Construction accounting is complicated, and recent rulings by accounting regulatory agencies have further complicated how construction firms record revenue and expenses.
Here's what you need to know about construction revenue recognition, how to use the five-step revenue recognition model, and a few tips on how to select the best construction accounting software to ensure compliance with the new revenue recognition requirements.
What is Revenue Recognition?
Companies use different methods to recognize revenue depending on their business. Retail stores, for example, recognize revenue when they sell a unit or several units of a product—sales are recorded instantly.
Companies in the construction industry, however, have projects that may span weeks, months, or even years and may involve multiple payments and progressive revenue reporting.
Revenue recognition is the starting point for contractors, banks, and other financial institutions in measuring the profitability and financial health of a construction company.
The method that a contractor uses to recognize revenue can affect the frequency of their billings and their ability to receive payments on a timely basis. The choice can also affect the accuracy of project income statements, have tax implications, complicate the company's cash flow, and lead to incorrect revenue forecasts.
Because of these complexities, there needs to be a way to recognize revenue consistently with certain standards that all parties can understand, and that is practical for the construction industry.
What is the Revenue Recognition Principle?
The revenue recognition principle states that revenue should be recorded when it has been earned, not when the cash for a product or service is received.
Revenue recognition is a feature of accrual accounting. This differs from cash-basis accounting, which recognizes revenue when cash is actually paid out and received. The revenue recognition principle is not applicable to cash-basis accounting.
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ASC 606 is the New Standard for Revenue Recognition
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) created ASC 606 to standardize the methods of reporting revenues across various industries. The idea is to make it easier for company managers, banks, creditors, and investors to analyze and compare the financial results of different businesses.
What is ASC 606?
Before ASC 606 was created in 2014, different industries had their own unique accounting methods to define revenue. There was no consistency in the financial reporting practices, which made it difficult for users to analyze and compare the financial statements of companies in different Industries. The FASB created ASC 606 to establish a universal method across all Industries to standardize revenue reporting.
ASC 606 is based on the delivery of promised goods and services to the client. These are labeled as performance obligations and are different from meeting the requirements and terms of a contract. The purpose is to identify each performance obligation under the contract and to recognize its fulfillment by recording the correct revenue amount as it's delivered.
How Does ASC 606 Impact Revenue Recognition in the Construction Industry?
Revenue recognition for long-term construction contracts has traditionally been reported using the percentage of completion method.
ASC 606 changes how revenue is recognized by redefining the activities that determine the completion of performance obligations under the contract. It follows a five-step revenue recognition model.
ASC 606 provides guidance on whether revenue is recognized over time, as with the completion-of-contract method, or at a specific point in time. The decision hinges on when the customer receives control of the asset or service and can enjoy the benefits as a result of the completion of the performance obligation.
The five-step method outlined in ASC 606 identifies the criteria for determining whether revenue is reported at a point in time or over a period.
5-step Revenue Recognition Model for the Construction Industry
1. Identify the Contract with the Customer
The first step for contractors is to identify all the legal agreements or contracts that they expect to perform for the customer to receive payment. Contractors may have several contracts with the same client that may be treated as a single contract or multiple contracts, depending on the agreement's structure.
According to ASC 606, whether a contract is considered a single legal obligation or multiple contracts depends on whether the distinct performance obligations are identified. Following the same logic, change orders could be considered amendments to an existing contract or a completely new contract, depending on the scope of the performance complication.
2. Identify the Performance Obligations
The first thing to understand is that a performance obligation and a contract aren't necessarily the same thing. Contracts must have at least one performance obligation, but they could have many more.
For example, suppose a contractor had a contract to renovate an office space for a client. The work could include flooring, framing, putting up partitions, installing an electrical system and low-voltage communications, installing the ceiling, and constructing a gym with workout equipment for employees.
Most of the work, such as flooring and framing, could be considered interrelated and treated as integral to the project. It could therefore be viewed as a single performance obligation. However, the gym could be considered a separate performance obligation since it would not necessarily be integrated with the completion of the entire project.
3. Determine the Transaction Price
In most cases, the transaction price is the amount the customer pays for goods and services under the contract. However, the final transaction price could vary if the contract contained performance incentives for early completion, penalties for missed delivery dates, or pending change orders. Any financing provided by the customer for the contractor, or vice versa, could affect the timing and recording of contract revenue or interest on financing.
4. Allocate the Transaction Price
After the contractor has identified the performance of obligations required under the contract, they can now determine a transaction price for each performance obligation. ASC 606 states that contractors can make these price allegations based on the "relative standalone prices of each distinct good or service." This means that price allocations are made as if the goods or services provided were performed as separate operations.
5. Recognize Revenue
Contractors record revenue after satisfying the performance obligation. However, this doesn't mean that you cannot recognize revenue until the performance obligation is complete. The issue hinges on the principle of "transfer of control."
The new standards for revenue recognition per ASC 606 fall into two categories:
- at a point in time
- recognition over time
The question is, when does control transfer from the contractor to the client?
If the contract terms state that the contract is only recognized as complete at a specific point in time, the contractor does not have the right to receive payment until the project is complete. If the agreement is for a point in time, the contractor retains legal title and physical possession until the project is complete and ownership is transferred to the customer.
If the contract allows recognition of revenue over time, then the contractor has the right to receive payments at various stages of the project. The customer then receives the title with the use and benefit of the contract's stage of completion.
For example, in an office renovation project, the customer might receive a transfer of control after the framing is complete. This is because the customer could possibly sell the office space in its uncompleted state since they have use and benefit.
Therefore, a contractor could recognize revenue over time as the project progresses, even though the entire performance obligation might not be complete.
Best Practices to Make sure You are Meeting Revenue Recognition Standards
Ensuring you meet the new revenue recognition standards may seem daunting.
However, below are some best practices to ensure compliance.
- Talk to your CPA about ASC 606 and how the new standard could impact the accounting for your current contracts and potential new contracts.
- Decide how your company will implement ASC 606.
- Review your current contracts to determine whether they contain any performance obligations. Then, assess new contracts to ensure ASC 606 compliance and adjust any implementation issues.
- Determine whether anything tied to revenue will be impacted, such as employee bonus plans.
How Construction Accounting Software Can Help with Revenue Recognition
Construction accounting software should be flexible and capable of reporting revenue based on various metrics. These could be percentages of the cost of materials consumed, labor hours spent, or stages of project development determined by the completion of certain performance obligations as defined in the contract.
The way billing and invoicing projects are spread out in construction-specific software—compared to general accounting software—affects how revenue is recognized on projects.
Being able to run WIP (Work In Progress) reports and correctly bill clients on time ensures you accurately recognize revenue.
Construction accounting requires reporting of a vast number of elements. Here are a few ways a dedicated construction accounting software program can help you stay on top of your projects:
- Sales and cost of sales: Construction accounting requires unique categories to be set up to record different types of revenue. These include construction, remodeling, service, and rental incomes, and tracking direct and indirect costs.
- Job costing: Job costing enables construction firms to categorize expenses in a way that allows measurement of a project's progress in comparison to budgets or estimates. This enables them to control spending.
- Retainage Reporting: It is important to have a system that helps you track all your billed and unbilled retainage to make sure that you receive all your retainage.
- Payroll: Construction payroll has complexities, such as prevailing wage, union payroll, and multi-state/multi-city requirements. There are also frequently changing payroll laws. The right construction accounting software will help ensure you stay compliant and will reduce the likelihood of mistakes.
- AIA Billing: Jobs requiring AIA Billing, such as federal jobs, require both G702 and G703 forms. These forms allow for streamlined client billing and provide detailed information regarding the completion status of a job. Staying compliant with AIA Billing requirements will allow your business to bid on a larger range of projects.
- Monitor Change Orders: Change orders skew your original estimates, can get messy if not managed properly, and can have a huge impact on your profitability. The right construction accounting software will allow you to monitor the status of change orders and analyze their impact.
- Manage Purchase Orders: It's important that your software can create and manage purchase orders. This enables you to track direct costs and their purchase status as well as committed costs.
- Cash Receipt Tracking: It's important to track cash receipts and ensure they are recorded within each project. Software that can maintain these records call for easy project audits.
How Deltek Supports the Construction Industry
Deltek ComputerEase is the leading construction software provider of job cost accounting, project management, and payroll services—delivering solutions that help customers connect and automate the project lifecycle that fuels their business. Deltek's dedicated team is committed to providing service excellence and product innovation, adapting to the evolving construction compliance requirements.
If you are currently using a generic accounting solution that's built for standard accounting processes, you will undoubtedly benefit from switching to a dedicated construction accounting solution. Contact us today to learn how Deltek ComputerEase can help you to boost your profitability.
