Understanding 2 Key Revenue Recognition Methods for Construction
- Cost Construction Accounting
- Jul 24, 2024
- 4 min read
Updated: Oct 16
Accurate revenue recognition is essential in construction accounting for reflecting a project's financial performance. Choosing between different ways to recognize income can have a big effect on how the financial health of a company is reported. This blog post explores two key revenue recognition methods for construction: the Completed Contract Method (CCM) and the Percentage of Completion Method (POC). Understanding these ways is important for managing money well and following the law.
Table of Content:
What is Revenue Recognition in Construction?
Revenue recognition is the accounting principle that determines when and how construction firms record revenue and associated costs in their financial statements. For construction companies, this means recognizing revenue in alignment with performance obligations and project progress, providing stakeholders such as investors, creditors, and management with clear and accurate financial results. Adhering to Generally Accepted Accounting Principles (GAAP) and guidance from the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) is vital for compliance and transparency.
Now, let's explore the two main revenue recognition methods used by construction firms to track progress and report financial data.
Method 1: Percentage of Completion Method
1. Definition and Explanation
The Percentage of Completion Method is an accrual-based accounting method that recognizes revenue and expense recognition proportionally based on the percentage of work completed during an accounting period. This method aligns revenue recognition with incurred costs and estimated total costs, offering a timely and accurate reflection of project performance throughout long-term construction projects.
Revenue and Expenses: Recognized based on actual costs incurred relative to total estimated costs.
Profit Margin: Updated continuously as the project progresses.
Read more: 4 Keys to Improve Construction Profit Margin
2. How Does the Percentage of Completion Method Work?
Revenue recognized is calculated by multiplying the transaction price (total estimated contract revenue) by the percentage of work completed, which is often determined by the cost-to-cost method:
Revenue Recognized = Estimated Total Contract Revenue × Percentage of Work Completed |
3. Pros and Cons
Pros:
Provides accurate financial reporting by matching revenue and expenses to project progress.
Enables construction firms to track progress and receive timely insights into financial health.
Supports better cash flow management by recognizing revenue throughout the project lifecycle.
Cons:
Requires reliable cost estimates and detailed monitoring, increasing accounting complexity.
Risks of estimation errors can lead to adjustments in financial statements.
4. When to Use Percentage of Completion Method
POC works great for long-term projects where you need to keep an eye on progress and report on it regularly. For instance, Large commercial building projects or infrastructure projects, for example, often use POC to give accurate and timely updates on how the money is doing. This method makes sure that the financial records show how the project is going right now, which helps with making decisions and managing money better.
Method 2: Completed Contract Method
1. Definition and Explanation
The Completed Contract Method is a cash basis accounting method where revenue and expenses are recognized only upon completion of the entire project. All incurred costs are accumulated on the balance sheet as construction in progress until the contract is finished, at which point revenue, expenses, and profit margin are recognized in full.
Revenue and Expenses: Recognized entirely at project completion.
Profit Margin: Calculated only when the project is completed.
2. How Does the Completed Contract Method Work?
During the project, costs incurred are recorded as assets on the balance sheet, and billings are recorded as liabilities. No revenue or expenses are recognized in the income statement until the project is substantially complete, at which point the total transaction price and associated costs are reported.
3. Pros and Cons
Pros:
Simplicity: CCM is easy to apply as it involves minimal estimation. Revenue and expenses are recorded in one period, making accounting straightforward.
Deferral of Income Taxes: By deferring revenue recognition until project completion, companies can potentially defer income tax liabilities. This can be advantageous for tax planning and cash flow management.
Cons:
Delayed Financial Insights: Since revenue and expenses are recorded only at the end of the project, CCM may not provide timely insights into the financial status of long-term projects.
Potential for Distorted Financial Statements: Finishing big projects in a short time can cause big changes in financial statements, which could affect how you analyze them and make decisions.
4. When to Use Completed Contract Method Work
CCM is typically used for short-term projects or when it is difficult to estimate the outcome of a project. For example, a small residential renovation project with a clear end date might be best suited for CCM.
How to Choose the Right Method for Your Business
The choice between POC and CCM depends on factors such as project duration, reliability of cost estimates, cash flow needs, and stakeholder reporting preferences. Construction firms should also consider compliance with GAAP, the revenue recognition principle, and guidance from accounting professionals.
Key considerations include:
Are your projects long-term construction projects with measurable progress?
Can your firm reliably estimate total estimated costs and incurred costs?
What are your company's cash flow management needs?
Do your stakeholders require timely financial reporting?
Conclusion
Understanding what are the two methods of revenue recognition for construction contracts the Percentage of Completion Method and the Completed Contract Method is crucial for construction firms aiming for accurate financial reporting and sustainable growth. While the POC method offers detailed, ongoing insights aligned with project progress, the CCM method provides simplicity and tax deferral benefits for suitable projects.
For construction companies looking to streamline their accounting practices, consider professional assistance to ensure accurate and efficient financial management. At Construction Cost Accounting, our expertise helps simplify your accounting and save you valuable time.
Need help with your construction accounting? Contact us today to learn how we can support your construction accounting needs and improve your financial data management.
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