Most common accounting practices for revenue recognition is by invoice method but for recognizing revenue for construction companies the common and most acceptable method is progress method which could be computed base on its project completion.
E.g. Contract Value $ 1,000,000.00
Contractors Margin is 85% ($ 850,000.00) or total estimated cost
Invoice 1 : $ 200,000.00
Cost : $ 150,000.00
To compute the revenue
Cost Incurred (Current) / Total Estimated Cost = Percent Complete (Current Period) x Total Revenue = Revenue Recognized (Current Period)
Revenue = $150,000/850,000 x 1,000,000 = $176,471.00
GAAP has carved out a special niche for construction contractors. While there is no FASB Statement for this area, AICPA Accounting Research Bulletin (ARB) No. 45, Long-Term Construction-Type Contracts, (1955) and AICPA Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, (1981) address it specifically. There is also an excellent AICPA Audit and Accounting Guide, Construction Contractors (see Resource IND 1).
Because most construction contracts by their nature are long-term, the underlying accounting principle known as matching — expenses follow revenues — would be violated if the revenue from the contract were recognized upon contract execution or sale of the services. There are two methods of revenue recognition are allowed under the preceding pronouncements for construction contractors.
One is percentage of completion (PC) method and the other is completed contract (CC) method. Under the PC method, the construction contractor recognizes revenue over the life of the construction contract based on the degree of completion: 50% completion means recognition of one-half of revenues, costs, and income. Under the CC method, all revenues, costs, and income are recognized only at completion of the construction project, ordinarily at the end of the construction contract.
SOP 81-1 requires that the PC method be used in lieu of the CC method when all of the following are present:
1. 1. Reasonably reliable estimates can be made of revenue and costs;
2. 2. The construction contract specifies the parties’ rights as to the goods, consideration to be paid and received, and the resulting terms of payment or settlement;
3. 3. The contract purchaser has the ability and expectation to perform all contractual duties; and
4. 4. The contract contractor has the same ability and expectation to perform.
The CC method is used in rare circumstances, which are set forth in SOP 81-1 to be any of the following:
1. 1. The contract is of a short duration (not defined), Such as 24 months or less. As a result, the recognized revenue would not differ under the PC or CC methods;
2. 2. The contract violates any one of the items 1 through 4 above; or
3. 3. The contract’s project exhibits documented extraordinary, nonrecurring business risks (such as extinguishing oil well fires in a country while hostilities are continuing).
In applying these revenue recognition methods, it is important that the following five items be kept in mind:
• Generally, each construction contract is treated as a profit center, with its own revenues, costs, and income. There are, however, circumstances in which multiple contracts, change orders, or options, for example, create the issue of whether to combine contracts into one profit center or to segment the contracts into separate profit centers.
SOP 81-1 sets forth the criteria for combining and segmenting construction contracts. As a general rule, the more interrelated and cohesive a project — for example, through substantial common costs, a single buyer, or concurrent performance of steps in the project — the more the scales tip in favor of combining. In contrast, when 1) separate project components have bids distinct from the entire project; 2) the buyer may choose to accept any, all, or more of the bids; and 3) the components of the project have the approximate revenues, costs, and income of a stand-alone project, then segmenting the contract is permissible. For such segmentation, SOP 81-1 has additional requirements that should be reviewed.
• GAAP requires that the accrual method be used for all reported billings and costs and losses.
• Cost allocation is based on direct and indirect costs as well as construction period interest.
• Assets are represented by underbillings (estimated costs and earnings exceed billings) whereas liabilities are shown as overbillings (billings exceed estimated costs and earnings).
• Consolidation theory applies to investments in construction projects or ventures per AICPA ARB No. 51, Consolidated Financial Statements; FASB Statement No. 94, Consolidation of All Majority-owned Subsidiaries — an amendment of ARB No. 51, with related amendments of APB Opinion No. 18 and ARB No. 43, Chapter 12; and, most importantly, APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. Because of potential changes in this area, the AICPA website http://www.aicpa.org and FASB website http://www.fasb.org should be consulted.
There are several modifications to revenue recognition rules for government contractors. These modifications should be reviewed by those engaged in federal government contracting.