get further into the revenue recognition standards set by ASC 606.
- Performance obligations: The specific services or goods promised to a customer within a contract. A contract can have multiple performance obligations.
- Transaction price: The amount of consideration to which a company expects to be entitled in exchange for transferring promised goods or services to a customer.
Revenue Recognition Standards: ASC 606
ASC 606 introduced a five-step model to guide revenue recognition. Ultimately, these steps are intended to make it easier to determine the amount of total revenue that you are going to “earn” within a given period.
The steps go as follows:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
It’s important to note that this isn’t always cut and dry. For example, if your company is given multiple contracts for a project on the same job site, these 5 steps can potentially make revenue recognition more difficult.
When you apply the ASC 606 principle, consider writing down each step, especially if you’re working with a complex contract. This will help you better justify why you broke the contract out into the revenue amounts you did.
A quick note on ASC 606 vs. Percent Complete – If you’re thinking that ASC 606 is really close to the POC process for recognizing revenue, you’d be right. The biggest difference between the two is that ASC 606 uses performance obligations to define the milestones and portions of revenue from a contract, which allow contractors to recognize revenue.
How Construction Contracts Relate to Revenue Recognition
Contracts not only outline the expectations, scope, and costs of a job, but play an essential role in establishing the terms that dictate revenue recognition during that job’s life cycle.
Elements of Construction Contracts
Construction contracts include several key components that determine how revenue is recognized. They should identify the parties involved, specify the scope of work, and detail the contract value, which reflects the total agreed-upon price for the project. Contracts are considered enforceable when they provide both parties with clear rights and obligations. Distinct performance obligations within the contracts delineate specific tasks or services, and each of these can trigger separate revenue recognition events.
- Parties Involved: Contractor and client.
- Scope of Work: A detailed description of services.
- Contract Value: The total price for the project.
- Enforceable Rights: Rights and responsibilities of each party.
- Distinct Performance Obligations: Specific tasks triggering revenue recognition.
All of these help define when revenue is recognized and for how much. Here’s a simple example:
You’re building a new retail location for a customer from the ground up, and you’re also going to do the buildout of the spaces in the location.
- The first distinct performance obligation is completing the shell building.
- The second distinct performance obligation is the buildout of each individual space based on what the initial tenant wants.
If the owner only gave you one number for the entire construction contract for the shell and buildout, what should you do? You now have to break out your contract costs for the two distinct obligations to determine the revenue for each portion. Now for the hairy part. At what point are you explicitly working on the buildout and not the new building?
The point is, distinct performance obligations must be clearly defined in the contract so you can properly recognize revenue. But, even when you do define them as clearly as possible, there will still be some gray areas on when each one can be considered met.
Contract Modifications and Change Orders
Contracts are almost always subject to modifications. From revised project specifications to unforeseen circumstances, several things can make adjusting the scope of work in the existing contract necessary.
Change orders are formal documents that alter the original contract by adding, removing, or updating details of the agreement. How does this impact how revenue is recognized? These changes can impact the total contract price, which then impacts how the timeline and amounts of revenue are recognized over the course of the construction contract.
Determining the Transaction Price
The transaction price is the total amount of consideration to which an entity expects to be entitled in exchange for transferring goods or services to a customer. When establishing this price, an entity must consider all forms of consideration, including:
- Fixed amounts
- Variable considerations
- Non-cash considerations
- Consideration payable to the customer
When determining the transaction price, any penalties or potential bonuses (variable considerations) outlined in the contract need to be carefully reviewed. The most likely amount method is easier to calculate on a singular contract, while the expected value method is often used over a series of multiple contracts to reflect a broader view.
Consideration and Variable Consideration
We threw around a couple terms just now — consideration and variable consideration. Let’s define those.
- Consideration – The explicit/stated contract value in the contract.
- Variable Consideration – Any additional costs/bonuses on top of the contract value. These include things like penalties, incentives, and potential bonuses.
Because consideration and variable consideration can affect the transaction price, they’re important components in determining how revenue is recognized.
There is always some ambiguity as to when variable considerations will occur and how much they will be. When calculating how much revenue should be recognized, you’ll multiply the probability of receiving them by the total amount of each consideration.
Estimating variable consideration might involve a range of possible outcomes, and should reflect your expectations for those outcomes. These should be reassessed at each reporting date as new information becomes available.
Recognizing Revenue Over Time
ASC 606 introduced several specific factors that must be considered when recognizing revenue over time. These include transfer of control to the customer and the measurement of progress toward the completion of the project. With this approach, you’ll get a more accurate financial representation of long-term contracts..
Transfer of Control Criteria
For revenue to be recognized over time, you need to determine if the control of the service or asset is being transferred continuously to the customer. The criteria for this transfer of control includes:
- Customer Consumption: The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- Asset Creation: The entity creates or enhances an asset that the customer controls as the asset is created or enhanced.
- No Alternative Use: The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
Revenue can only be recognized over time if one or more of these criteria are met. If not, revenue recognition at a point in time may be more useful.
Progress Measurement
For revenue to be recognized over time, you need to be able to accurately measure the progress of a project, because this determines the amount of revenue to recognize at each reporting date. Most often, this is operationalized using either of the following methods:
- Output Method: Measures results achieved. Examples include surveys of performance completed, appraisals of results achieved, milestones reached, or units produced/delivered.
- Input Method: Measures effort expended. Examples include resources consumed, labor hours worked, costs incurred, or time elapsed.
Through these methods, you ensure that the progress measurement depicts your performance toward the completion of the contract. Using consistent and reliable measures is critical for maintaining the accuracy and integrity of revenue recognition over the duration of the contract.
Costs and Expenses in Construction Accounting and Revenue Recognition
We can’t overstate the importance of accurately recognizing and allocating contract costs and expenses. They not only influence the financial reporting to your income statement and balance sheet, but paint a picture of your company’s overall health.
Allocating Costs to Contracts
Your construction company should pay attention to what costs you’re putting on jobs to make sure they accurately capture everything needed to complete the job. These can include:
- Labor: Wages and benefits for the workforce on-site.
- Materials: Raw materials used during construction.
- Equipment: Depreciation or rental costs of machinery.
- Subcontracts: Costs related to subcontracted work.
- Other: Costs related to the job like bonds, specific insurance, etc.
Mobilization costs like transporting equipment to a site are direct costs, but may be amortized over the contract’s duration if significant. Precise cost estimates and allocations ensure that your contract revenues and expenses match, reflecting the accurate job costing and revenue of each project. You want to double-check that you are also accurately capturing overhead costs if the contract allows it.
Expense Recognition and Contractor Payments
The recognition of expenses in construction accounting should align with the progress of a project. Construction costs are typically recognized based on the percentage-of-completion method, where costs incurred are a proportion of the estimated total costs.
A lot of contractors still use the percent of completion method as their starting point to determine what the job looks like from a revenue and expense perspective and then consider the other factors of ASC 606 to see if they need to do more.
Contractors recognize expenses as they occur, ensuring that payment schedules and expense recognition reflect the actual work done. However, this can lead to fluctuations in reported income if costs vary significantly from initial estimates, or if delays affect progress billing.
Financial Reporting and Disclosure
Financial reporting and disclosure are vital for the transparency and accuracy of a company’s financial health and are something you’ll most often see in larger construction firms. In our industry, these are particularly essential because of the long-term nature of contracts and the potential complexity in revenue recognition.
Tax Implications and Revenue Recognition
Of course, the way you recognize revenue will have tax implications. All construction companies must adhere to the specific tax reporting regulations set by the IRS. While financial reporting has placed requirements on which accounting method you can use, the IRS allows you to use different accounting methods.
The cash method allows income to be reported when received, and expenses when they are paid. The accrual method, however, requires reporting when income is earned and expenses are incurred, which may not coincide with the actual cash flow. Moreover, percentage-of-completion is commonly used by construction businesses where revenue is recognized progressively, affecting taxable revenue within that tax year.
Revenue Recognition and Tax Calculations
The way your business recognizes revenue can significantly affect tax calculations and the resulting tax burden. If revenue is recognized too early or too late, it can misrepresent tax liabilities. The IRS has rigid guidelines for how revenue recognition aligns with taxable income, and construction businesses need to align their practices with these rules. To ensure proper tax reporting and avoid any potential penalties, your company must accurately calculate what portion of the revenue is recognized as taxable revenue during a given tax period.
- Taxable Revenue Calculation: Must align with IRS revenue recognition guidelines.
- Tax Liabilities: Accurate tax reporting is crucial to reflect the true tax obligations.
Alignment here makes it easier for your business to report its taxes with confidence, all while maintaining a clear understanding of any cash flow implications.
A Few Last Items to Think About
When construction companies recognize revenue under GAAP, they need to consider the implications of warranties and surety bonds. These items can have a big impact on financial statements, and require specific attention to detail.
Accounting for Warranties and Surety Bonds
Warranties are promises made by construction companies to repair or replace defective work or materials. Under GAAP, these companies must assess the probability and amount of warranty claims to record a warranty liability at the time of sale. For nonpublic entities, the cost of warranties can be expensed as incurred or accrued, with the latter being more common to match the expenses with the revenue of the respective period.
Surety bonds provide a financial guarantee that the construction company will adhere to the terms of a construction contract. Collectibility is an essential factor in revenue recognition; if it’s not likely that the surety bond will be enforceable, your revenue recognition may be impacted. Construction companies often use surety bonds to reassure clients of performance, which influences the timing and amount of revenue recognized.
Long-term contracts require construction companies to exercise judgment when accounting for these items. GAAP allows for early adoption of certain standards, which can influence how warranties and surety bonds are treated. The specifics of how these are accounted for will vary depending on the size of the entity, the complexities of the contract, and the terms of the individual warranties or bonds.
For more deep dives into construction accounting, check out our guide to accounting essentials.