Construction accounting for contractors: Revenue Recognition
In the Surety Corner’s second construction accounting installment we take a deeper look at revenue recognition for contractors. Specifically, we will review the “Percentage of Completion” calculation and why it is the most commonly used revenue recognition method amongst contractors who have a strong grasp on their financial picture.
What is the “Percentage of Completion” method for revenue recognition?
The first question one may ask is, “what is this method and why should I care”?
The Percentage of Completion method of accounting stipulates that the revenue a contractor shows as “earned” for any given period of time is dictated by the exact amount of work they have completed during that period.
Intuitively, this makes the most sense, but the calculation may not be an obvious one. When completing this calculation, we do not focus on what a contractor has been paid to date, or what they have billed for to date. Rather, we calculate revenue based on the costs incurred relative to the estimated total costs that will be incurred to complete the work.
For this calculation, a contractor or accountant will need four key inputs for every job a contractor has on the go:
- 1. Contract Value: adjusted for change orders and applicable taxes;
- 2. Amounts Billed to Date;
- 3. Total Cost to Date;
- 4. Estimated Cost to Complete.
While items 1 through 3 are actual figures, the 4th point (estimated cost to complete) requires strong job costing and estimating to determine. This figure may change over the course of a job. Ensuring this figure is as accurate as possible will avoid surprises when jobs finish.
Calculating revenue earned: An example
ABC Construction has been completing a fit-out for a large office building. As at January 31st, 2022 the following figures outline their current progress:
- 1. Total Contract value inclusive of HST = $1,500,000
- 2. Amounts Billed to Date = $900,000
- 3. Cost to Date = $500,000
- 4. Estimated Cost to Complete = $750,000
Based on these numbers, ABC Construction needs to determine what figure will be used as their revenue figure on their income statement. The calculation is as follows:
- 1. Determine total costs: (Cost to Date + Cost to Complete) = $1,250,000
- 2. Determine percentage complete based on costs to date relative to total job costs; (Cost to Date / Total Costs) = 40% Complete
- 3. Apply that percentage to the contract value; (Percentage Complete * Total Contract Value) = $600,000
- 4. Account for discrepancy between amount billed and revenue earned.
In this example, the contractor will recognize $600,000 in revenue, despite having billed for $900,000 to date. Next, we will explore how we account for that $300,00 discrepancy and why it may occur!
Over-billings and Under-billings
In the example provided above, ABC Construction is in an over-billed position. What this means is that they have billed for more than they have earned. Or in simpler terms, they have billed for more work than they have truly completed. The $300,000 discrepancy does not disappear, rather, it is recognized on the balance sheet as a liability. (Deferred Revenue) This is because they now OWE their client work valued at $300,000.
This is a common occurrence for general contractors. The reason for this is that they are closest to the money in the construction pyramid and are responsible for ensuring trades and suppliers are paid in a timely fashion. So long as ABC Construction is maintaining proper project accounting, holding project funds in their pocket for the purpose of paying trades can help them avoid using a line of credit to finance project costs.
For learning purposes, let’s pretend that ABC Construction had only billed $500,000 as at January 31st, 2022. In this instance, we would classify them as under-billed relative to the $600,000 they have earned. Being under-billed means that you have billed for less than you have earned. Or, in simpler terms, they have completed work that they have not yet billed for.
Being in an under-billed position is more common for trades that are working under the general contractor. The under-billed position is recognized as an asset on the balance sheet. (Work in Progress) This is because the contractor is owed money for the work completed, but it has not yet been posted to accounts receivable as it has not been billed.
How does revenue recognition affect your construction bond facility?
If you are a contractor that requires construction bonds, your bonding company will very likely ask you for a “work on hand statement”. This statement will be a listing of all projects that are currently underway, outlining the four items needed for a revenue recognition calculation above for each.
The surety will have a particular interest in any jobs that bid bonds and subsequently performance bonds have been issued for. As a party that is guaranteeing your contractual obligations, the surety will want to understand progress made, profit trends over the course of the job and whether the contractor is over or under billed.
If over-billed, the surety will be looking for a healthy cash position to match the corresponding liability. This is because the over-billing indicates work that remains to be completed, which requires liquidity and cashflow that will not be supported by future billings. On the flip side, an under-billed position may be inquired about if it is late in the job, related to an unapproved change order or if that work in progress figure represents a large portion of a companies working capital.
Prior to applying for surety bonds, contractors are encouraged to review their work on hand report and proactively identify any under-billings that may require further information to be provided.
By understanding whether your company is in an over-billed or under-billed position (as well as accurately representing your revenue), the owner of a construction business can more effectively manage cash, billings and projections for future earnings.
Failure to have a handle on exactly where profitability on a project lies can lead to false profits or losses being reported throughout the year and large swings when your accountant makes their year-end adjustments. By analyzing jobs on the go monthly or quarterly, earnings can be more accurately recognized throughout the year.