Construction accounting is complex, and recent rulings by accounting regulatory agencies have made the process of recording revenue and expenses even more challenging for contractors.
For mechanical contractors, accurately recognizing revenue is critical to maintaining profitability, managing cash flow, and ensuring compliance with accounting standards.
Here’s what you need to know about construction revenue recognition, how the five-step revenue recognition model applies to mechanical contractors, and how construction accounting software can help simplify compliance.
What is Revenue Recognition?
Companies use different methods of recognizing revenue depending on the type of business they operate.
Retail businesses, for example, recognize revenue at the point of sale when a customer purchases a product. Mechanical contractors, however, often manage projects spanning weeks, months, or even years that involve progress billing, retainage, and multiple phases of work.
Revenue recognition is the process contractors use to determine when revenue should be recorded throughout a project lifecycle. Proper revenue recognition is essential for producing accurate financial reports, forecasting profitability, and maintaining healthy relationships with banks, bonding companies, and stakeholders.
What is the Revenue Recognition Principle?
The revenue recognition principle states that revenue should be recorded when it is earned, not necessarily when payment is received. This principle is a core component of accrual accounting.
For mechanical contractors, that means revenue may need to be recognized as work is completed on a project rather than when invoices are paid.
ASC 606 is the New Standard for Revenue Recognition
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) introduced ASC 606 to standardize revenue recognition across industries.
The goal of ASC 606 is to create consistency in financial reporting, making it easier for business owners, lenders, and investors to compare financial performance across companies.
What is ASC 606?
Before ASC 606 was introduced in 2014, industries often followed different accounting practices to recognize revenue. This lack of consistency made it difficult to compare financial statements between businesses.
ASC 606 establishes a universal framework centered around performance obligations — the promised goods or services a contractor agrees to provide to a customer.
For mechanical contractors, this could include HVAC installation, piping systems, sheet metal fabrication, preventative maintenance agreements, or phased equipment commissioning.
Revenue is recognized as these performance obligations are satisfied.
How Does ASC 606 Impact Revenue Recognition for Mechanical Contractors?
Mechanical contractors have traditionally relied on percentage-of-completion accounting for long-term projects. ASC 606 changes how contractors evaluate and recognize project revenue by focusing on the completion of performance obligations.
ASC 606 helps determine whether revenue should be recognized over time or at a specific point in time based on when the customer gains control of the asset or service and receives the benefit of the completed work.
Five-Step Revenue Recognition Model for Mechanical Contractors
1. Identify the Contract
The first step is determining whether a valid contract exists between the mechanical contractor and the customer. The contract must be legally enforceable and clearly define payment terms, scope and responsibilities.
2. Identify Performance Obligations
Once the contract is identified, the next step is determining the performance obligations within the agreement. A performance obligation is a distinct promise to transfer goods or services to the customer.
For mechanical contractors, performance obligations may include HVAC installation, plumbing systems, refrigeration systems, fabrication work, or ongoing service agreements.
It's important to note that many construction contracts contain only one performance obligation. Contractors should be careful not to assume that ASC 606 requires them to break every contract into multiple performance obligations. Separate performance obligations only exist when the promised goods or services are distinct and separately identifiable within the contract. In many cases, the various tasks performed by a mechanical contractor are highly integrated and work together to deliver a single combined output to the customer, resulting in a single performance obligation for revenue recognition purposes.
3. Determine the Transaction Price
The transaction price is the amount the contractor expects to receive in exchange for completing the work.
Mechanical contractors should consider factors such as incentives, penalties, allowances, escalation clauses, or potential change orders that could impact the final contract value.
4. Allocate the Transaction Price
If a contract contains multiple performance obligations, the transaction price must be allocated among them based on their standalone selling prices.
For example, a mechanical contractor may have a contract for a new hospital project that includes both the installation of the building’s HVAC system and a separate central utility plant. The HVAC system may be completed and turned over months before the utility plant is operational.
Even though the work falls under one contract, these may be treated as separate performance obligations with revenue recognized independently as each obligation is completed.
5. Recognize Revenue as Performance Obligations are Satisfied
Revenue should be recognized as performance obligations are fulfilled. In many cases, this occurs over time using percentage-of-completion methods based on labor hours, installed quantities, project milestones, or costs incurred.
Depending on the contract structure, some revenue may also be recognized at a specific point in time when the customer takes control of the completed work.
It’s important for mechanical contractors to work closely with accounting professionals to ensure compliance with ASC 606 and properly evaluate the unique terms of each project.
How Construction Accounting Software Helps Mechanical Contractors with Revenue Recognition
Construction accounting software plays a critical role in helping mechanical contractors accurately manage revenue recognition and maintain compliance with ASC 606.
Mechanical contractors manage highly detailed projects involving labor tracking, equipment procurement, subcontractors, fabrication, and service work. The right software provides visibility into project financials and helps ensure revenue is recognized accurately throughout the project lifecycle.
Here are several ways construction accounting software supports revenue recognition for mechanical contractors:
Track Sales and Cost of Sales
Mechanical contractors need the ability to separate and track different revenue streams, including new construction, service work, maintenance agreements, and fabrication revenue.
Construction accounting software helps organize direct and indirect costs for more accurate financial reporting.
Improve Job Costing Accuracy
Job costing allows contractors to track labor, materials, equipment, and subcontractor costs against budgets and estimates in real time.
Accurate job costing helps mechanical contractors measure project progress, control costs and recognize revenue appropriately.
Simplify Retainage Tracking
Retainage can significantly impact cash flow. Construction accounting software helps contractors monitor billed and unbilled retainage to ensure nothing is overlooked.
Manage Complex Payroll Requirements
Mechanical contractors often deal with union labor, certified payroll, prevailing wage requirements and multi-state payroll regulations.
Dedicated construction accounting software helps reduce compliance risks and payroll errors while simplifying reporting requirements.
Streamline AIA Billing
Many commercial and government mechanical projects require AIA billing forms such as G702 and G703.
Construction accounting software helps contractors generate accurate billing documents and maintain compliance with project requirements.
Monitor Change Orders
Change orders are common on mechanical projects and can quickly impact profitability if not properly tracked.
The right software helps contractors monitor approved, pending and disputed change orders while analyzing their financial impact on the project.
Manage Purchase Orders and Equipment Costs
Mechanical contractors often manage large equipment purchases and long-lead materials.
Construction accounting software helps track purchase orders, committed costs and procurement status to improve financial visibility and forecasting.
Improve Cash Receipt Tracking
Tracking payments and allocating them correctly across projects is essential for accurate financial reporting and auditing.
Construction accounting software helps maintain organized records for improved visibility and easier audits.
