While many businesses handle sales in a single transaction, construction contracts often cover months or even years and include multiple payments. As you’re well aware, the longer-term nature of construction projects can prevent contractors from billing and collecting on a timely basis, which can lead to accounting, tax and cash flow complications.
From an accounting perspective, the term “revenue recognition” refers to precisely how you determine when you’ve received payment and when you can record the revenue. Let’s review the three most commonly used types of revenue recognition in the construction industry.
1. Cash basis method
The simplest and easiest method to use, cash basis accounting records revenue when payments are received and records expenses when they are paid — regardless of when the project began or ended. For instance, if you receive a down payment for a job, you can record that immediately even if work hasn’t started yet.
This accounting method provides a clear picture of your construction company’s cash flow and allows flexibility in income reporting. For example, in some cases, you might be able to delay receipts to move income to the next tax period. However, the cash basis method also makes it more difficult to connect financial results with project activities for analysis.
Many contractors who carry no inventory prefer the cash method. Small construction businesses with average annual revenues of $26 million or less over the past three tax years can use the method for tax purposes. However, if your company’s average annual revenues exceed that amount, you’ll have to use another method to report to the IRS.
2. Percentage of completion method
Designed to help track project progress, the percentage of completion method allows a contractor to recognize revenue based on the degree of project completion.
For instance, 50% completion means recognition of one-half of all project revenue, costs and income. As a project progresses, you can bill regularly as designated milestones are met — and record the earned revenue each time you issue an invoice. This continues until the contract is completed, with all performance obligations met.
Commonly used for large or long-term projects, the percentage of completion method is effective so long as you can make reliable, straightforward cost estimates and your project data is dependable. There are several ways to calculate how much of the contract you’ve earned or completed for a billing period, including:
- Cost to cost, in which you divide current costs by total estimated costs and multiply by 100 to get the percentage of completion, and
- Per project costs, in which you multiply total estimated costs by the percentage of completion and subtract any costs you’ve incurred.
Another benefit of the percentage of completion approach is it allows tax calculations to be made based on the percentage completed during that tax year. This can reduce your tax burden at project’s end and protect you from the risk of tax fluctuations for multiyear projects.
To use this accounting method, the construction contract must clearly state each party’s enforceable rights and payment or settlement terms. Additionally, each party must have the ability and expectation to fulfill contractual obligations, including payment and collections.
3. Completed contract method
Under the completed contract method, revenue, costs and income aren’t reported until the project is finished and all performance obligations satisfied. At this point, accrued revenue and expenses are then recognized on your income statement.
Of course, that doesn’t mean you can’t bill in the meantime. It just means that, officially, reporting revenue and expenses is delayed until project completion. While the project is in progress, incurred costs are debited to inventory accounts and billing is debited to accounts receivable. Once the project is complete, the difference in these accounts is calculated and recorded as profit.
This accounting method is often applied to short-term projects; that is, those less than one or two years in duration. It’s a useful approach when a contractor can’t clearly recognize revenue via percentage of completion because of a lack of clarity around project milestones or performance obligations.
Plus, the completed contract method enables you to defer taxable revenue if the project won’t be completed until the following tax year. Tax liabilities can be postponed, but keep in mind that also means recording the projects’ expenses, which can reduce your taxes, is delayed as well.
Important: The IRS imposes restrictions on using this method to report taxes. Construction businesses can’t exceed a certain average annual revenue, and their contracts must be able to be completed within a set time frame — currently, two tax years.
If you’ve been using the same revenue recognition method for a long time, and it’s working for you, that’s great. Just bear in mind that, if you venture into different types of jobs, you might need to vary your approach. We can help assess your revenue recognition method and offer suggestions for fine-tuning the procedures you use to follow it.