When managing long-term construction projects, it’s crucial to recognize revenue and expenses accurately. This ensures that your financial reports reflect the true economic reality of the project as it progresses. The percentage-of-completion method is widely used in construction to align revenue recognition with the actual work completed. This method helps ensure that both the contractor and client can track the financial status of the project in real-time.
In this guide, we’ll walk through the five key steps for recognizing revenue in construction projects, as well as how to handle progress billing and final project settlements.
The Five-Step Model for Revenue Recognition
1. Identify the Contract with the Customer
The first step is to establish the contract with the customer. This could be a formal written agreement, a verbal understanding, or a combination of both. Contract must be enforceable and have following attributes:
Parties involved (contractor and client) are committed to performance.
Scope of work (detailed description of the project) and rights to goods and services can be identified.
Project timeline (start and end dates)
Price(agreed-upon amount for the work) and payment terms are identified.
Contract is agreed / approved and has commercial substance. It is probable that the contractor would collect consideration from client.
You must also assess whether the contract includes any modifications, such as change orders or amendments, which could affect revenue recognition.
2. Identify Performance Obligations in the Contract
A performance obligation refers to a promise to deliver a specific service or product within the contract. In construction, this could be individual milestones, project phases, or specific tasks. Examples might include:
- Completion of foundational work
- Delivery of specific materials or equipment
- Final project handover
The performance obligations should be clearly defined, and each one needs to be tracked and fulfilled for proper revenue recognition.
3. Identify the Contract Price
This refers to the total amount that will be paid by the customer for the construction project. The contract price can sometimes change due to factors such as:
- Change orders: Additional work or scope adjustments.
- Discounts: Price reductions or rebates.
- Incentives: Performance-based rewards.
It’s important to factor in all these variables to ensure an accurate assessment of the contract price.
4. Allocate the Price to Performance Obligations
Once the total contract price is determined, it needs to be allocated to the various performance obligations. If there are multiple obligations, you will allocate the total price based on the relative standalone selling prices of each performance obligation.
For example, if the contract includes both the delivery of materials and the completion of certain construction phases, each of these items should be assigned a portion of the total price according to their estimated value.
5. Recognize Revenue as Performance Obligations are Satisfied
Revenue is recognized either at a point of time or overtime as you fulfill each performance obligation. The percentage-of-completion method aligns with this step, as it ties the recognition of revenue to the percentage of work completed.
Revenue is recognized in proportion to the costs incurred to date compared to the total estimated costs for the project. This ensures that revenue is matched with the work actually completed.
Accounting for Progress Billing and Revenue Recognition
In many construction projects, contractors bill clients at certain intervals or milestones based on the percentage of work completed. This process is called progress billing. Below, we explain how to account for progress billing along with revenue recognition.
Progress billing allows the contractor to invoice the client based on the completion of certain stages of the project. This helps maintain cash flow throughout the life of the project, as payments are made incrementally.
Recording Progress Billing
When a progress bill is issued, the contractor needs to recognize both a liability and a receivable. The journal entries for progress billing are:
At the Time of Billing:
Debit: Accounts Receivable
Credit: Billings on Construction Contract (a contra-asset account, which offsets the Construction in Progress (CIP) account or a liability account)
Recording Cash Receipts
When the client pays a progress bill, the receipt settles the progress bill.
Debit: Bank Account
Credit: Accounts Receivable
Tracking Progress and Revenue Recognition
Throughout the project, it's important to regularly review and reconcile the Billings on Construction Contract and Construction in Progress (CIP) accounts.
The Billings on Construction Contract account shows the total amount billed to date and offsets the CIP account, while the CIP account tracks the actual costs incurred and recognized gross profit. It is important to review costs to completion estimate before each revenue recognition run.
Dr. Construction in Progress
Cr. Revenue
Final Settlement
At the completion of the project, you’ll need to reconcile the final amounts billed with the total revenue recognized. At this stage revenue recognized should equal progress billings, if that's not the case then adjustments are needed to reconcile the two.
Final Thoughts
Proper revenue recognition is vital for construction projects, ensuring that financial statements reflect the true financial position of the project. By following the five-step revenue recognition model, contractors can accurately recognize revenue as they fulfill their performance obligations. Additionally, careful management of progress billing helps track cash flow and ensures that invoices align with the work completed.
It’s also essential to regularly review project estimates, costs, and billing amounts, adjusting for any changes in scope or unforeseen issues. By maintaining accurate and timely records, contractors can avoid costly errors and ensure compliance with accounting standards.
By adhering to these practices, contractors can better manage their long-term projects, ensuring transparency, proper financial reporting, and smoother operations throughout the life of the project.
Further Resources
IFRS Navigator Conceptual Framework
The above links are to ifrs.org. To access the standards, log in or create a free account