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The accounting world for construction firms operates by a different set of rules than most other industries. Unlike a retail company that recognises revenue at the point of sale, contractors must account for income on projects that can take months or even years to complete. This is a critical financial practice that ensures a company’s financial statements accurately reflect its performance. Without a proper method, a firm might appear to be losing money for years, only to report a profit when a project is finally finished.
This article provides a clear overview of revenue recognition for long-term construction contracts. We’ll explore the shift from traditional accounting methods to the modern, standardised framework of ASC 606. Contractors can gain better insight into their ongoing profitability by understanding this and ensure their financial reporting is compliant.
Continue reading to find out more about how your long-term construction contract can benefit from updated revenue recognition.
The Evolution of Revenue Recognition
Percentage-of-Completion Method (PCM)
Construction companies rely on this method to recognise revenue gradually over the life of a project based on its progress. It helps to give a clearer picture of a company’s financial performance, as it matches revenue to the effort and costs that have happened during each stage of the build. It’s perfect for long-term projects, meaning that it’s not recommended for a short term solution.
Completed-Contract Method (CCM)
CCM is completely different from PCM, as it only focuses on revenue recognition when the project is finished. It can be much simpler to manage this way, but it does come with some downfalls. For example, it can create large swings in reported income and can hide the profitability of ongoing projects. This makes it difficult to see the true financial health of the company during the construction process.
Construction Contracts Five-Step Model
ASC 606 simplifies revenue recognition by focusing on the core principle of when a company satisfies its performance obligations. Here’s how the model works:
- Identify the Contract: The first step is to identify a legal and enforceable contract with a customer, so that you are both aware of everything that’s going on with a project. This is something that we see in plant hire contracts to establish lengths of the hire and the services the engineers can provide.
- Identify Performance Obligations: The contract then needs to be broken down into distinct promises to the customer. This could include the overall building of a structure, but it could also be separate obligations like site preparation, foundation work and electrical systems if they are distinct.
- Determine the Transaction Price: You then need to establish the total amount of consideration the company expects to receive from the customer, which can include bonuses for early completion or penalties for delays.
- Allocate the Transaction Price: Then, divide up the total transaction price to each individual performance obligation identified in step two. This is typically based on the relative standalone selling price of each project stage.
- Recognize Revenue: Finally, recognise revenue when each task is finished. For long-term construction projects, this is almost always recognised over time as control of the work is transferred to the customer.
Breaking down long-term projects into manageable performance obligations allows firms to accurately measure and report their progress. This method ensures that financial statements reflect the true economic reality of a project as work is completed, moving away from outdated practices and promoting greater transparency in financial reporting.
Over Time vs Point in Time
Under ASC 606, revenue on a construction project is recognised over time if any of the following criteria are met:
- The customer receives and consumes the benefits of the contractor’s work as it’s performed.
- The contractor’s work creates or enhances an asset that the customer controls.
- The contractor’s work does not create an asset with an alternative use and the contractor has an enforceable right to payment for performance completed to date.
Most long-term construction projects will meet at least one of these criteria, making the over-time method an appropriate approach. The revenue is then calculated based on the progress toward completion, which is usually measured by a cost-to-cost basis. This provides a continuous reflection of the project’s financial performance.
In contrast, the point-in-time method is used when the customer obtains control of the asset at a single point in time, such as when a prefabricated home is delivered and installed.
Final Thoughts
Adhering to standards like ASC 606 allows contractors to move beyond outdated methods like the CCM and embrace a more transparent and continuous view of their financial health. Revenue recognition over time can be seen as performance obligations are met, so companies can track profitability on a real-time basis.
This enables better project management, smarter resource allocation and more accurate forecasts. When you have a proactive approach like this, financial reporting can then build trust with investors, ensuring the firm’s long-term stability and success in a highly competitive market.