Construction Revenue Recognition: An Introductory Guide

Once your construction company grows beyond the point of using cash accounting, you’ll have to become familiar with several construction accounting concepts. One of those is revenue recognition: a core principle of accrual accounting that determines how and when a business can recognize revenue.

Understanding this principle is crucial to ensuring your construction business remains on a solid financial footing as it makes progress on long-term projects. It’s vital to collecting timely payments, producing accurate financial reporting and managing the cash flow of your business.

If you’re an up-and-coming contractor just getting started on major projects that demand this approach to accounting, there’s no question this accounting method is very different from the more simple cash accounting method you’re used to.

This introductory guide to construction revenue recognition will help you understand the key points. We’ll explore all the basics you need to understand and highlight common areas where construction companies get tripped up, so you know exactly what to watch out for as you embark on this next stage of your company’s growth.

Revenue Recognition 101: The Basics of Revenue Recognition in Construction

Under accrual accounting, revenue is recognized when it’s earned (not when you collect payment from a customer) and is based on the percentage of completion. In the construction industry, revenue is recognized as your company completes the work within long-term contracts.

It’s important to note that the discussion here only applies to financial reporting for a construction company. A construction company’s financial statements should be produced on a regular basis. They indicate the financial health of the business and are important when it comes to securing the bonding capacity necessary to work on large projects.

For tax purposes, however, a construction business might recognize revenue at a different time than in their financial reports. For more information on the tax implications of construction accounting methods, read Tax Implications of Construction Accounting Methods

ASC 606: 5 Steps to Revenue Recognition

ASC 606 determines how companies should recognize revenue under accrual accounting. This standard lays out a five-step process for recognizing revenue in long-term contracts.

Here’s a hypothetical example of what that process looks like. Acme Construction is a construction company hired to build an office building for a client.

1. Identify the Contract with the Customer

The first step for Acme Construction is to identify the contract with a customer. In construction, this tends to be relatively straightforward, since the construction company and client usually sign a written contract that specifies all of the key details pertaining to the project.

Under ASC 606, several criteria must be met for a contract to be identified, including clear performance obligations and consent from both parties. Change orders may be considered changes to an existing contract or a separate contract; your construction CPA can help advise which is most appropriate.

In our hypothetical example, Acme Construction makes a written contract with its client to build an office building. The contract specifies the building’s design, materials, timeline and payment schedule. Both parties sign the contract, and Acme Construction identifies the contract.

2. Identify Performance Obligations

The next step is to identify separate performance obligations within the contract. In large-scale projects, multiple performance obligations may exist in the overall project.

For instance, Acme Construction might include many phases in the contract, each of which may represent a separate performance obligation. Often, it depends on whether the good or service is distinct from other items in the contract and should be evaluated on each contract. Assume in our example that there are two phases of an apartment complex that can be used separately. Thus, there are two separate performance obligations distinct from one another.

3. Determine the Transaction Price

The transaction price is the total value of the contract that the company agrees to with its customer. This includes any incentives for early completion, penalties for late delivery, or change orders.

In our hypothetical scenario, Acme Construction agrees to a $10 million contract to build the office building for its client. For the sake of simplicity in this example, we’ll set aside any incentives or penalties for now.

4. Allocate the Transaction Price

The next step is for the contractor to allocate the transaction price calculated in Step 3 between the performance obligations identified in Step 2. This is typically done based on the relative cost of each of the performance obligations.

Following that principle, Acme Construction might allocate the transaction price to the two phases of the apartment complex evenly if the makeup of each phase is roughly the same.

5. Recognize the Revenue

Companies can record the revenue allocated to each performance obligation once they have satisfied that performance obligation. Under ASC 606, performance obligations are considered met when control of the goods or services transfers to the customer.

In the construction industry, this transfer of control typically occurs over time rather than at a single point. Progress is typically measured using the percentage of completion method, which recognizes revenue and expenses over time as the project progresses.

For instance, once Acme Construction has completed 50% of the work for Phase 1, it may recognize $2,500,000 of the revenue associated with that performance obligation.

Unique Revenue Recognition Considerations in Construction

ASC 606 applies to all kinds of industries, not just construction. However, there are some unique considerations construction companies have to navigate when it comes to ASC 606 — both in terms of how they recognize revenue and the practical implications for managing the finances of their business.

One key element to success is understanding the relationship between the percentage of a job that has been completed and the percentage of costs that have been incurred. Often, your company may have a significant portion of uninstalled materials sitting on a job site. Because these materials are yet to be installed, the costs related to these materials aren’t considered progress toward a performance obligation.

Contract assets and liabilities (commonly referenced as over and under billings) must also be considered. These occur when a contractor has provided a good or service to a customer but has not been paid for it, or has billed for a good or service they have yet to provide. Contractors also have to consider retainage: a small percentage of the contract value that is held back until all performance obligations are met. Retainage is typically considered a contract asset, provided the right to the retainage is conditional on factors other than time (such as the successful completion of the project).

Contract assets, liabilities and retainage can all have an impact on a company’s accounting. They may cause timing differences between when work is completed, revenue is recognized and payments are received — all of which are important to track and understand to present to bonding and surety partners appropriately. Proposals to revise the way construction companies present contract assets, liabilities and retainage are currently open for public feedback.

James Moore: Specialized Construction Accounting CPAs

Construction revenue recognition may seem complex. But with the right approach, this accounting principle brings significant clarity to complex construction projects. Adopting the five-step approach to revenue recognition mandated by ASC 606 helps construction companies better tie the progress of their projects to revenue and plan for cash flow needs.

If you need support understanding revenue recognition, producing financial statements to secure bonding, or with any other construction accounting or tax issue, the team at James Moore is here to help. Our experienced construction accounting CPAs provide a wide range of services to construction companies, spanning everything from audit and assurance to sophisticated tax planning solutions.

Contact a James Moore advisor today to learn more.

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