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Accounting for Construction Contracts

 

Accounting for construction revenue can be a complex topic, especially for large contracts of long durations that take many months or even years to complete. The revenue that a company shows in its annual financial statements is not necessarily the same as the amount that it has billed (i.e. invoiced) or collected in cash. Furthermore, the amount of profit on which it pays corporate income tax is also different from these amounts. This is because long-term contracts must be accounted for using an accounting method called percentage of completion accounting, which is often not the same as the amount billed and not the same as the amount that is taxed by the Canada Revenue Agency (CRA).

 

 

Percentage of Completion Accounting

 

Percentage of completion accounting is a method of recognizing revenue for long-term contracts and is the most common way of accounting for the revenues of construction contractors. Under the percentage of completion method, revenue is recognized based on the amount of work accomplished, which is not necessarily the same as the amounts billed or collected in cash. The amount of work accomplished may be determined in a variety of ways. The method used to determine the amount of work accomplished depends on the nature of the contract.

 

 

Methods to Calculate the Percentage of Completion

 

The approaches to measuring the degree of completion of construction contracts can be grouped into input and output measures. Input measures are made in terms of efforts devoted to a contract. Output measures are made in terms of results achieved.

Input measures are used to measure the degree of completion indirectly. The most common example of this is the costs incurred vs. total estimates costs method. Under this method, the total estimated costs for a project are divided by the actual costs incurred to date to arrive at the percentage of completion. Then, the total contract value is multiplied by the percentage of completion to arrive at the amount of revenue to recognize on that project.

For example, if a contract is expected to cost $2,000,000 to complete and $1,500,000 in costs have been incurred to date, then the contract is 75% complete ($1,500,000 ÷ $2,000,000). If the contract’s value was bid and accepted at $2,400,000, then $1,800,000 ($2,400,000 x 75%) would be shown as revenue for this contract regardless of how much was billed or received in cash to date. This would mean the contractor’s financial statements would include $1,800,000 in revenue and $1,500,000 in costs for this project, leaving $300,000 in gross profit earned. Keep in mind this would not necessarily be the profit subject to income tax at this point, which we will further explain in the section below.

Output measures are used to measure results directly. The most common output measure in the construction industry is the milestone method, where each component of the project is given a specific value up front in the contract. Once the contractor and the client (or general contractor) agree that a milestone has been achieved, the value of that milestone, as detailed within the contract, is recognized as revenue. This method requires less math than the percentage of completion method but can be complex in its own right if there are many milestones to track.

 

 

Tax Considerations for Construction Companies

 

It is very important to note that profit on construction contracts is taxed by the CRA differently than it is calculated for financial statement reporting purposes. One key difference is that any amounts that have been recognized as revenue for accounting purposes but not yet billed (i.e. not invoiced and due for payment), such as holdbacks, are not considered taxable until they are billed and due. Thus, there is typically a deferral of the recognition of profit for tax purposes than for accounting purposes, which means less tax owing in earlier stages of the contract and more tax owing when the contract is completed.

In other words, if you have a 10% holdback receivable that is withheld on a construction contract’s billings, the contractor would include these holdback amounts as revenue for accounting purposes but not for tax purposes, and would not have to pay any income tax on the holdbacks until they become due, which is usually at the substantial completion of the project and release by the client.

 

 

How Clearline CPA Can Help

 

If you are a construction company that is seeking assistance in preparing financial statements, filing corporate income taxes, and advice on how to account for contracts using the percentage of completion method and other construction related accounting matters, we can help. Clearline provides compilation, review and audit engagements for companies in the construction industry. We also prepare and file corporate tax returns and provide tax planning and corporate reorganization and restructuring services to clients within the construction industry.

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