Accounting in the Constrution Industry

May 10, 2024 Business

Construction companies account for revenue recognition under the percentage of completion method (PoC) by recognizing revenue based on the progress of a contract.

Here's how they determine contract revenue, costs, and calculate the percentage of completion:

Contract Revenue: Contract revenue represents the total amount the company expects to receive for completing the contract. It is usually determined based on the agreed-upon contract price or the progress billing terms.
Costs: Costs incurred in a construction project include direct materials, direct labor, and overhead costs directly attributable to the contract. Indirect costs that cannot be specifically allocated to a contract are generally excluded. These costs are accumulated and recorded as work-in-progress (WIP) or inventory.
Percentage of Completion: The percentage of completion is calculated by comparing the costs incurred to date with the estimated total costs of the project. This ratio determines the proportion of the project that is completed. The formula for calculating the percentage of completion is:
Percentage of Completion = (Costs Incurred to Date) / (Estimated Total Costs)
Once the percentage of completion is determined, revenue is recognized based on the proportion of work completed. This is done by multiplying the percentage of completion by the contract revenue.

 Specific accounting considerations for construction companies related to work-in-progress (WIP) include the valuation of WIP, the allocation of costs, and the impact on financial statements and project profitability analysis:

Valuation of WIP: WIP is typically valued at the lower cost or net realizable value. Cost includes direct materials, direct labor, and attributable overhead costs. The net realizable value represents the estimated selling price of completed projects less the estimated costs to complete and sell them.
Allocation of Costs: Costs incurred in a construction project are allocated to the WIP account. These costs include direct materials, direct labor, and overhead costs directly attributable to the contract. Indirect costs that cannot be specifically allocated to a contract are generally excluded.
Impact on Financial Statements: WIP affects the balance sheet and income statement. On the balance sheet, WIP is reported as an asset under current assets. As the project progresses, the costs are transferred to the income statement as expenses and matched with the recognized revenue.
Project Profitability Analysis: WIP provides valuable information for project profitability analysis. By comparing the costs incurred to date with the estimated total costs, construction companies can assess project efficiency, identify cost overruns, and make informed decisions regarding resource allocation and project management.

Accounting principles and guidelines for recognizing and measuring construction-related revenue from service contracts, such as maintenance and repair agreements, differ from revenue recognition on construction contracts. Here are some key differences:

Revenue Recognition: Revenue recognition for service contracts is typically based on the passage of time or the completion of specific tasks. Unlike construction contracts, which use the percentage of completion method, service contracts often employ the completed contract method or the proportional performance method.
Completed Contract Method: Under the completed contract method, revenue and related costs are recognized only when the contract is substantially completed. This method defers revenue recognition until the project is finished, and all costs are accumulated as WIP until that point.
Proportional Performance Method: The proportional performance method is used when the outcome of a service contract can be reliably measured. Revenue is recognized proportionally as the services are performed, based on the assessment of the work completed or the costs incurred.
Cost Allocation: Cost allocation for service contracts is typically straightforward, as costs are directly attributable to the specific services provided. Direct costs, such as labor and materials, are allocated to the contract, while indirect costs are generally expensed as incurred.
Financial Statements: The impact on financial statements for service contracts is similar to construction contracts, with revenue and expenses recognized in the income statement. However, the timing of revenue recognition may differ, depending on the revenue recognition method used.