Building the framework for financial success starts long before any ground is broken in the construction industry. Accurately recognizing revenue can be as complex as the projects themselves, given all the fluctuating costs, multi-phase timelines, and long-term contracts.
Contractors must understand the varying revenue recognition methods for construction and choose the right one to ensure they meet compliance standards and maintain financial stability.
This guide explores the ins and outs of recognizing revenue in the construction industry so firms can navigate them successfully. By mastering revenue recognition, construction companies can avoid pitfalls, bolster their credibility with stakeholders, and achieve sustainable growth.
Understanding Revenue Recognition
Revenue recognition is a fundamental accounting method determining when and how revenue is recorded. It plays an integral role in accurately reflecting a company’s financial performance in all industries, including construction.
What Is Revenue Recognition?
Revenue recognition is the process of recording revenue when it’s earned, not necessarily when cash is received. It reflects the completion of a performance obligation (a promise to transfer goods or services to a customer in exchange for consideration).
Two standards—ASC 606 and IFRS 15—provide a comprehensive five-step framework for recognizing revenue that includes identifying contracts with customers, pinpointing performance obligations in the contract, determining the transaction price, allocating the transaction price to performance obligations, and recognizing revenue as those obligations are satisfied.
These accounting standards promote accuracy, transparency, and comparability in financial reporting, helping stakeholders better assess a company’s financial performance and obligations. Check out RightRev’s ASC 606 Revenue Recognition Guide and ASC 606 revenue recognition examples to learn more about them.
Why It Matters in Construction
Construction projects often last a long time and involve complicated contracts, making determining when revenue is earned is challenging. Issues like changing timelines and cost estimation add even more complexity.
Proper construction revenue recognition allows investors to assess profitability and reduces risks for lenders. Mismanaged recognition, on the other hand, can result in misleading financial reports, jeopardize project funding, and negatively impact stakeholder confidence.
Key Revenue Recognition Methods for Construction
Contractors can recognize revenue using several different accounting methods. Construction accounting teams must choose one that will help them accurately reflect their financial performance and achieve compliance with industry standards like Generally Accepted Accounting Principles (GAAP).
Percentage of Completion Method
As its name implies, this common revenue recognition method uses the percentage of the completed project to recognize revenue, making it ideal for long-term contracts. It relies on precise cost estimates and progress tracking to provide timely financial insights.
This method generally works well for construction and large-scale infrastructure projects because it matches revenue recognition with a portion of the project’s completion rather than the entirely completed project.
Completed Contract Method
The completed contract method, on the other hand, recognizes revenue only when a project is fully completed. It is usually applied to short-term contracts or contracts with significant uncertainty (e.g., when estimating direct costs is hard).
Although this method can suit a small-scale project or contracts with an unpredictable outcome, it impacts a company’s cash flow because it delays revenue recognition until the end.
Also, it should be noted that the completed contract method doesn’t comply with the Financial Accounting Standards Board (FASB)’s ASC 606 framework. Per ASC 606, contractors must recognize revenue as their company satisfies its performance obligations, either over time or at a point in time, depending on when control transfers to the customer—regardless of whether a project is completed.
Cost-to-Cost Method
Meanwhile, the cost-to-cost method recognizes revenue based on actual costs incurred relative to total estimated costs. It offers timely insights that reflect actual progress but relies on exacting cost estimates, which can be difficult to obtain.
RightRev’s ACS 606 solution suits large projects with reliable cost tracking, such as highways or commercial buildings. In these instances, revenue is recognized progressively as the project advances, based on incurred expenses and achieved benchmarks.
Milestone Method
Finally, there’s the milestone method. In this case, construction firms record revenue when certain project milestones are reached. Commonly used for projects with clear, measurable phases, it simplifies tracking and provides fast revenue recognition. The only catch is that contractors must define and achieve milestones, which can sometimes be challenging.
Outside the construction industry, the milestone method is frequently used for software development projects and research grants where payment is tied to accomplishing key deliverables or predefined goals.
Overview Comparison of Construction Revenue Recognition Methods
| Milestone Method | Percentage of Completion Method | Completed Contract Method | Cost to Cost Method | |
| Revenue Recognition Timing | Intermittent, as project milestones are reached | Ongoing, as project completion percentages are met | Point in time, as the project is completed | Based on actual costs incurred relative to total estimated costs. |
Choosing the Right Method for Your Construction Business
Construction companies must choose the right revenue recognition method for their business and customer contracts. Their choices directly impact projected revenue, financial transparency, and compliance with accounting standards, all of which affect investor confidence and project management capabilities.
Factors to Consider
When choosing a revenue recognition method, contractors should consider:
- Project duration and complexity: Long-term projects may benefit from methods like percentage of completion and milestones.
- Contract terms and conditions: The chosen method should be able to fulfill the contractual requirements.
- Financial implications and tax considerations: Tax liabilities, cash flow timing, and the overall financial outlook of the business should all be considered when deciding which method to use.
- Company size and internal accounting capabilities: Complex methods require well-established internal processes and accurate cost tracking.
How to Evaluate Which Method Is Best
When deciding which method to use, contractors should follow these steps:
- Assess the project’s duration and complexity
- Review the contract terms
- Analyze all the financial implications
Next, they should consider consulting an accounting professional for advice and expert guidance.
Leveraging technology, such as construction accounting software, can also help simplify revenue recognition, streamline data tracking and reporting, and ensure compliance with industry standards like the FASB’s ASC 606 and the International Accounting Standards Board (IASB’s) IFRS 15.
Case Studies and Examples
There can be much to learn from examples of revenue recognition principles and case studies showing how different revenue recognition methods are applied in real-world scenarios. Let’s examine some.
Real-World Examples of Revenue Recognition in Construction
These real-world examples put this into perspective:
- Case study 1: A construction company used the percentage of completion method for a large-scale infrastructure project. The company reported revenue incrementally throughout the project by closely tracking costs and progress. The approach facilitated cash flow management and aligned revenue recognition with the project’s performance.
- Case study 2: A small residential construction firm opted for the completed contract method to manage its projects, recognizing revenue only upon completion. While this tactic kept things simple and avoided the need for cost estimations, the firm faced cash flow challenges because of the delayed revenue recognition, underscoring the importance of carefully assessing project timelines and financial implications.
Common Pitfalls and How to Avoid Them
Identifying and navigating common pitfalls can help construction companies recognize revenue accurately, avoid costly mistakes, stay compliant, and preserve stakeholder trust.
Challenges in Revenue Recognition
Below are some challenges that contractors often need to overcome while adhering to the revenue recognition principle:
- Delays in project completion: Delays can disrupt cash flow and lead to discrepancies in financial reporting timelines, making it hard for companies to forecast revenue and budget effectively.
- Changes in project scope: Changes in the project scope can complicate the estimation of costs and revenue allocation. This can lead to financial reporting inaccuracies and necessitate adjustments that don’t match initial projections.
- Misalignment between project milestones and revenue recognition: A misalignment can create inconsistent financial reporting, undermining stakeholder confidence and increasing audit risks.
Strategies for Mitigating Risks
To reduce the risk of falling victim to these challenges, construction firms can follow these helpful strategies:
- Conduct regular financial reviews and audits: Frequent assessments will help them spot discrepancies early on and meet all compliance requirements.
- Implement robust project management tools: Advanced project management software enables firms to track progress, costs, and milestones more efficiently and precisely.
- Establish clear communication with all stakeholders: Maintaining open lines of communication supports collaboration, cuts down on misunderstandings, and ensures everyone is on the same page regarding project expectations and timelines.
Master Revenue Recognition in Construction With RightRev
There’s no denying the prominent role that revenue recognition plays in all industries, including the construction field. Without a clear understanding of the concept and how to implement it, contractors might run afoul of compliance authorities, disrupt their cash flows, or mislead their investors.
Here at RightRev, we live and breathe revenue recognition. We understand the hassle of all those spreadsheets and want to liberate your accounting team from them as soon as possible.
Our automated revenue recognition solutions track every aspect of revenue contracts, from orders to revenue journal entries. Our platform is also specifically designed to support all revenue recognition methods for construction. Contact us to learn exactly how RightRev can help improve all your revenue management processes.
