14 min read
Revenue Recognition in Construction: A Comprehensive Guide
Published 15 Nov 2024
Revenue recognition ensures financial health for construction businesses and compliance with required accounting standards. Revenue recognition means recording revenue when earned, not when payment is received for services and products.
Contractors use revenue recognition to first measure their business' profitability and current financial stability. This starting point allows the contractor to recognize revenue that affects billing and the company’s ability to receive timely payments.
Yet, in construction, recognizing revenue accurately can feel like a moving target—missteps can lead to profit losses, cash flow issues, and compliance risks. This article will walk you through practical methods, best practices, and useful tools to streamline your revenue recognition process.
Contractors use revenue recognition to first measure their business' profitability and current financial stability. This starting point allows the contractor to recognize revenue that affects billing and the company’s ability to receive timely payments.
Yet, in construction, recognizing revenue accurately can feel like a moving target—missteps can lead to profit losses, cash flow issues, and compliance risks. This article will walk you through practical methods, best practices, and useful tools to streamline your revenue recognition process.
Contents
Why Accurate Revenue Recognition Is Essential for Construction Projects
Accurate income recognition is the backbone of your financial reporting system. In turn, this system influences business decisions and, ultimately, business health.
It impacts the following areas of your business:
It impacts the following areas of your business:
Creating a standard measure of performance. Your business needs a framework that guides the revenue recognition process. This means creating a standard measure of performance that everyone in the business adheres to.
In Dubai, International Financial Reporting Standards (IFRS) are used to determine the activities and tasks of financial management. This standard manages specific transactions and events for financial reporting.
The IFRS describes how accountants can maintain their records. It is also designed so that the guidelines are understood by construction businesses and accounting managers worldwide.
Your business is required to comply with IFRS as stated by the Central Bank of the UAE.
The IFRS describes how accountants can maintain their records. It is also designed so that the guidelines are understood by construction businesses and accounting managers worldwide.
Your business is required to comply with IFRS as stated by the Central Bank of the UAE.
Enhancing financial reporting accuracy. Financial statements can accurately reflect your business’s financial position when revenue recognition is implemented properly. It allows you to establish the revenue earned during a specific period. This is crucial for calculating both profits and losses.
Accuracy in financial reporting is also essential for anyone with a stake in your business, including creditors and investors. When they have the right information, they can make better decisions.
Maximizing project profitability. Revenue recognition is a major part of revenue management in the construction industry. This principle allows you to optimize service pricing correctly and allocate resources accordingly.
For example, if revenue is recognized accurately, a construction company can see whether a project is staying within budget, generating expected profit margins, or requiring adjustments. This visibility helps manage costs, prevent overspending, and adjust pricing if necessary to meet profit goals.
It also makes it easier to sell your construction services to the right customer at the right time. In turn, this improves the profitability of each of your projects.
Streamlining cash flow management. It is not always easy to project your cash flow over a period of time. Using revenue recognition methods, you can improve your cash flow using reliable revenue data as and when your revenue is earned. When your data is reliable, you can anticipate and plan better for incoming cash flows.
Building stakeholder trust. Continuous, accurate, and timely financial reporting backed by sound revenue recognition practices will ensure trust among your stakeholders.
Top Revenue Recognition Methods Every Construction Company Should Know
You must use the most effective revenue recognition methods in your business to ensure success. How your business recognizes revenue impacts how you present your earnings and how much each stakeholder benefits from these earnings.
With the introduction of ASC 606 (Accounting Standards Codification), how your business needs to recognize revenue has changed. The following accrual methods were widely used before the ASC 606 regulation was passed.
1. Percentage-of-Completion Method
Most construction companies used the percentage of completion method until the ASC 606 standard was passed. This method uses a construction project's progress to create an estimate.
The ‘percent complete’ method made it easy to match revenue recognition with costs incurred to earn that revenue as a project continued. This allowed contractors to report revenue more evenly across the lifespan of a project.
The ‘percent complete’ method made it easy to match revenue recognition with costs incurred to earn that revenue as a project continued. This allowed contractors to report revenue more evenly across the lifespan of a project.
Percentage-of-Completion Steps
Step 1: Cost-to-Cost Method
Divide the total costs incurred to date by the total estimated costs of the entire project. For instance, you may have incurred $500,000 thus far on a project that is estimated to cost $1,000,000.
The calculation looks like this:
Divide the total costs incurred to date by the total estimated costs of the entire project. For instance, you may have incurred $500,000 thus far on a project that is estimated to cost $1,000,000.
The calculation looks like this:
Percentage complete = Costs incurred to date/Total estimated costs x 100
500,000/1,000,000 x 100 = 50%
500,000/1,000,000 x 100 = 50%
Efforts-Expended Method: Use labor hours or machine hours to calculate the percent completion. This is based on actual work done compared to expected work to be completed.
Step 2: Calculate Revenue to Recognize
Multiply the percentage of completion by the total contract value to find revenue:
Step 2: Calculate Revenue to Recognize
Multiply the percentage of completion by the total contract value to find revenue:
Revenue to recognize = percentage complete x total contract value
If your total contract value is $2,000,000 and the project is 50% complete, the recognized revenue is:
50% x 2,000,000 = 1,000,000
Step 3: Adjust for Costs and Gross Profit
To match revenue with expenses, calculate the gross profit using the recognized revenue and incurred costs.
Gross profit = Recognized revenue – Costs incurred to date
1,000,000 - 500,000 = 500,000
The $500,000 is the profit recognized.
Step 4: Revisit Your Calculations
The percentage-of-completion method relies on estimates. Therefore, it is important to revisit calculations regularly during a project, especially when changes are made to the costs or timeline. Regular updates will ensure that your financial statements are always accurate.
To match revenue with expenses, calculate the gross profit using the recognized revenue and incurred costs.
Gross profit = Recognized revenue – Costs incurred to date
1,000,000 - 500,000 = 500,000
The $500,000 is the profit recognized.
Step 4: Revisit Your Calculations
The percentage-of-completion method relies on estimates. Therefore, it is important to revisit calculations regularly during a project, especially when changes are made to the costs or timeline. Regular updates will ensure that your financial statements are always accurate.
2. Completed Contract Method
This method delays revenue and expense recognition until a project has been completed. It provides a clearer understanding of how successful a project is after its completion. However, it also leads to fluctuations in a construction company’s income statements and balance sheets.
Choosing the Right Revenue Recognition Method
With the advent of ASC 606, the Financial Accounting Standards Board (FASB) outlines the new standards for how your business needs to recognize revenue with accrual account methods.
Under ASC 606, your business should recognize revenue when it has fulfilled its performance obligations and not when payment is received.
Under ASC 606, your business should recognize revenue when it has fulfilled its performance obligations and not when payment is received.
Performance obligations refer to the services that your business promises to a customer. These obligations are laid out within a legal contract.
Add to this the transaction price, and you can establish how much revenue to recognize over a determined period.
Transaction price refers to the consideration given to how much your business is entitled to after delivering the said obligations.
Therefore, the five-step model introduced in ASC 606 must guide the decision on revenue recognition methods for construction.
Identify the contract your business has with a customer. Both parties must approve the agreement. The payment terms must be clearly stipulated, and the contract must have commercial substance (change your financial position).
Always review any written agreement and do not rely on verbal commitments. There must be a written mutual understanding of terms and conditions. If a customer signs a contract that outlines payment milestones and project deliverables, it is valid under ASC 606.
Highlight and understand the performance obligations as laid out in the contract. The contract must be broken down into its most important components. These include the tasks that the customer has agreed to pay for. They also include extra tasks or work that your business can complete independently to add value to the project.
Establish the transaction price. Start with the base contract price. Adjust the costs to allow for contingencies. These may include penalties for delays or performance bonuses.
Consider whether payment terms will affect the timing of money collected. For example, if a contract’s base price is $1,000,000 with a $50,000 performance bonus, the transaction price will range from $950,000 to $1,050,000, depending on performance.
Allocate the transaction price to the obligations set out in the contract. If you have already established the prices for each component in the contract, use those. If you have not, estimate the selling price of each obligation. To do this, you would have to use market data or a cost-plus-margin calculation.
If, for example, a construction project involves preparing the site ($200,000), foundation work ($300,000), and interior work ($500,000), you allocate the $1,000,000 contract value in proportion to these prices.
Recognize revenue as and when your business satisfies an obligation. Use the above-mentioned percentage of completion to measure progress. Update estimates when project costs or timelines change.
This process becomes more complicated when you work on multiple projects simultaneously. Using the ASC 606 principle will make it easier to write down each step and ensure you follow each one as you go along.
If you have been using the Percent Complete method, you will find adjusting to the ASC 606 guidelines effortless because the two processes are very similar. The main difference is that ASC 606 focuses on performance obligations to highlight milestones and sections of revenue based on a contract.
Overcoming Challenges in Revenue Recognition for Construction Projects
Your construction business will likely encounter several challenges as you work towards accurately recognizing revenue. Addressing and overcoming these challenges is important to maintaining your company's financial integrity.
1. Navigating Complex Project Structures
Dubai is known for intricate project structures, including complex contracts, joint ventures, and consortiums. The nature of these project structures can make it challenging to determine the most appropriate revenue recognition methods.
To overcome this challenge, you must ensure all contracts are clear on performance obligations, payment terms, and risk allocation. You must also implement the proper project management systems to track progress and monitor costs.
Consult accounting experts who can guide you on revenue recognition for joint ventures or multiple contracts.
To overcome this challenge, you must ensure all contracts are clear on performance obligations, payment terms, and risk allocation. You must also implement the proper project management systems to track progress and monitor costs.
Consult accounting experts who can guide you on revenue recognition for joint ventures or multiple contracts.
2. Ensuring Regulatory Compliance
The regulatory environment in the UAE, including the IFRS, continues to evolve. Your business must stay updated on the latest regulations to stay compliant.
Review your accounting policies and procedures regularly to ensure compliance with all mandatory regulations. Engage with regulatory authorities if you are unclear about anything regarding requirements for your business.
Use the right accounting software to automate compliance checks and help you generate accurate financial reports.
Review your accounting policies and procedures regularly to ensure compliance with all mandatory regulations. Engage with regulatory authorities if you are unclear about anything regarding requirements for your business.
Use the right accounting software to automate compliance checks and help you generate accurate financial reports.
3. Maintaining Data Accuracy
Precise revenue recognition relies on accurate data collection and analysis. If you constantly deal with inconsistent data entry and missing information, it will distort your financial reporting.
To prevent this, you need a data management system that improves data accuracy and consistency. Even with such a system, you must conduct data audits to find and fix errors. You should also train staff to enter data correctly and implement quality control measures.
To prevent this, you need a data management system that improves data accuracy and consistency. Even with such a system, you must conduct data audits to find and fix errors. You should also train staff to enter data correctly and implement quality control measures.
4. Managing Contract Modifications
When modifications are made to an original contract, it impacts the initial decided-upon terms and conditions. You must assess the impact of these changes on your revenue recognition process and adjust your accounting process accordingly.
Establish a formal change order process that documents and approves modifications. Change orders must be reviewed promptly to avoid delays in your project and the revenue recognition process.
Establish a formal change order process that documents and approves modifications. Change orders must be reviewed promptly to avoid delays in your project and the revenue recognition process.
5. Handling Change Orders
Document all change orders and note the reasons for the change. Detail the impact on costs and timelines and the revised revenue recognition plan.
It is important to maintain effective communication with all clients, project teams, and stakeholders throughout this process. This will help minimize the impact of ongoing change orders on revenue recognition.
It is important to maintain effective communication with all clients, project teams, and stakeholders throughout this process. This will help minimize the impact of ongoing change orders on revenue recognition.
Best Practices for Optimizing Revenue Recognition in Construction
The following best practices can help you build a foundation for effective revenue recognition in your business.
1. Implement Effective Project Management
Develop detailed project plans that outline the work needed. Create timelines for each project and allocate resources accordingly.
Implement a progress monitoring system to track project milestones and proactively identify potential issues. It is also crucial to maintain accurate records of project costs, which include labor, materials, and overhead expenses.
If you do not already have a change order management process, you should implement one as part of your project management strategy.
Implement a progress monitoring system to track project milestones and proactively identify potential issues. It is also crucial to maintain accurate records of project costs, which include labor, materials, and overhead expenses.
If you do not already have a change order management process, you should implement one as part of your project management strategy.
2. Utilizing Technology for Efficiency
Construction accounting software will allow your business to automate routine but important tasks. These include invoicing, expense tracking, and even revenue recognition.
Other technologies you should use include project management software to manage resources and improve collaboration between construction teams.
You must also have a data analytics tool to help you identify positive and negative trends. This will allow you to improve your resource allocation process and make better decisions for each project.
Other technologies you should use include project management software to manage resources and improve collaboration between construction teams.
You must also have a data analytics tool to help you identify positive and negative trends. This will allow you to improve your resource allocation process and make better decisions for each project.
3. Ongoing Staff Training and Updates
Train your staff on accounting standards, revenue recognition principles, and using relevant software. Your business must stay updated on industry trends and evolving best practices or regulations.
It is fairly easy to stay on top of staff training with regularly scheduled training sessions. You can also use online learning platforms or implement a mentorship program. With a mentorship program, you assign senior staff to teach and guide junior staff on complex concepts.
It is fairly easy to stay on top of staff training with regularly scheduled training sessions. You can also use online learning platforms or implement a mentorship program. With a mentorship program, you assign senior staff to teach and guide junior staff on complex concepts.
How FirstBit ERP Can Revolutionize Revenue Recognition in Construction
The FirstBit ERP software solution can help you strive for and achieve efficiency, accuracy, and compliance in your revenue recognition processes.
Real-time data and analytics. The FirstBit ERP system provides data and analytics on project costs, progress, and contractual obligations. With these real-time insights, you can use revenue recognition methods that align with Dubai’s requirements and regulations.
The software allows you to monitor costs associated with labor, materials, and overhead expenses, ensuring you can identify issues early on. With all your data on one platform, you can make better and faster decisions. This will also improve resource allocation, which will improve project profitability.
Integration across financial and project management functions. You can integrate your project management function and financial reporting using the FirstBit ERP software. Doing this helps break down silos in your business and promotes communication.
This type of integration helps reduce costly errors while streamlining your revenue recognition methods. You will be able to track the progress of projects alongside financial data, ensuring accurate cost-to-revenue analysis. You can also generate financial reports accurately reflecting project performance and revenue status.
Automating compliance and reporting. FirstBit ERP software can help you maintain compliance with IFRS accounting standards by automating compliance checks.
The system provides you with compliant financial reports on revenue, costs, and project progress while reducing the risk of errors associated with manual data capturing and calculations.
Success Stories: Transforming MoonLink’s Revenue Recognition with FirstBit ERP
Construction businesses throughout Dubai continue to find success with the FirstBit ERP software solution.
Moon Link Building Contracting LLC has been in business since 2011. They are a leading construction company based in Dubai and have made inroads in the construction sector and other industries, such as civil and mechanical engineering.
Around a year and a half ago, Moon Link reviewed its manual accounting and project management processes. The company identified several inefficiencies and inaccuracies because it relied on manual processes. Their manual processes led to missing invoices and discrepancies in financial data management. This made it nearly impossible to maintain accurate records, essential for revenue recognition.
The company also found it hard to keep its projects on track because it did not have a centralized system that all employees could access. The Moon Link teams worked in silos, creating a fragmented picture of projects in progress.
Moon Link chose FirstBit ERP to help them solve these issues. From the start, the company experienced several benefits that helped them get their processes back on track. The software allows the company to manage and track expenses throughout each project. This ensures financial discipline and prevents overruns. Moon Link also enjoys the fact that the FirstBit ERP system is tailor-made for the construction industry.
The company continues to enjoy accuracy, efficiency, and improved decision-making thanks to the FirstBit ERP software solution. The system also supports Moon Link's future growth by scaling up as the company grows.
Moon Link Building Contracting LLC has been in business since 2011. They are a leading construction company based in Dubai and have made inroads in the construction sector and other industries, such as civil and mechanical engineering.
Around a year and a half ago, Moon Link reviewed its manual accounting and project management processes. The company identified several inefficiencies and inaccuracies because it relied on manual processes. Their manual processes led to missing invoices and discrepancies in financial data management. This made it nearly impossible to maintain accurate records, essential for revenue recognition.
The company also found it hard to keep its projects on track because it did not have a centralized system that all employees could access. The Moon Link teams worked in silos, creating a fragmented picture of projects in progress.
Moon Link chose FirstBit ERP to help them solve these issues. From the start, the company experienced several benefits that helped them get their processes back on track. The software allows the company to manage and track expenses throughout each project. This ensures financial discipline and prevents overruns. Moon Link also enjoys the fact that the FirstBit ERP system is tailor-made for the construction industry.
The company continues to enjoy accuracy, efficiency, and improved decision-making thanks to the FirstBit ERP software solution. The system also supports Moon Link's future growth by scaling up as the company grows.
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