Published May 22, 2023 . 10 mins read

What is revenue recognition in construction?

“Billings do not equal revenue in construction accounting.”

That was one of the big takeaways from a recent ProNovos webinar “Introduction to Construction Financial Analytics” that covered a critically important topic for contractors: revenue recognition in construction.

GBQ Partners LLC

Chris Mast, Director of Construction Industry Services for Top 100 tax, accounting and consulting firm GBQ Partners LLC (GBQ), offered an easy to understand overview of how it’s supposed to be done and why it’s important.

Mast (CPA, CCIFP) routinely advises construction contractors on WIP-schedule reconciliation, helping them make sure they provide accurate financial statements to banks and bonding companies. And of course, having an accurate WIP is critically important for maintaining a competitive contracting business as well. Mast and GBQ are proponents of running these calculations in analytics platforms using contractors’ ERP data. Back in August 2022, GBQ and ProNovos formed a strategic agreement focused on bringing advanced analytical tools to contractors across Ohio and the Midwest.

During the webinar, Mast emphasized the importance of grasping the ins and outs of construction revenue recognition. Understanding precisely when and how revenue should be recognized in a construction financial statement can be tricky, he noted.

That’s because construction projects are more complex and drawn out than simpler transactions, like paying cash for a pair of jeans.

“As soon as I buy those jeans from you, you’re going to recognize that revenue, which is what we call point-in-time revenue recognition,” Mast explains. “Well, in construction a lot of times we’re working with contracts that last months if not over a year. We need to find a way to recognize revenue over time. When we do that in construction, the big confusion is that people still think you’re going to recognize revenue based on what you’ve billed.”

I’m very excited about ProNovos because I believe it’s going to save our clients a lot of time and money both in the field and in the accounting office. GBQ and I have been so involved with ProNovos because we really believe it can make a big difference.

Chris Mast, CPA, CCIFP
Director of Construction Industry Services at GBQ

Three key steps in revenue recognition

Using a mock statement of income, Mast explains what contractors should be focused on for GAAP-compliant revenue recognition: percentage completion accounting. “Within your revenues earned, you actually have what you have billed so far to date, as well as a percentage of completion adjustment, to bring it back to what you’ve actually earned, under percentage completion accounting,” Mast explains.

Imagine a scenario in which a contractor early in the project bills the customer for work that will not be completed for weeks or months. Or one in which the contractor has completed part of the job but hasn’t yet billed for it. In neither case, per the principles of percentage completion accounting, would it be acceptable for the contractor to recognize those billed amounts as revenue.

Pulling up a work-in-process schedule, Mast first explains how to calculate three key steps in construction revenue recognition:

Cost to date ÷ estimated project cost = percent complete
Percent complete × contract amount = revenue earned to date
Revenue earned to date — billed to date = over/under billings

Revenue recognition in construction: an under-billed project

The veteran construction accountant uses the example of a $1 million contract, with estimated costs of $930,000 and a cost-to-date of $465,000.

“For whatever reason, you haven’t been able to send a bill,” he says. “Before you do a percentage completion adjustment, your income statement is going to look like you have no revenue … if you sent this to the bank or your owner, it would look like you were about to go bankrupt.”

It’s part of why contractors should never base their financial statements just on billings.

Mast’s hypothetical project looks like this:

$465,000 cost to date ÷ $930,000 estimated project cost = 50% complete
50% complete × $1,000,000 contract amount = $500,000 revenue earned to date
$500,000 revenue earned to date – 0 billed to date = $500,000 under-billed

He now adds the newly calculated, $500,0000 under-billing to the financial statement. The adjustment restores normalcy to the picture. “The whole idea here is, we’re matching our expenses with our revenues, so they’re hitting at the same time,” Mast says. “It makes our income statement look a lot more reasonable.”

Construction revenue recognition: an over-billed project

Mast then switches to an over-billed example. That project looks like this:

0 cost to date ÷ $930,000 estimated costs = 0% complete
0% complete × $1,000,000 contract amount = 0 revenue earned to date
0 revenue earned to date — 0 billed to date = $500,000 over-billed

In this scenario, the contractor has done no work yet but is able to send a bill for $500,000, with no offsetting costs yet added to the calculation. Selling, general and administrative expenses come to $25,000.

“It looks like we made $475,000,” Mast says. “You send that to your owner, and they think they can go out and buy a boat. So you need to be really careful when you’re recognizing revenue and presenting financial statements in construction.  The revenue and the percentage of completion can play a big role in how healthy your financial statements look.”

Run these numbers through the financial statement, and once again the situation looks more reasonable, with matching revenues and costs. Rather than an apparent $475,000 for potential watercraft purchases, the project shows -$25,000 in selling, general and administrative expenses.

It looks like we made $475,000. You send that to your owner, and they think they can go out and buy a boat. So you need to be really careful when you’re recognizing revenue and presenting financial statements in construction.

Chris Mast, CPA, CCIFP
Director of Construction Industry Services at GBQ

The power of estimated costs

Mast’s final scenario is all about illustrating the importance of estimated costs to the adjustment. In this case, the PM has decided she can do the job faster and with lower materials costs, and so she drops the previous $930,000 estimated cost to $800,000:

$1,000,000 contract amount
$800,000 estimated costs
$465,000 costs to date
$500,000 billings to date

If the contractor were to run the adjustment with $930,000 in estimated costs as before, net income would be $10,000 ($35,000 in gross profit – $25,000 in selling, general and admin expenses).

Mast runs it again with that lowered, $800,000 estimated cost:

$465,000 cost to date ÷ $800,000 estimated cost = 58.125% complete
58.125% complete × $1,000,000 contract amount = $581,250 revenue earned to date
$581,250 revenue earned to date — $500,000 billed = $81,250 under-billed

“Now, instead of being 50 percent complete, just because I changed my denominator, I’m 58.125 percent complete,” Mast explains. “By changing that percentage of completion, I’m now going to recognize more revenue, sooner.”

Decreasing estimated costs by $130,000, in other words, propelled the contractor forward on percent complete to 58.125%. “So I take what I’ve earned and compare it to my billing and I’m $81,250 under-billed,” Mast said. “I need to actually increase my revenue by $81,250 to bring it back to compliance with percentage-of-completion construction accounting.”

The end result? “I’m now recognizing $91,000 instead of the $10,000 in our last example—again, all because I changed that estimated cost to complete.”

Advantages of an automated WIP

Clearly, contractors should never base their financial statements just on billings. Nor should they run these revenue-recognition calculations too infrequently.

Mast, for one, encourages contractors to do percentage-of-completion adjustments at least every month. If they wait until the end of the year, he says, their monthly financial statements “will look like a roller coaster.”

As Mast noted during the webinar, many contractors spend inordinate amounts of time manually updating their WIP. “At least ninety percent of that time, it’s completed in Excel, which is prone to formula errors,” he said.

Tying the manually calculated, Excel-based WIP report to the financial statements for auditors and other stakeholders “can be a very tedious process, not just for the client, but also when I come in,” Mast explained.

The CPA firm needs to be able to tie back to an income statement—essentially a snapshot of one year—and do things like break out the current year’s performance versus prior, if the job ran across multiple years. Typically, though, the old-school WIP schedule will be based on job to date, with today’s contract amount, estimated cost, actual cost and billings.

Automation solves this and other problems: The remainder of the webinar is a deep dive into how ProNovos’ data-driven, real-time financial workflows simplify life for PMs, financial managers and execs.