A Contractor’s Guide to Revenue Recognition

Companies use different methods of revenue recognition depending on their industry and core business operations. Companies in the construction industry have projects that may cover weeks, months, or even years to recognize revenue.

Revenue recognition is the starting point used by contractors, banks, and other financial institutions to measure the profitability of construction companies. Because of the complexities, there needs to be a consistent, standardized way to recognize revenue, so that all parties can understand throughout the construction industry.

Key Takeaways

• Revenue recognition is crucial in the construction industry.
• Establishing a standardized methodology allows for enhanced compliance, increased accuracy, and transparency in financial reporting, and more informed decision-making.
• There are five primary revenue recognition methods: point of sale, percentage of completion, completed contract, installment, and the cash method.

Understanding the Regulatory Landscape: ASC 606

The Financial Standards Accounting Board (FASB) and the International Accounting Standards Board (IASB) created ASC 606 to standardize the methods of reporting revenue across various industries. This new standard makes it easier for company managers, banks, creditors, and investors to analyze and compare the financial results of different businesses. ASC 606 is based on the delivery of promised goods and services to the client.

These are considered performance obligations, and they are different from meeting the requirements and terms outlined in a contract. These contracts don’t recognize revenue until the performance obligations are complete; however, issues hinge on the principle of transferring control from the contractor to the client.

The Five Methods of Revenue Recognition

There are five methods of revenue recognition, each one offering a unique approach to revenue. The five methods are:

• The point of sale method recognizes revenue when a product or service is sold, and the customer takes possession. This method is commonly used in retail and other transactional businesses where products are sold immediately. (Ex. 1)
• The percentage of completion method is used in the construction industry. It recognizes revenue based on the long-term construction project’s completion status. Revenue is recognized based on the percentage of the work completed during the period. This method requires careful estimation of the work completed and the total project cost. The percentage of completion is calculated by dividing the costs incurred to date by the total estimated costs. (Ex. 2)
• The completed contract method is also used in the construction industry. Revenue is only recognized when the entire project or contract is completed. This method is more conservative and is generally used in situations where the outcome of the contract is uncertain. (Ex. 3)
• The installment method is used when payment is received in installments over time, and it’s uncertain whether the full payment will be made in the short term.  This method is usually used with sales of expensive items with installment plans. (Ex. 4)
• The cash method recognizes revenue when cash is received, rather than when the sale occurs.  This method is used by small businesses that want to be cash basis taxpayers. (Ex. 5)

Small business owners and management should discuss and analyze their business processes to use the right revenue recognition method that fits their business needs.

Practical Examples of Each Revenue Recognition Methodology  

Example #1

A company sells a machine costing $180,000 for $300,000. The sales contract calls for four annual payments of $75,000. Under the point-of-sale method:

Debit Accounts Receivable for $300,000 

Credit Sales Revenue for $300,000 

Debit Cost of Goods Sold for $180,000 

Credit Inventory for $180,000 

• The revenue recognition is $300,000 as seen in the journal entries above. 

Example #2 

Stony Bridges Ltd. was awarded a $20 million contract to build a bridge. The estimated time to complete the project is three years with an estimated cost of $15 million. Assuming that the cost estimates do not change, the project is expected to generate $5 million in profit. What is the revenue recognition if $10 million of costs have been accumulated after 2 years? The following is a schedule for the project using the alternate percentage of completion method:

Costs Incurred (Cumulative) - $10 M

Percentage used: 10/15 = 66.67% 

Estimated Total Costs - $15 M 

• Revenue recognition is ($5,000,000 x 66.67% = $3,333,500 after 2 years. 

Example #3 

Using the same scenario as Example #2, Stony Bridges Ltd. was awarded a $20 million contract for the completion of the bridge. The project took three (3) years with a total cost of $16 million to build. Under the completed contract method:

Debit Cash for $20,000,000

Credit Sales Revenue Construction for $20,000,000

Debit Cost of Goods Sold for $16,000,000

Credit Work in Progress - Bridge for $16,000,000

• Revenue recognition is ($20,000,000 – $16,000,000 = $4,000,000) at completion.

Example #4

Company A is a furniture company and makes a sale for a piece of furniture with a retail price of $10,000 at the beginning of December 20X8. The cost of the furniture for the company is $4,000. Therefore, the gross margin for the good is 60%. The company strikes a deal with the customer in which the customer is required to make installment payments of $2,500 each month for the furniture until the full amount is paid ($10,000). Under the installment method:

• Revenue recognition is ($2,500 - $1,000 = $1,500) in 20X8, and the revenue recognition is ($7,500 - $3,000 = $4,500) in 20X9 for total revenue recognition of $6,000 combined.

Example #5

A consultant invoiced a company for $20,000 in November for completion of a project, but received payment in January. Under the cash method, the consultant recognizes the revenue in January when the cash is received, not when the service was rendered.

• Revenue Recognition is $20,000 in January, not November of last year. 

The Importance of Revenue Recognition  

In the construction industry, revenue recognition is essential as it enhances compliance while also promoting an environment of accuracy. Revenue recognition helps to make sure revenues are recorded accurately and consistently over the lifespan of a construction project. This accuracy allows for more transparent communication and enables more informed decision-making. Having a more precise, encompassing view of the profitability of a project allows for better financial planning and forecasting, as it provides a clear view of estimated or expected earnings.

At EisnerAmper, our construction team has extensive experience and knowledge. With tailored solutions, we strive to provide excellent services while helping you increase profitability and reach financial objectives. To learn how we can help your firm, contact us below.