Which Revenue Recognition Method Fits Long Construction Contracts

Construction accounting differs from general business accounting because it addresses projects, long-term contracts, variable costs, and complex revenue recognition. The accounting method you pick will affect your financial reporting quality, tax obligations, and strategic decisions.

Cash vs. accrual basis in construction

Construction companies must choose between two main accounting approaches: cash and accrual.

Cash-basis accounting follows a simple rule: you record revenue only when you are paid and expenses only when you pay them. Let's say your company gets a USD 20,000 deposit for an upcoming project. Under cash accounting, that money counts as income immediately. This relaxed approach makes cash accounting easy to understand and manage.

Smaller contractors get several benefits from the cash method:

• They see exactly how much money they have right now
• They don't pay taxes until they actually receive money
• They can manage their taxable income by timing when they pay bills

However, cash-basis accounting has its limits. It doesn't show money owed to you or bills you haven't paid yet. This can give you a misleading view of how your long-term projects are performing. Cash-basis accounting also doesn't follow Generally Accepted Accounting Principles (GAAP) and doesn't align well with standard retainage practices. The IRS only lets contractors who make under USD 25-30 million use this method (based on specific guidelines).

Accrual basis accounting works differently. You count revenue when you earn it and expenses when they occur, regardless of payment timing. For example, if you finish 40% of a USD 1 million project, you can count that portion as revenue even if your client hasn't paid yet. This gives you a better picture of your project's financial health.

Why is accrual preferred for long-term contracts?

Accrual accounting has become the best choice for construction companies with long-term contracts for good reasons.

Accrual accounting shows you what's really happening with your project's finances. This helps significantly when you're handling long-term contracts or projects that span several accounting periods. By recording revenues and expenses as they occur, accrual accounting aligns well with the percentage-of-completion method used by many contractors.

Only accrual basis accounting follows GAAP and International Financial Reporting Standards (IFRS). Large contractors and public companies must use these standards. Banks and investors usually ask for GAAP-compliant financial statements, so this compliance helps you get financing.

This method also helps match costs and revenues throughout your project. You can forecast earnings better and plan your finances more effectively. You'll track progress, billing,s and work-in-progress accurately, and record all your costs - from subcontractor payments to materials and labor - in the same period you did the work.

Contractors who earn USD 25 million or more in average annual revenue over three years must use accrual accounting. Even smaller contractors who can choose often find that accrual accounting gives better insights for projects lasting more than a year.

The biggest challenge with accrual accounting is its complexity. You must track everything carefully, manage revenue recognition, and maintain detailed records for audits. You may also need to pay taxes on income you've earned but haven't yet received.

For construction companies facing industry billing standards, contract types, and cash-flow challenges, accrual accounting remains the best choice. It's the foundation for specialized revenue recognition methods, such as percentage-of-completion, which you need for long-term contract accounting.

ASC 606's five-step model reshapes revenue recognition for construction companies with long-term contracts. Construction companies need to analyze contract terms, performance metrics, and variable elements that show up in construction agreements.

Identifying contracts and obligations

Construction businesses face their first challenge when they must determine whether a contract exists under ASC 606. ASC 606 needs five specific criteria before revenue recognition can start, unlike older standards:

• Both parties must approve the contract and commit to their obligations
• The rights regarding goods and services must be clearly identified
• Payment terms must be established
• The contract must have commercial substance
• A collection of most of the considerations must be probable

Your team may begin work under verbal agreements or established business practices before finalizing paperwork. You'll need to review whether these are oral or implied contracts and determine their legal terms. Legal counsel might need to help with this. How you assess contract terms is critical, as it determines which promised goods or services are identified and how the transaction price is calculated. Termination clauses require close review because they affect the duration of enforceable rights and obligations.

You must combine contracts with the same customer for accounting purposes if they were negotiated as a package with a single commercial objective. This applies when one contract's consideration depends on another, or when goods and services from different contracts constitute a single performance obligation.

Construction often sees contract changes that need special attention. ASC 606 provides a comprehensive model for handling contract modifications. These changes may arise from approved change orders or disputes that result in liquidated damages or claims. The way you treat modifications depends on factors such as pricing and whetherthe added goods/services stand alone. They can be separate contracts, end one contract to start a new one, or adjust the original contract.

Performance obligations are the foundations for revenue recognition. These promises to deliver distinct goods or services are distinct when:

1. The customer can benefit from it alone or with other accessible resources
2. The promise to transfer it stands apart from other promises

Construction companies must exercise judgment to determine whether work elements are distinct. Many contracts end up with a single performance obligation rather than multiple separate ones due to high integration levels in construction projects.

Determining and allocating transaction price

The transaction price goes beyond the simple contract amount - it's what you expect to get for meeting contract obligations. You must estimate and include variable consideration elements such as contract options, unapproved change orders, performance bonuses, and penalties.

ASC 606 asks you to estimate variable consideration through either:

Expected value method: The sum of probability-weighted amounts across possible outcomes. This method works best with many similar contracts.

Most likely amount method: The single most likely outcome. This applies to situations with only two possible outcomes, such as receiving or missing a performance bonus.

There are limits to including variable consideration. You should add amounts only when a significant revenue reversal is not expected. These limits apply when:

• Outside factors control the amount
• Uncertainty stays unresolved for a while
• You don't have much experience with similar contracts
• You often give many price concessions
• The contract could have many different consideration amounts

Rare cases in construction have multiple performance obligations. The transaction price needs allocation based on relative standalone selling prices. You can assign variable consideration to specific performance obligations if it connects to your work for that obligation and matches your expected earnings.

Your construction company can achieve better revenue recognition by applying these ASC 606 principles. This approach shows the true project economics and contract realities.

ASC 606 highlights a key difference in how construction companies recognize revenue: either "over time" or at a specific "point in time." Your financial reporting depends on when control moves from your construction company to the client.

Transfer of control criteria

Control transfers when your customer can "direct the use of, and get all the remaining benefits from, the asset. This concept serves as the foundation of ASC 606's single revenue recognition model.

Construction projects often make it hard to pinpoint control transfer. Take a building renovation, does the client control the asset during construction or only after completion? ASC 606 lists five key indicators that show control has transferred:

• Your company has a present right to payment for the asset
• Your customer has obtained legal title
• You've transferred physical possession
• The customer has assumed significant risks and rewards of ownership
• The customer has accepted the asset

These indicators help you decide whether to recognize revenue throughout a project or at completion. You'll need careful judgment to evaluate them, especially with service-oriented and construction contracts where "control" might seem abstract.

When to use overtime recognition

Over-time revenue recognition lets you record earnings as your project moves forward. Most long-term construction contracts prefer this approach. ASC 606 allows revenue recognition over time when you meet any one of these criteria:

1. The customer gets and uses the benefits while you perform the work
2. Your work creates or improves an asset that the customer controls during construction
3. Your work doesn't create an asset with alternative use to your company, and you have an enforceable right to payment for completed work.k

Service arrangements usually fall under the first criterion. The second fits projects where you build on the customer's property. The third needs two conditions: no alternative use and payment rights.

An asset has "no alternative use" if you can't redirect it to another customer or would lose money trying to do so. You have an "enforceable right to payment" when you're entitled to compensation for completed work, even if the customer cancels for reasons beyond your control.

An office renovation project illustrates this well. The customer might receive control after you finish the framing. They could sell the unfinished space since they have use and benefit, letting you recognize revenue for that completed work.

Point-in-time recognition applies when none of the over time criteria fit. This happens when:

• Customers don't benefit until project completion
• The asset stays under your control until it is finished
• You could use the asset for another customer if the contract fails

After choosing overtime recognition, you'll need a way to measure progress. Input methods track costs or labor hours, while output methods look at milestones or completed units. Each method suits different construction accounting needs.

This choice between recognition approaches matters. It shapes how your construction company shows its financial performance, especially for long-term projects where timing can change your reported profits dramatically.

You need to pick the right way to track progress once you decide to recognize revenue over time. These tracking methods are the foundations of figuring out revenue numbers for each accounting period during a project.

Input method: costs incurred

The input method tracks progress based on what you've put into the project. This looks at your resources, work hours, or costs compared to what you expect to need for the whole project.

The cost-to-cost method is the most accessible approach in construction. The math is straightforward: your revenue matches the percentage of costs you've spent. Here's the formula:

Percent Complete = Costs of Construction to Date ÷ Total Estimated Cost of Construction

Once you have this percentage, you can calculate your earned revenue:

Revenue Earned to Date = Percent Complete × Total Contract Price

Let's say your project has spent $400,000 out of an estimated $1,000,000 total cost. That puts you at 40% complete. With a $1,500,000 contract, you'd recognize $600,000 in revenue ($1,500,000 × 40%).

The input method works best when:

• Your customer gets goods or services that aren't easy to measure
• You run service contracts where it's hard to calculate the value given to customers directly

Keep in mind that the input method might not always match real project progress. Things like worker inefficiency, wasted materials, or delays can throw off the link between costs and actual progress. Leave out any inputs that don't show real progress toward finishing the contract.

Output method: milestones and deliverables

Output methods look at things differently. They recognize revenue based on what you've actually given to the customer. These methods focus on results rather than spending.

You can measure output through:

• Units delivered or produced
• Milestones reached
• Surveys of work performed
• Appraisals of results achieved

The milestone method shines in projects with clear phases or deliverables. You recognize revenue when you hit specific goals within the project. A construction project might count finishing the foundation, passing inspections, or completing structural work as milestones.

The incremental milestone method (or "steps" method) fits well with cost accounts that have sequential subtasks. Each step you finish represents part of the total installation, which lets you recognize revenue along the way.

Pick an output method that truly shows your progress toward meeting obligations. Watch out - using just milestones might not work if you do lots of work between them. Your chosen measure should include all significant items or services already given to the customer.

Both approaches feed into Work-in-Progress (WIP) reports. These reports track your project's revenue and costs while showing if you're overbilling or underbilling. They make project management easier and help you spot risks early.

Revenue recognition in construction projects depends heavily on accurate cost allocation. Construction firms use job costing to categorize expenses and measure project progress against budgets. These categorizations determine the timing and amount of revenue recognition for long-term contracts.

Direct vs. indirect costs

Project managers can trace direct costs to specific construction projects. These costs change based on project scope and complexity. Project managers and CFOs who track these costs can spot trends, anticipate shortfalls, and adjust their plans quickly.

Typical direct costs include:

• Labor costs: Wages for on-site workers and foremen
• Materials: Concrete, steel, lumber, drywall, wiring, piping
• Equipment: Rental or purchase of bulldozers, cranes, and other power tools
• Subcontractor fees: Payments to electrical, plumbing, or HVAC specialists

Project type and construction phases affect direct costs differently. Steel beam materials represent major direct expenses during framing, while finishing stages need flooring materials and specialty subcontractor work.

Poor management of direct costs leads to project delays, higher expenses, and financial losses. To cite an instance, projects with underestimated labor costs might lack skilled workers and miss deadlines. Inaccurate equipment rental tracking could also result in unexpected expenses.

Indirect costs, also known as overhead or G&A expenses, support overall operations without linking to individual projects. These costs include:

• Administrative salaries
• Office rent and utilities
• Insurance and legal fees
• Business development expenses
• Software licenses and technology costs

Companies must account for indirect expenses even though they aren't directly billable. Each project should carry its share of overhead to ensure accurate pricing. A real-life example shows how one company ignored rising utility costs during a large infrastructure project, which caused a 10% budget overrun.

Allocation methods for indirect costs typically include:

• Percentage of direct labor hours
• Square footage of job sites
• Proportion of direct costs

Treatment of uninstalled materials

ASC 606 brings unique challenges for uninstalled materials. These materials are purchased or allocated to projects but remain unused. Materials might sit in warehouses or on-site while earmarked for specific jobs.

Previous accounting standards (Topic 605) treated materials delivered to jobsites but not installed as inventory. ASC 606 changed this approach because purchased materials might not transfer immediate value to customers.

Companies must first determine if uninstalled materials qualify as inventory. Materials that don't qualify need evaluation based on control and title by asking:

1. Has control transferred to the customer?
2. Are the materials so specific to one job that they couldn't be used elsewhere?

Materials meeting either condition generate revenue equal to their cost with zero margin. These materials should not affect progress calculations when measuring completion percentage.

This approach changes revenue recognition patterns. A job with 10% total gross profit might show only 4% job-to-date gross profit with significant uninstalled materials present. Zero margin recognition on uninstalled materials moves profit recognition to installation periods.

Searchable codes help track material-intensive jobs effectively. Project managers who understand material delivery timing create more efficient evaluations of uninstalled materials.

Construction projects see frequent contract modifications. These change orders alter existing agreements and need careful accounting treatment under ASC 606. This ensures proper revenue recognition.

How change orders affect transaction price

Change orders directly shape your transaction price calculations. They modify scope, pricing, or both, usually showing up as additions or changes to the original contract. Both parties must approve and document these orders properly to create new enforceable rights and obligations.

Several factors make a change order enforceable:

• Written approval of the change order's scope
• Clear contract language that shows entitlement
• Separate documentation for identifiable costs
• Past success with negotiating similar changes

Some change orders spell out the work but leave pricing for later talks. These "unpriced change orders" become variable consideration. You'll need to estimate them using either expected value or the most likely amount methods.

Here's a real-world example: You build a commercial structure for $1 million with a possible $200,000 completion bonus. The client asks for floor plan changes halfway through. This bumps up costs by $120,000 and the contract price by $150,000. The change affects both your transaction price and completion timeline.

Reassessing performance obligations

You must reassess performance obligations after contract changes based on remaining deliverables. ASC 606 handles modifications in three ways:

• A separate contract emerges when you add distinct goods/services at standalone selling prices.
• The existing contract ends, and a new one begins when the remaining goods/services stand apart from those already delivered.
• A cumulative catch-up adjustment happens when remaining goods/services blend with work already done. This fits situations where modifications just change partially finished performance obligations.

Let's look at our commercial building example. The modifications blend with the original building as one performance obligation. You'd use the cumulative catch-up method here. This means recalculating the percentage complete using the revised total costs ($820,000 instead of $700,000) and adjusting revenue immediately.

Timing plays a crucial role in change order economics. Changes to finished areas cost more than early-stage modifications. Changes that break the workflow can reduce productivity. This extends project timelines and increases expenses beyond direct modification costs.

Accurate accounting for these modifications helps financial statement users better understand project economics. It also prevents profit fade as projects move forward.

Tax rules follow their own path, often differing from financial reporting standards. Your construction company might use one method for financial statements and a completely different one for tax returns.

IRS rules for long-term contract revenue recognition

The Internal Revenue Code sets specific requirements for construction projects that span multiple tax years. Long-term contracts are contracts not completed within the tax year in which they start. We primarily used the percentage-of-completion method (PCM) for tax purposes. A project that begins on December 27 and ends on January 6 would be considered "long-term," even though it runs just 10 days.

PCM requires you to recognize taxable income as your project moves forward. You can calculate this by comparing your costs as of year-end with the total estimated costs. This gives you a completion percentage, which you multiply by the estimated gross profit.

The rules have some exceptions. Small contractors with average annual gross receipts under USD 29.00 million (as of 2023) can qualify for different treatment. This amount changes yearly with inflation. Qualifying businesses can choose from these methods:

• Cash method: You recognize revenue when you get paid and deduct expenses when you pay them
• Completed contract method: You wait to record all revenue and costs until the project ends
• Pure accrual method: You recognize revenue based on your contract billing terms

The IRS takes method selection seriously. Companies face penalties and interest charges if they don't report income correctly.

Taxable income timing under different methods

These timing differences between tax and financial reporting create opportunities to plan strategically. With the completed contract method (CCM), you can defer recognizing income and expenses until specific completion criteria are met.

Your contract counts as complete for tax purposes when either:

1. Your customer uses the work, and you've incurred at least 95% of allocable costs
2. You've reached final completion and acceptance

CCM helps you defer taxes but comes with some risks. You might get hit with a big tax bill if several contracts finish at once.

Here are other tax timing factors to think about:

You need to recognize variable items like bonuses and penalties as soon as you can reasonably predict earning them - this might be earlier than financial reporting requires.

Uninstalled materials create special challenges. Tax rules count them as job costs when they're "dedicated to the job," not when you install them. This means you might pay taxes sooner than under GAAP reporting.

You must include claim revenue in your taxable contract value once you can reasonably predict a favorable resolution, whatever the payment timing.

These differences between book and tax accounting affect your balance sheet's deferred taxes. New GAAP standards mean you'll need ways to separately track items like variable consideration and uninstalled materials for tax reporting.

Construction companies face significant risk exposure with their long-term projects. These risks need proper consideration in their accounts. Companies that handle these risks well avoid distorting their financial statements and show the true economics of their projects.

Accounting for warranty liabilities

Construction warranties come in two distinct categories, each needing different accounting approaches. Assurance-type warranties guarantee that delivered work meets contract specifications and serve as quality guarantees against construction defects. These warranties don't create separate performance obligations. Service-type warranties offer additional services beyond fixing defects and begin separate performance obligations. The revenue allocation depends on standalone selling prices.

Companies must record expenses for assurance-type warranties as contingent liabilities once losses become probable and estimable. The customer receives the work along with estimated repair or replacement costs recorded as liabilities. Warranty bonds usually last 1-2 years after completion, so companies need liability reserves to cover potential defect repairs.

Accounting standards state that warranty expenses follow the matching principle. Companies record these expenses at the time of sale, no matter when repairs happen. This helps maintain consistent financial reports by lining up costs with related revenue periods.

Recognizing provisions for loss-making contracts

A contract becomes loss-making (onerous) when the costs to meet obligations are nowhere near the expected economic benefits. Companies should test all contract assets for recoverability before creating loss provisions. They must write down these assets if needed.

Companies must record the entire loss immediately once it becomes evident. Here's an example: A contract price of $1,000,000 with estimated costs rising to $1,250,000 means recording the full $250,000 expected loss in the current period.

The costs you can't avoid include both incremental costs, such as direct labor and materials, and allocated costs that align with fulfillment, such as equipment depreciation. Expected benefits show the net present value of future inflows.

Loss provisions appear as separate items on the balance sheet and as contract costs on the income statement. Regular project monitoring helps companies spot potential losses early. This enables timely reporting and allows management to step in.

Your construction company's financial picture depends heavily on revenue recognition methods. You've learned how cash and accrual accounting choices affect your coverage accuracy. Accrual has become the preferred approach for long-term projects.

ASC 606 has revolutionized how construction companies record earnings. The five-step model provides a clear framework for aligning revenue with your transfer of control to customers. Your financial statements become more consistent and better reflect project economics this way.

One of your most significant accounting decisions is choosing between over-time and point-in-time recognition. Most construction contracts qualify for overtime recognition. They either create customer-controlled assets or have no alternative use, plus payment rights. You can calculate the exact revenue for each period using progress measurement techniques like cost-to-cost or milestone methods.

Cost allocation is a vital part of the process. Your revenue calculations directly depend on how you categorize direct costs, indirect expenses, and uninstalled materials. Contract modifications and change orders complicate matters. You need a complete picture to determine if they represent separate obligations or changes to existing work.

Tax rules bring their own challenges. While financial reporting follows GAAP standards, tax rules often diverge. Small contractors qualify for exemptions. These allow completed contract methods that defer taxable income. Such timing differences create both planning opportunities and compliance challenges.

Your warranty obligations and loss provisions just need careful attention. The timing of revenue and expense recognition depends on whether you have assurance-type or service-type warranties. Early identification of potential losses allows you to address them promptly. This prevents distortions in future financial statements.

Construction management software can play a quiet but influential role in ensuring revenue recognition is accurate for long-term contracts. Centralizing budgets, schedules, change orders, and progress tracking in one system creates a reliable, real-time view of job status, exactly what methods like percentage-of-completion depend on. Accurate cost-to-date reporting, automated subcontractor and materials tracking, and precise documentation of scope changes reduce the risk of over- or under-recognizing revenue as the project evolves. In practice, this means fewer surprises at closeout, stronger audit trails, and smoother alignment between field progress and financial reporting, helping contractors confidently and compliantly recognize revenue across multi-year builds.

Construction companies face unique accounting challenges. Consistent application of these revenue recognition principles will give stakeholders accurate financial statements that reflect your project performance. Your company will also build credibility with regulators, investors, and lenders who rely on your financial accuracy.