What Contractors Need to Know About Revenue Recognition

Businesses across all industries are under an obligation to follow generally accepted accounting principles (GAAP) when it comes to handling their finances—and this remains true when choosing a revenue recognition method.

However, because of some inherent challenges of being in the construction industry, businesses may face some obstacles when deciding on the revenue recognition method that works best for them.

What Is Revenue Recognition?

Specifically, revenue recognition refers to an accounting principle where a company's revenue is documented and recognized only after the final product/service is delivered and the company has a reasonable expectation of payment.

Revenue recognition matters in the construction industry specifically because it helps to paint a realistic picture of the company's overall financial health by recording revenue at the time services have been delivered and the terms of a contract fulfilled. This can also help to improve confidence and trust among clients and other stakeholders while ensuring consistency in accounting practices.

Challenges in Construction

At the same time, the construction industry sees some unique challenges when it comes to choosing a revenue recognition method. Consider, for example, that it is not uncommon for a construction project to span many weeks, months or even years.

As a result, these companies may have revenue-generating projects in the works that they're unable to formally recognize in their accounting for long periods of time.

Ultimately, the most important thing to remember when choosing a revenue recognition method is to keep it consistent. By selecting a methodology and sticking with it, construction contractors and stakeholders can improve their own accounting compliance while enhancing the accuracy of their recordkeeping.

Meanwhile, understanding the regulatory landscape surrounding ASC 606 may also be helpful in choosing a method. Specifically, this standard requires revenue to be documented at the time of delivery of promised goods and services to a client (not necessarily when payment is actually received).

Five Revenue Recognition Methods for Contractors

So, what options do construction contractors have when it comes to revenue recognition? The five main options to consider are:

• Point of sale method – revenue is recognized when the product/service is sold and the customer accepts possession (most common in retail and other businesses where point of sale transactions are common).
• Percentage of completion method – revenue is recognized based on the completion status of a project. Most often used in long-term projects, this method requires careful tracking of the project and involves dividing costs incurred by total estimated costs on any given date to reach a calculation.
• Cash method – revenue is not recognized until the payment for the goods/services is actually received by the business. This method is most common among small businesses that choose to follow cash basis accounting.
• Installment method – revenue is recognized as payments are received in installments over an agreed-upon amount of time. This method is commonly used in larger projects where clients may make multiple payments rather than a single lump-sum payment.
• Completed contract method – revenue is recognized at the time the project or contract terms are completed. Often used in construction, this method is useful for businesses looking for a more conservative option.
  
  
  

A Practical Example

As you can see, there are many potential revenue recognition methods to consider—but which option is best in construction? It can be helpful to look at a practical example of how revenue recognition is often handled in this industry.

Example:

A construction company is hired to build a custom home for a client to the tune of a $500,000 contract. The company followed the completed contract method, and the project took a year to finish. Under this arrangement, revenue recognition may look like:

• Debit for cash: $500,000
• Debit cost of goods sold: $400,000
• Revenue recognition: $500,000 - $400,000 = $100,000 at time of completion.
  
  
  

The Bottom Line: Which Method Is Best?

Construction businesses have a lot to keep in mind when it comes to deciding on the revenue recognition method that best suits their needs. Ultimately, the most important thing is to choose a method and stick with it as much as possible, as this will lead to more consistent accounting.

If your team has additional questions about choosing a revenue recognition method, then it may be time to reach out to a trusted and experienced accounting professional who can provide more personalized guidance.

To learn more about LGT and how we can serve you, contact us here.