Accounting Methods for Construction Company Revenue Recognition

By Evan Schiller, CPA

In financial accounting, the two most common methods of accounting are the accrual method and the cash method. However, other accounting methods can be used as long as they conform to generally accepted accounting principles (GAAP). For construction companies, the percentage of completion method and the completed contract method are often used.

Percentage of Completion Accounting Method

Percentage of completion is a method of accounting used for long-term contracts that recognizes both revenue and expenses based on the percentage of the work completed. Long-term contracts are contracts that begin in one year and are completed in a later tax year. Percentage of completion is required to be used by all contractors with more than $25 million in revenue. The percentage of completion method requires the taxpayer to maintain a work-in-process (WIP) schedule.

A WIP schedule contains:

1. The total contract amount at 100% completion
2. The actual costs the project has incurred to date
3. The estimated costs to complete the project
4. Percentage of completion—This is determined by dividing the actual costs incurred by the estimated costs of completion

A WIP schedule is also critical to maximizing a construction company’s bonding capacity, another key financial reporting objective for contractors.  The information required to track WIP properly can be gathered using specialized construction accounting software. 

Percentage of Completion Example

1. The total contract amount at 100% completion: $1,912,909
2. The actual costs the project has incurred to date: $1,750,006
3. The estimated costs to complete the project: $1,855,522
4. Percentage of completion: $1,750,006/$1,855,522 = 94%

In this example, the total revenue that will be recognized on this contract upon completion is $1,912,909.  Multiply that by the percentage of completion, 94%, to get $1,804,130 in revenue to report.

The main risk of using the percentage of completion method is the use of estimates. As a result, revenues and expenses may differ from actual totals when the project is complete. The IRS has a lookback provision to offset the time-value effects of using estimates. Interest may be due to the IRS if estimates differ from actual costs, and cash flow problems can also result.

Additionally, underbilling (contract assets) and overbilling (contract liabilities) are adjustments made to revenue based on amounts billed to the customer. Overbilling occurs when the amount billed exceeds the revenue recognized by the percentage. The opposite is true for underbilling. Underbilling occurs when the amount billed to date is less than the recognized revenue by the estimated percent complete. Underbilling and overbilling are tracked and recorded on the balance sheet and impact revenue recognized for the period.

Completed Contract Accounting Method

The completed contract method allows taxpayers to delay reported income until the entire contract is completed. Even if payments are received before the contract is complete, no revenue is recorded until the completion of the contract. Contractors often use the completed contract method with short-term projects of less than one year.

The IRS requires taxpayers to use the percentage of completion method for long-term contracts; however, two exceptions enable contractors to use the completed contract method. Those are home construction contracts and small contractors with less than $25 million in gross receipts.

One of the main advantages of the completed contract method is the built-in tax deferment of income until the project is completed. Unlike percentage of completion, revenue is not recognized using estimates, and all numbers are finalized before revenue is recorded.

Conclusion

A comprehensive understanding of financial requirements specific to the construction industry is critical for long-term success.  If you have questions about which methods are best suited for your construction business or would like other accounting, tax, assurance, or valuation and advisory services, contact author Evan Schiller, CPA, or another member of our Construction Committee at 813-875-7774.