The fifth and final part in a 2023 series from Deltek
By John Meibers, Deltek ComputerEase
Construction accounting is complex, and recent rulings by accounting regulatory agencies have complicated how construction firms record revenue and expenses even more.
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 of recognizing revenue depending on the business they’re in. Retail stores, for example, recognize revenue when they sell a unit or several units of a product — sales are recorded instantly.
Companies in construction, like electricians, have projects that may cover weeks, months, or even years and could include multiple payments and progressive reporting of revenues.
Revenue recognition is the starting point used by contractors, banks, and other financial institutions to measure the profitability and financial health of a construction company. Proper revenue recognition is critical to producing accurate financial reports, forecasting revenue properly, and accurately paying taxes.
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.
ASC 606 is the New Standard for Revenue Recognition
The Financial Standards Accounting 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 reporting of revenues.
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 amount of revenue 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 the way in which revenue is recognized by redefining the activities that determine the completion of performance obligations as required by the contract. It follows a five-step revenue recognition model.
ASC 606 provides guidance to determine whether revenue is recognized over time, as with the completion of the contract method, or should be reported 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.
Five-Step Revenue Recognition Model for the Construction Industry
- Identify the Contract: The first step is to determine if a valid contract exists between the construction company and the customer. A contract is considered valid if it is legally enforceable and includes agreed-upon terms and conditions.
- Identify Performance Obligations: Once a contract is identified, the next step is to determine the performance obligations within the contract. Performance obligations refer to the distinct goods or services that the contractor has agreed to provide to the customer.
- Determine the Transaction Price: The transaction price is the amount the company expects to receive in exchange for providing the goods or services. It is important to consider any variable considerations, such as discounts, penalties, or incentives, that may impact the final transaction price.
- Allocate the Transaction Price: If the contract includes multiple performance obligations, the transaction price needs to be allocated to each obligation based on their relative standalone selling prices. This step requires estimating the standalone selling price of each distinct good or service. For example, you have one contract that covers the electrical work at a new high school complex that includes all electrical work for the new building and lights for the new stadium. The school is set to open in August and will be completed and turned over in July. The stadium will not be complete until the following spring, so it will be turned over in March. Even though this is one contract it would be considered two separate performance obligations and revenue would be split out and recognized on each separate obligation.
- Recognize Revenue as Performance Obligations are Satisfied: Revenue should be recognized as the contractor satisfies each performance obligation. This typically occurs over time using a suitable measure of progress, such as the percentage of completion method, or at a point in time when control of the goods or services is transferred to the customer.
It’s important to note that the revenue recognition model may vary depending on the specific circumstances and contract terms in the construction industry. It is advisable to consult with accounting professionals or refer to the specific accounting standards applicable in your jurisdiction for detailed guidance.
How Construction Accounting Software Can Help with Revenue Recognition
Construction accounting software should be flexible and able to handle the reporting of revenue as determined by 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. Having the ability to run WIP (Work in Progress) reports and correctly bill clients on time ensures that you are accurately recognizing revenue. Construction accounting requires reporting 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 and multi-state / multi-city requirements. There also are 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 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.
Overall, construction accounting software streamlines revenue recognition processes, improves accuracy, enhances compliance, and provides valuable insights for financial management in the construction industry.
Previous articles in the series are:
The Basics of Construction Accounting (January / February 2023 Insights)
The Complete Guide to Work in Progress (WIP) (March / April 2023 Insights)
The Complete Guide to Construction Job Costing (May /June 2023 Insights)
The Complete Guide to Construction Payroll (July / August Insights)