CONSTRUCTION ACCOUNTING

BEST PRACTICES
GUIDE ON REVENUE RECOGNITION

Published by
Canadian Construction Association

www.cca-acc.com
Printed in Canada
TABLE OF CONTENTS
1.0 Purpose of Guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

2.0 The Value of Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2

2.1 Accounting Principles and Reporting Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2

2.2 Financial Statements and Their Users . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2

2.3 Audit, Review and Compilation Engagements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

3.0 Revenue Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

3.1 Completed Contract Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

3.2 Percentage of Completion Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

4.0 Lines of Credit, Bank Loans and Long Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

5.0 Differential Reporting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

6.0 Future Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

7.0 GST/HST and the Construction Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

7.1 General Timing Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

7.2 Special Timing Rules for Certified Progress Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

7.3 Completed Construction Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

7.4 Special Timing Rules for Holdbacks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

7.5 Builder Lien Holdbacks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

8.0 Financial Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

9.0 Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

A-1 XYZ Construction, Balance Sheet and Income Statement Comparison,

Percentage of Completion and Completed Contract Methods . . . . . . . . . . . . . . . . . . . . . . . 15

A-1-1 XYZ Construction Sample Data, Percentage of Completion

versus Completed Contract Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

A-1-2 XYZ Construction Sample Journal Entries, Percentage of Completion

versus Completed Contract Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

A-2 XYZConstruction Balance Sheet and Income Statement Comparison,

Percentage of Completion Method Using Billings Basis versus Cost Basis . . . . . . . . . . . . . . 20

A-2-1 XYZ Construction Sample Data, Percentage of Completion Method,

Billings Basis versus Cost Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.0 PURPOSE OF GUIDE
The primary purpose of this guide is to identify and promote a better understanding of the accounting
principles relevant to the construction industry, in the areas of revenue recognition, future income taxes
and debt financing. It also discusses differential reporting options available to private companies. This
guide will provide guidance on when to use the percentage of completion and the completed contract
methods of revenue recognition, and demonstrate the effect these methods have on a company’s
bottom line.

For the percentage of completion method, the guide will also discuss the use of billings as the basis
for determining the extent of work accomplished versus using costs (or other rational bases) in that
determination. It will demonstrate the effect that these bases will have on a company’s bottom line,
including the income tax effect.

The guide addresses current and future income taxes as they relate to holdbacks on construction
contracts and other temporary differences resulting from amortizing assets for book purposes at
different rates than the capital cost allowance rates stipulated by the Canada Revenue Agency (“CRA”).
It provides guidance on the special GST/HST rules that apply to the construction industry.

The guide will introduce contractors to the new accounting rules surrounding “financial instruments”
which will become mandatory for private companies in the first fiscal year beginning on or after October
1, 2007. Due to the complexity of the new rules and their application, contractors will need to consult
with their professional accountants to decide on the alternatives that will best serve the needs of their
financial statement users.

This guide is written primarily with a view to help contractors understand that their decision on
recognizing revenue using one of the two methods discussed in this paper, may impact upon the
informational needs of banks in determining debt capacity and covenants for companies in the
construction industry and for credit rating agencies. It is also relevant to the needs of a surety company
in determining the bonding capacity of a contractor, thereby increasing or decreasing a contractor’s
success in receiving a bond. For more information on the banking industry, contractors should also refer
to the “Banking Guide for the Canadian Construction Industry” published on the Canadian Construction
Association (“CCA”) website at www.cca-acc.com.
This guide is targeted to small and medium sized contractors who may not have the resources to employ
in-house expertise and to more sophisticated contractors who may find it useful as a training tool for
new staff in their accounting and finance departments. The objective is to make small and medium sized
contractors aware of the implications of alternative revenue recognition methods and the importance
of adopting sound accounting principles that reflect a contractor’s economic activities. This is critical to
cementing positive business relationships with surety companies and banks.

The CCA believes that adopting sound accounting principles will increase a contractor’s ability to receive
bonding capacity through their surety company and improve their success in securing lines of credit
and equipment loans. This guide also provides practical examples to assist contractors in implementing
the percentage of completion method using costs and costs to complete as the basis for revenue
recognition.

CONSTRUCTION ACCOUNTING BEST PRACTICES 1 GUIDE ON REVENUE RECOGNITION

 Many industry associations encourage their members to adopt similar principles and standards so that
benchmarks can be compiled of use to the industry as a whole. Industry benchmarks are useful tools that
members can use to compare themselves to their competitors without sacrificing the confidentiality of
their own financial data. The CCA believes that the percentage of completion method, using cost as a
method for determining extent of work accomplished (or another rational basis such as machine hours),
is the appropriate standard for revenue recognition for contractors across Canada. This guide provides
the rationale for the recommendation.

2.0 THE VALUE OF FINANCIAL STATEMENTS

2.1 ACCOUNTING PRINCIPLES AND REPORTING STANDARDS
The Canadian Institute of Chartered Accountants Handbook (the “CICA Handbook”) sets out generally
accepted accounting principles (commonly known as GAAP) and standards for financial reporting to
guide management in the preparation of its financial statements. These principles and standards are
critical as they increase the comparability of financial reporting within and across various industries.
The adoption of these principles and standards, combined with a reliable accounting system (usually
packaged software acquired through third party suppliers) and competent management and staff, also
increase the accuracy and reliability of financial information. Comparability, reliability and accuracy are
important to internal and external users of financial statements for a number of reasons, which will be
discussed in Section 3.2 of this guide.

Under GAAP, management has some leeway in selecting accounting policies but once selected,
management is expected to consistently follow the policy unless a change in the company’s business
dictates that a change is warranted or a change in GAAP is issued by the Accounting Standards Board (the
“AcSB”). For the most part, it is important to select the alternative that will produce the most meaningful
financial results and meet the needs of the primary users of the financial statements over time.

2.2 FINANCIAL STATEMENTS AND THEIR USERS

The basic objective of financial statements is to communicate useful and meaningful information that
meets the needs of the users of the financial statements.

Qualitative characteristics of useful and meaningful financial statements include:

• Understandability – financial statements that are unduly complicated can send up a red flag
to banks, surety companies and potential investors; transparency is key to success in today’s
business environment.

• Relevance – financial statements provide feedback on a company’s performance (normally over

1 to 5 years) and are used by banks and surety companies to predict the future success of a
company; timeliness of the preparation of financial statements is also important as outdated
information may not be useful to users in assessing a bond or loan application.

• Reliability – financial statements are management’s responsibility and to be reliable,

representational faithfulness is key – the substance of a transaction must be consistent with how
it is presented in the financial statements; the underlying transactions in financial statements
must normally be verifiable to an economic event and neutral or free from bias; external users

CONSTRUCTION ACCOUNTING BEST PRACTICES 2 GUIDE ON REVENUE RECOGNITION

 also subscribe to the concept of conservatism in management judgments where uncertainty
exists or estimates have to be made.

• Comparability – financial statements that are comparable allow users to compare a company to
another similar company or to compare a company’s performance over a period of time; both
are techniques used by banks, surety companies and potential investors to evaluate a company’s
performance.

Financial statements provide financial information at a point in time and changes to assets, liabilities
and equities covering a certain period of time. The following makes up a set of traditional financial
statements:

• Balance sheet (a statement of financial position at a specific date, including assets, liabilities and
equity);

• Income statement (a statement of operations covering a period such as a month, quarter or

year, showing revenues, expenses, income taxes, gains/losses, net income/loss);

• Statement of changes in retained earnings (changes in retained earnings from the previous
period, adding in net income/loss for the year and deducting dividends);

• Statement of changes in cash flow (changes in cash balances from the previous period, which
shows sources and uses of cash); and

• Notes to the financial statements, which provide additional information for users for clarification
purposes.

With the implementation of the new accounting standards for financial instruments, comprehensive
income and its components, when applicable, are displayed with the same prominence as the other
statements.

Internal users such as management, owners and shareholders of private companies rely on financial
statements to:

• Assess the appropriateness of the company’s policies (pricing, credit, payment) to improve
profitability and evaluate success by comparing its financial benchmarks to those of its
competitors; for example, gross profit comparisons to industry standard (note that these are
more meaningful if everyone in the industry prepares their financial information in the same
way).

• Determine net income after taxes, which results from recognizing revenue when it has been
earned and matching the corresponding expenses against that revenue in the same period;
this enables management to determine how profitable the company was in a given year and
measure return on equity invested.

• Measure the company’s true growth from year to year, avoiding fluctuations in net income due
to the inconsistent application of accounting principles (i.e. changing from one to another in
the following year) or the application of a principle that skews financial results in a particular
industry.

CONSTRUCTION ACCOUNTING BEST PRACTICES 3 GUIDE ON REVENUE RECOGNITION

 External users such as potential partners, investors or shareholders rely on financial statements to:

• Assess the financial health of a company and its ability to generate long term returns on
investment, including a risk premium reflecting the nature of the industry; for example, a private
company may want to grow without adding debt by admitting another partner or shareholder,
or an owner may want to sell the company as a going concern and retire.

• Assess the company’s exposure to liability through lawsuits, commitments and contingent
liabilities.

External users such as banks and surety companies rely on financial statements to:

• Assess the credit worthiness of the contractor, as well as ongoing credit worthiness once the
initial position is established (i.e. credit risk);

• Determine the price for which lines of credit, long term debt and surety bonds will be offered
(i.e. premiums, interest rates);

• Determine the terms and conditions (set out in covenants) and security requirements based on
an overall assessment of risk (i.e. financial risk);

• Assess the company’s exposure to foreign exchange fluctuations which may negatively impact
net income (exchange risk); and

• Assess overall company liquidity and its ability to handle any difficult situations that may arise.

• Determine the debt load or bonding capacity that a potential customer can carry and ability to
service debt and meet its obligations (i.e. liquidity risk);

For example, through an in-depth review of a contractor’s financial statements, a bank assesses the
company’s ability to consistently maintain positive cash flow, collect its receivables, pay its employees
and suppliers and meet its obligations to the government and other creditors. Surety companies do
the same, as they want to ensure that a contractor can meet its obligations while waiting for progress
payments to be made to them on a contract. Surety companies want to see that a contractor has
adequate lines of credit to finance (multiple) contracts for which they are providing surety bonds. Surety
companies and banks also assess a company’s profitability as compared to others in the same industry,
the stability of historical profits and the company’s capacity to grow and be profitable.

Establishing and maintaining good supplier credit is also essential to a contractor. External users such
as credit rating agencies rely on financial statements to assess the credit worthiness of a company,
compiling this information and providing it to their subscribers. These subscribers use the agency’s
rating in determining supplier credit to be given to or withheld from a particular contractor. This can be
very important to a contractor who is starting up and is trying to establish credit with various suppliers
when it has no track record to demonstrate its credit worthiness. So although the financial statements
are provided to these agencies by a contractor on a voluntary basis, it is normally in the contractor’s best
interests to do so.

External users such as the CRA rely on financial statements to collect tax that is owing by a company.
In general, under the Income Tax Act, companies are expected to follow GAAP in the preparation of
financial statements.

CONSTRUCTION ACCOUNTING BEST PRACTICES 4 GUIDE ON REVENUE RECOGNITION

 2.3 AUDIT, REVIEW AND COMPILATION ENGAGEMENTS
2.3.1 Audit Engagements
An audit engagement is conducted by a professionally accredited public accountant, who is required
to be completely independent of the company’s management, owners or shareholders and Board of
Directors and hence be objective. The public accountant is required to follow auditing standards set
out in the CICA Handbook. The auditor’s objective is to express an opinion on whether the company’s
financial statements present fairly, in all material respects, the financial position, results of operations
and cash flows in accordance with GAAP. In performing audit procedures, the auditor seeks a high level of
assurance that the financial statements are free of material misstatement, as a result of fraud or error.

Absolute assurance is not attainable in an audit because the auditor does not audit 100% of a company’s
transactions and there are also limitations in the quality of audit evidence, a need to place some
reliance on management representations and a need to make professional judgments pertaining to
management’s estimates.
Audit procedures however, are rigorous and are targeted to areas of risk, and the auditor keeps
management’s biases in mind. Audit procedures include physical inspection of assets to confirm
existence, observation and documentation of client procedures, confirmation from external parties
and examination of documents supporting various assets and liabilities on the balance sheet. Audited
financial statements, therefore, have the highest degree of credibility among surety companies, banks
and other external users of the financial statements.

A bank in its debt covenants may set the requirement for an audit of a company’s financial statements.
Many companies, unless they are required to do so, do not have an audit performed on their financial
statements as audit engagements are more costly than non-audit engagements. Instead, if they are
able to do so, most companies opt for a less expensive review of their financial statements by a public
accountant.
2.3.2 Review Engagements
Review engagements are distinguishable from audits in that the level of assurance provided by the
professionally accredited public accountant is lower. Review procedures consist primarily of enquiry,
analytical procedures and discussion related to information supplied by the company. The objective
of a review engagement is to assess whether the information being reported on is plausible. “Plausible
information” is generally that which appears to be worthy of belief based on the information obtained
by the public accountant from company’s management.

Financial statements, which have been “reviewed” by a public accountant normally, have some
credibility among the external users of the financial statements. This however, is based primarily on the
credibility of the public accountant and the perceived independence from the company subject to the
review. Therefore, contractors are encouraged to utilize the services of professionally accredited public
accountants. Contractors should discuss the need for an audit versus a review with their bank and surety
company.
2.3.3 Compilation Engagements
A compilation engagement provides the lowest level of assurance to users of the financial statements.
The public accountant simply compiles the financial statements of a company from information

CONSTRUCTION ACCOUNTING BEST PRACTICES 5 GUIDE ON REVENUE RECOGNITION

 provided by the company’s management and attaches a “notice to reader” outlining the scope of the
work conducted. They may or may not meet GAAP and the accountant is not required to be independent
of the company. Compilation engagements are often used by companies who do not have any in house
expertise to maintain accounting records and/or prepare financial statements and are doing so for tax
purposes only.

Regardless of whether a company chooses an audit, a review or a compilation, there is an expectation by

external users such as banks and surety companies that the contractor will follow GAAP. A compilation
engagement might not meet the needs of these external users.

3.0 REVENUE RECOGNITION

Under GAAP, the general rules associated with revenue recognition are:

• Revenue from the sale of goods or provision of services should be recorded in the financial
statements when a seller has transferred to a buyer, the significant risk and rewards of ownership
and when the consideration (i.e. the selling price) can be reasonably determined.

• Revenue from the sale of goods or provision of services should be recorded when ultimate
collection is reasonably assured.

GAAP currently provides additional guidance allowing contractors to use either the completed contract
or the percentage of completion method of revenue recognition, depending on their situation. When
a contractor’s contracts typically extend past two years, the CRA requires that the contractor use the
percentage of completion method. A contractor can currently select the completed contract method
for tax purposes (i.e. if contracts are less than two years in duration) and the percentage of completion
method for financial statement purposes.

3.1 COMPLETED CONTRACT METHOD

Under the completed contract method, revenue is recognized when the sale of goods or the provision
of services is complete or substantially complete. The CICA Handbook permits the use of this method
only when performance of a contract consists of the execution of a single act or when company’s
management cannot reasonably estimate the extent of progress toward completion of the contract.

Since most construction contracts involve the execution of many acts by a contractor, the completed
contract method is not appropriate under GAAP. And it is likely only in exceptional circumstances
that the stage of completion of a contract cannot be reasonably estimated. Nonetheless, some small
contractors have adopted this method for the following reasons:

• It is simple and it is easy to determine when a contract is virtually complete;

• There is no need to estimate costs to complete a project (i.e. costs are all known when the profit
is booked); and

• Assuming that the contractor is profitable, the income tax is deferred to the end of the
contract.

For very small contractors, where the contract duration is relatively short (less than one year), this method
is acceptable, provided it meets one of the two criteria. The contractor (small or otherwise) however has

CONSTRUCTION ACCOUNTING BEST PRACTICES 6 GUIDE ON REVENUE RECOGNITION

 to weigh the benefits against the potential costs in terms of satisfying its financial statement users’
needs. Contracts, by their nature, tend to fluctuate from year to year, depending on the size, length
and number of projects undertaken, and can produce wide fluctuations in net income. Gross profit
percentages also fluctuate from year to year under this method, all of which can be misinterpreted by
users as volatility. With volatility, there is normally an assumption of risk.

In reviewing a contractor’s financial statements, surety companies and banks look at stability of
operations and growth. The misapplication of the completed contract method to contracts involving
the execution of a number of acts could produce unfavourable financial results in some years and very
positive results in others. This can negatively impact on the contractor’s bonding capacity and on the
small contractor’s ability to grow. And, under the completed contract method, if management becomes
aware that a contract will end in a loss, under GAAP the loss is to be recorded immediately (i.e. not at the
end of the contract).

Appendix A-1 provides an example of the completed contract method as compared to the percentage
of completion method for a construction company, spanning a period of four years. The completed
contract method produces a balance sheet with inventory and work in progress relating to costs
incurred and deferred revenue, which reflects over-billings to owners for work accomplished. The costs
and the corresponding revenue do not appear on the contractor’s income statement until the contract is
complete. Net income and gross profit percentages therefore are skewed from year to year. For financial
statement presentation purposes, under and over billings on multiple contracts may not be netted on
the balance sheet. Since contractors often must complete monthly progress applications/billings in
advance of the actual end of the period covered by the invoice/application, (i.e. submit on the 27th of
the month and invoice for work completed to the 31st), it is not uncommon for the amount invoiced to
be more than the actual work performed.

This Appendix also provides the journal entries to record revenue under both methods. The percentage
of completion method clearly is superior, resulting in steady growth in revenues and net income. As
mentioned earlier in this guide, CRA currently allows contractors to use the completed contract method
for tax purposes although the contractor’s financial statements are prepared using the percentage of
completion method. As a result, the contractor can, with the additional effort have the best of both
worlds.

It should be noted that the AcSB has approved the adoption of International Financial Reporting
Standards (“IFRSs”) in Canada with a targeted transition date of 2011. IFRSs do not permit the use of the
completed contract method. The AcSB has not determined whether IFRSs will be required for private
companies but it is unlikely that the standards applicable to private companies will be significantly
different from those for publicly accountable entities. Contractors can expect to have to adopt the
percentage of completion method. As a result, given that surety companies and banks are interested
in historical profitability as a measure of the future success, contractors should seriously consider early
adoption of the percentage of completion method.

CONSTRUCTION ACCOUNTING BEST PRACTICES 7 GUIDE ON REVENUE RECOGNITION

 3.2 PERCENTAGE OF COMPLETION METHOD
The percentage of completion method is used when the contract involves the completion of more than
one act. Under the percentage of completion method, revenue is recognized proportionately with “the
extent of work accomplished” by the contractor, by reference to the performance of each act.

Many contractors have adopted what they believe to be the percentage of completion method using
billings or periodic payment certificates as a basis for recognizing revenue. This is only appropriate
under GAAP if the amount billed is representative of the extent of work accomplished. For the reasons
stated above, the amount billed can be greater than the work actually completed. This is a practical bias
as it can be up to two months or more before the contractor is paid and under billing, from a cash flow
perspective, can be hazardous to a contractor’s health. Using billings as a base also distorts revenue
recognition, causing more revenue to be earned at the front end and a mismatch with costs incurred.
This has implications for tax purposes, as income tax may be paid prematurely. Contractors should use
deferred or accrued revenue to report incomplete jobs at the expected final profit percentage.

Included in Appendix A-2 is an example of the percentage of completion method, using billings as a
basis for measuring the extent of work accomplished versus the cost based method.

In the construction industry, the most reliable measurement of the extent of work accomplished tends
to be cost based, in particular when materials, labour and equipment costs/rentals are inputs to the
“production” process. Other bases that would be considered appropriate are labour hours or machine
hours, where material costs in a contract are negligible (i.e. site work for road construction). The
percentage of completion is then derived from a simple formula, “actual costs incurred (or hours spent)
to date” divided by “total costs (or hours) to complete the contract”. The total cost to complete a project
is equal to actual costs incurred to date for a project plus estimated costs to complete the project.

Since the initial costing of a contract in the bidding phase is based on estimated total costs, actual
total costs to complete a contract will change as the project progresses. As a result, it is necessary for
management to make its best estimate of costs to complete a project to determine the expected total
cost of the project. So while the formula is simple, there is effort required on the part of management to
estimate costs to complete contracts that are in process.

The frequency with which a contractor is required to provide financial statements to its bank or surety
company will determine how frequently these estimates will need to be made. Most contractors are
required to report on an interim basis (monthly or quarterly) and on an annual basis with a complete set
of GAAP compliant financial statements each reporting period; some small or mid sized contractors may
only be required to provide a complete set of GAAP compliant financial statements on an annual basis.

The intent of the recommendation to use costs as a basis for determining work completed (or another
rational base such as labour hours or machine hours), is not to change the way in which contractors
bill for work performed on contracts. Current practices involving owner sign off and certifications by
architects and/or engineers are industry practice and are not affected by these recommendations.
These recommendations are targeted to revenue recognition in a contractor’s financial statements not
changing the contractor’s billing practices.

The most compelling reason for adopting the cost based (or machine or labour hours, as appropriate)
percentage of completion method, is that the contractor’s financial statements will meet the needs of

CONSTRUCTION ACCOUNTING BEST PRACTICES 8 GUIDE ON REVENUE RECOGNITION

 important external users such as banks and surety companies. This method most closely reflects the
economic activities of companies in the construction industry. The consistent adoption of this method
by contractors will enhance comparability and allow these important users to make meaningful and fair
assessments of contractor financial statements.

4.0 LINES OF CREDIT, BANK LOANS AND LONG TERM DEBT

Under GAAP, liabilities are classified as current when they are payable within one year or within the
normal operating cycle of the business when that is longer. Current liabilities normally include:

• a line of credit with a bank or financial institution;

• a demand bank loan;

• the current portion of long term debt; and

• the current portion of capital leases.

The current portion is equal to the principal due within one year of the balance sheet date.

Examples of long term debt include a bond, debenture, an equipment loan or a mortgage against real
property. Bank debt may also be classified as long term, when a maturity date beyond one year is set by
a banking agreement.

The general disclosure requirements for debt include:

• the interest rate, whether it is fixed (7%, for example) or floating (prime + 3%, for example);

• the currency;

• the maturity date of the debt (due March 31, 2017, for example) or if it is payable on demand;

• the amount and timing of any scheduled principal repayments;

• if the loan is secured and type of security (for example, a personal guarantee by a shareholder,
pledging of cash or accounts receivable, a mortgage against real property or a chattel against
equipment); and

• any conditions which if breached would change the terms of the debt.

Where an asset is pledged as security against liabilities, the nature and carrying amount of the asset
needs to be disclosed. This information will be of interest to the surety company.

Interest on short term and long term debt also needs to be disclosed separately on the income statement.
In addition, principal repayments over the next five years, following the balance sheet date are disclosed
in the notes to the financial statements.

Because loan agreements with a contractor’s bank can impact on bonding capacity, it is critical that the
contractor ensure that both the bank and surety company are aware of a contractor’s bonding needs.
Since the bank’s security interests will normally place above that of the surety company’s interests, in
negotiations with the bank, the pledging of assets as collateral needs to be carefully considered.

CONSTRUCTION ACCOUNTING BEST PRACTICES 9 GUIDE ON REVENUE RECOGNITION

5.0 DIFFERENTIAL REPORTING
Differential reporting was introduced to the CICA Handbook in 2002, in recognition that in contrast to
publicly accountable companies, privately held companies tend to have fewer financial statement users.
In addition, those users are generally known to the company and often have an intimate knowledge of
the company. Further, most of the external users of a private company’s financial statements likely have
access to additional information from management as part of a contractual obligation.

To qualify for differential reporting, a company must meet the following two criteria:

• It must be privately held (i.e. the company is a non-publicly accountable enterprise); and

• Its owners must unanimously consent, in writing, to the application of each differential reporting
option chosen, prior to the date of completion of the company’s financial statements.

Differential reporting options available to private companies who qualify include:

• Accounting for subsidiaries (a company may choose to prepare non-consolidated financial

statements and account for its subsidiaries using the cost or equity methods);

• Investments (a company may choose to account for its investment in other companies in which
it has significant influence using the cost method as opposed to the equity method);

• Interests in joint ventures (a company may choose to account for its interest in a joint venture
using either the cost or equity method, rather than a proportionate consolidation);

• Share capital (a company may choose to disclose details only on authorized share capital that
has actually been issued);

• Income taxes (a company may choose to account for income taxes on a current taxes payable
basis, as opposed to reporting on current and future income taxes);

• Financial instruments (a company may choose to measure available for sale financial assets
at cost or amortized cost, under certain conditions, and present preferred shares as equity, as
opposed to a liability on the balance sheet); and
• Goodwill and intangibles (a company may choose to test for an impairment in value of goodwill
only when an event or circumstance suggests that the fair value is lower than the carrying value,
as opposed to annually).

There are a number of choices to be made between accounting principles and a number of disclosures
that will need to be made, including the fact that the company has chosen to report using differential
reporting. As a result, contractors are encouraged to seek the advice of a professionally accredited public
accountant. Contractors should also discuss their intent to use differential reporting with their bank and
surety company.

CONSTRUCTION ACCOUNTING BEST PRACTICES 10 GUIDE ON REVENUE RECOGNITION

6.0 FUTURE INCOME TAXES
GAAP requires that companies, other than those who may opt to report using the differential reporting
options set out in Section 6, set up a provision for future taxes, which reflect temporary differences
between the carrying value and tax values of a company’s assets and liabilities.

Future income tax assets and liabilities may result from:

• temporary deductible differences between capital cost allowance and amortization of capital
assets, resulting in the net book value differing from the unamortized capital cost, as calculated
following the CRA’s rules;

• construction holdbacks as a result of provincial construction/builder’s lien legislation;

• unused tax losses from prior years; and

• income tax reductions implemented by federal and provincial governments.

Differences between the unamortized capital cost of capital assets and the net book value typically
have been managed by adopting amortization rates equal to those specified by the CRA. Contractors,
however, should be cautious in adopting this approach since using the CRA’s rates may not reflect
the useful life of the assets and hence, the value of capital assets may be under or over stated on a
contractor’s financial statements.

Under GAAP, future tax assets are recognized in the financial statements to the extent that they are more
likely to be realized than not. Future tax liabilities, on the other hand, are to be recognized immediately.
The calculation of future tax assets and liabilities are based on the tax rates and laws that are expected
to apply when the asset is realized or the liability is settled. On the income statement, future income
tax provisions (recoveries), combined with current tax provisions (i.e. taxes based on the company’s tax
return with the CRA) have the effect of smoothing taxes, and hence net income. The use of future taxes
better matches tax obligations with the economic activities of a company.

The taxes payable basis is the method of accounting which is allowed under the differential reporting
options. Under this method, a company reports as an expense (income) of the period only the cost
(recovery) of current income taxes for that period, determined in accordance with CRA’s rules. Contractors
should discuss their intent to use the taxes payable method with their bank and surety company.

CONSTRUCTION ACCOUNTING BEST PRACTICES 11 GUIDE ON REVENUE RECOGNITION

7.0 GST/HST AND THE CONSTRUCTION INDUSTRY
Contractors, who are GST/HST registrants, collect GST/HST on behalf of the applicable government
entity. A contractor, carrying on business in Canada, must register for GST/HST and obtain a “business
number” if its revenues exceed $30,000 in a single calendar quarter or in four consecutive calendar
quarters.

From an accounting perspective, GST and HST collected on a contractor’s sales are not revenues of the
contractor, but liabilities. Contractors who are GST/HST registrants are also eligible to claim, for refund,
the GST/HST paid on all of their purchases in the form of input tax credits. The net payable (receivable)
is remitted to (refunded by) CRA on a periodic basis (monthly, quarterly, annually).

7.1 GENERAL TIMING RULES

Generally, GST/HST becomes payable on the date payment is made or the date payment becomes due,
whichever is the earlier date. For GST/HST purposes, payment becomes due the earliest of the day: (i)
the invoice is first issued; (ii) the contractor would have issued an invoice, except for an undue delay;
and (iii) the recipient (client) is required to pay an amount to the contractor under a written agreement.
However, it is important to remember that there are special timing rules that apply to certain types of
construction payments.

7.2 SPECIAL TIMING RULES FOR CERTIFIED PROGRESS PAYMENTS

It is very common in the construction industry for the contract to provide for monthly or other periodic
payments to the contractor based upon the value of work completed as certified by someone other
than the contractor. When the scheduled work is completed, an application for payment is issued.
Subsequently, the payment certifier, usually an engineer or architect, issues a certificate stating the
value of work completed and the value of materials delivered to the site as of the date of the application.
The client/owner is then required by the contract to pay the amount certified within a certain period of
time after the engineer, or architect has issued the certificate.

In this situation, the application for payment is NOT considered to be an invoice for GST/HST purposes,
since it is only a request that a certificate for payment be issued. Therefore, GST/HST does not become
payable when the application is issued.

Where an invoice is not issued in respect of the certified amount, GST/HST becomes payable on
the amount certified on the day the client pays the amount, or on the day the client has to pay the
amount under the terms of the contract, whichever day is earlier.
Example: A contractor submits a monthly progress application on June 30th for work performed in the
previous 30-day period. That amount is certified on July 8th and is due and payable under the contract
on July 18th. No invoice is issued in respect of the certified amount. The GST is payable on the certified
amount on July 18th, unless payment is made earlier.

The same timing situation would apply in the case of progress payments made under subcontract
agreements where such agreements state that payments to the subcontractor are dependant upon the
amount being certified.

CONSTRUCTION ACCOUNTING BEST PRACTICES 12 GUIDE ON REVENUE RECOGNITION

 7.3 COMPLETED CONSTRUCTION CONTRACTS
A special GST/HST provision applies to written construction contracts when the billing or invoice has
been unduly delayed. Where the construction work has been substantially completed, (90% or more) and
the owner has not paid for the work, or the payment has not become due, GST/HST becomes payable on
the last day of the month following the month in which the work was substantially completed.
Example: The contractor substantially completes a project on October 20th but has not billed the owner
and the owner has not paid the contractor. GST/HST is payable on November 30th.

7.4 SPECIAL TIMING RULES FOR HOLDBACKS

Payments on construction contracts are normally subject to statutory holdbacks under applicable
provincial lien legislation. GST/HST payable on the holdback amount does not become payable until
the day the holdback amount is paid or the day on which the holdback period expires under the written
agreement or applicable legislation, whichever is earlier.

Example: A contractor submits a monthly progress draw on June 30th for work performed in the previous
30-day period. That amount is subject to a statutory holdback of 10%. The statutory holdback period
does not expire until September. The GST/HST on the holdback amount would not be payable until
September unless payment of the holdback amount is made earlier.

7.5 BUILDER LIEN HOLDBACKS

GST/HST is payable on a builder lien holdback only when the holdback is released. When a lien is filed,
the portion of the holdback that is withheld to satisfy the lien is not released. Often this amount is paid
into court. GST/HST is payable on that amount on the day the holdback amount is paid out or the day it
becomes payable, whichever is earlier.

8.0 FINANCIAL INSTRUMENTS

As defined by the CICA, a financial instrument is any contract that gives rise to a financial asset of one
party and a financial liability or equity instrument of another party. They include cash, trade accounts
receivable and accounts payable, loans and notes receivable and payable, investments in equities
and debt instruments as well as derivative contracts such as forward contracts, swaps and options.
Construction contracts create financial instruments, including holdbacks receivable and payable.

Under GAAP, contractors must disclose information for each type of risk arising from its financial
instruments:

• Credit risk (the amount that best represents a contractor’s maximum exposure to credit risk at
the balance sheet date without taking any collateral held or other credit enhancements into
consideration, a description of collateral held as security and other credit enhancements and
information about the credit quality of its financial assets);

• Liquidity risk (a maturity analysis for financial liabilities that shows remaining contractual
maturities and a description of how it manages liquidity risk); and

CONSTRUCTION ACCOUNTING BEST PRACTICES 13 GUIDE ON REVENUE RECOGNITION

 • Market risk (a sensitivity analysis for each type of market risk which the contractor is exposed to,
which may reflect interdependencies between risk variables such as interest rates and exchange
rates).

Disclosures on risk enable banks and surety companies to evaluate the nature and extent of risks arising
from financial instruments to which the contractor is exposed at the balance sheet date. Hence, these
disclosures are an important source of information for these users when evaluating a contractor’s
management strength and financial stability.

In 2005, the AcSB introduced new GAAP for “financial instruments” to be applied in fiscal years
commencing on or after October 1, 2006 (2007 for private companies).

If a contractor doesn’t have any financial instruments other than cash, accounts receivable and payable
and arm’s length debt (i.e. debt with an unrelated third party such as a bank), there will be little change
from current accounting under GAAP. However, if a contractor has investments in common shares or debt
securities, uses derivatives or hedges interest rate and foreign exchange risk, there will be a significant
impact. Loans that are not at market rates may also need to be adjusted to ensure the appropriate
amount of interest expense is recognized. There are also policy choices that must be made for costs
associated with loans and investments.

With the introduction of new GAAP for financial instruments, came the creation of the concept of
“comprehensive income”. Comprehensive income is the change in equity from non-owner sources. It
includes net income plus all other changes in equity except those resulting from investments by or
distributions to owners. Some standards require certain revenues, expenses, gains, or losses to be
recognized in comprehensive income but not in net income. Those “other comprehensive income” items
include foreign currency translation gains and losses on investments in self-sustain foreign operations,
unrecognized gains and losses (including foreign currency translation) on assets classified as available
for sale and gains or losses on qualified cash flow hedging items.

Because of the complexity of these standards, contractors are encouraged to seek the advice of a
professionally accredited public accountant.

CONSTRUCTION ACCOUNTING BEST PRACTICES 14 GUIDE ON REVENUE RECOGNITION

9.0 APPENDICES
APPENDIX A-1
XYZ Construction
Balance Sheet % of Completion Page 1
Years 1 to 4
Year 1 Year 2 Year 3 Year 4

Cash/Receivables $ 30,000.00 $ 145,555.60 $ 371,532.00 $ 581,228.20

WIP/Inventory 27,340.00
$ 30,000.00 $ 172,895.60 $ 371,532.00 $ 581,228.20

Taxes Payable $ 4,444.40 $ 31,023.60 $ 37,303.80 $ 35,028.20

Deferred Revenue 7,778.00 43,141.00 115,000.00
Retained Earnings 17,777.60 141,872.00 291,087.20 431,200.00
$ 30,000.00 $ 172,895.60 $ 371,532.00 $ 581,228.20

XYZ Construction
Income Statement % of Completion
Years 1 to 4

Revenue $ 222,222.00 $ 855,118.00 $ 1,229,519.00 $ 1,403,141.00

Wages, Benefits & Materials 200,000.00 700,000.00 1,043,000.00 1,228,000.00

Net Income Before Taxes 22,222.00 155,118.00 186,519.00 175,141.00

Income Taxes (20%) 4,444.40 31,023.60 37,303.80 35,028.20
Net Income $ 17,777.60 $ 124,094.40 $ 149,215.20 $ 140,112.80

Retained Earnings, Beginning of Year 17,777.60 141,872.00 291,087.20

Retained Earnings, End of Year $ 17,777.60 $ 141,872.00 $ 291,087.20 $ 431,200.00

Profit % 10.0% 18.1% 15.2% 12.5%

Pros.
1. Stability in operation.
3. Billings based on understanding of total expected cost of project.
4. More stable gross profit %.
5. More closely reflects economic activities of XYZ.
6. Accounting not significantly more difficult than completed contract.

Cons:
1. Tax disadvantage (mitigated by CRA, allows completed contract for tax only).
2. Need for management to estimate cost to complete.

CONSTRUCTION ACCOUNTING BEST PRACTICES 15 GUIDE ON REVENUE RECOGNITION

 APPENDIX A-1

XYZ Construction
Balance Sheet Completed Contract Page 2
Years 1 to 4
Year 1 Year 2 Year 3 Year 4

Cash/Receivables $ 30,000.00 $ 150,000.00 $ 400,000.00 $ 588,771.00

WIP/Inventory 200,000.00 585,000.00 268,000.00 1,255,000.00
$ 230,000.00 $ 735,000.00 $ 668,000.00 $ 1,843,771.00

Taxes Payable $ - $ 7,000.00 $ 58,229.00 $ 1,571.00

Deferred Revenue 230,000.00 700,000.00 348,855.00 1,575,000.00
Retained Earnings 28,000.00 260,916.00 267,200.00
$ 230,000.00 $ 735,000.00 $ 668,000.00 $ 1,843,771.00

XYZ Construction
Income Statement Completed Contract
Years 1 to 4

Revenue $ - $ 350,000.00 $ 1,651,145.00 $ 248,855.00

Wages, Benefits & Materials 315,000.00 1,360,000.00 241,000.00

Net Income Before Taxes 0.00 35,000.00 291,145.00 7,855.00

Income Taxes (20%) 0.00 7,000.00 58,229.00 1,571.00
Net Income $ - $ 28,000.00 $ 232,916.00 $ 6,284.00

Retained Earnings, Beginning of Year 0.00 28,000.00 260,916.00

Retained Earnings, End of Year $ - $ 28,000.00 $ 260,916.00 $ 267,200.00

Gross Profit % 0.0% 10.0% 17.6% 3.2%

Pros:
1. Simplicity.
2. Tax deferral opportunities.

Cons:
1. Justifying this method under GAAP.
2. Volatility in sales and net income.
3. High inventory and deferred revenue values.
4. Billings based on costs to date, ignores overall picture.
5. Skewed gross profit %.
6. Determining/justifying projects as virtually complete (judgement required).

CONSTRUCTION ACCOUNTING BEST PRACTICES 16 GUIDE ON REVENUE RECOGNITION

 XYZ Construction
Completed Contract vs Percentage of Completion
Year 1 to 4
Total Management’s Revenue Revenue
Contract Estimated Costs Estimated Costs Incurred Customer Estimate of Cost Recognized Recognized %
Projects Year 1 Amount as per Quote Profit During the Year Billings to Complete Completed Contract Completion
Word Pharmacy (63.5% complete) 350,000.00 297,500.00 52,500.00 200,000.00 230,000.00 115,000.00 - 222,222.00
APPENDIX A-1-1

350,000.00 297,500.00 52,500.00 200,000.00 230,000.00 115,000.00 - 222,222.00

CONSTRUCTION ACCOUNTING BEST PRACTICES

Total Management’s Revenue Revenue
Contract Estimated Costs Estimated Costs Incurred Customer Estimate of Cost Recognized Recognized %
Projects Year 1 Amount as per Quote Profit During the Year Billings to Complete Completed Contract Completion
Word Pharmacy (100% complete) 350,000.00 297,500.00 52,500.00 115,000.00 120,000.00 - 350,000.00 127,778.00
Excel Manufacturing (40.9% complete) 1,600,000.00 1,300,000.00 300,000.00 520,000.00 625,000.00 750,000.00 - 655,118.00
Time Foods (72.2% complete) 100,000.00 90,000.00 10,000.00 65,000.00 75,000.00 25,000.00 - 72,222.00
2,050,000.00 1,687,500.00 362,500.00 700,000.00 820,000.00 775,000.00 350,000.00 855,118.00

17
Estimated Management’s Revenue Revenue
Total Contract (Actual) Costs Estimated Costs Incurred Customer Estimate of Cost Recognized Recognized %
Projects Year 3 Amount as per Quote (Actual) Profit During the Year Billings to Complete Completed Contract Completion
Word Pharmacy (Project Closed) 350,000.00 315,000.00 35,000.00
Excel Manufacturing (96.9% complete) 1,600,000.00 1,300,000.00 300,000.00 750,000.00 925,000.00 40,000.00 1,551,145.00 896,027.00
Time Foods (100% complete) 100,000.00 90,000.00 10,000.00 25,000.00 25,000.00 - 100,000.00 27,778.00
Web Design (10% complete) 200,000.00 180,000.00 20,000.00 18,000.00 25,000.00 162,000.00 - 20,000.00
Outlook Manufacturing (35.7% complete) 800,000.00 700,000.00 100,000.00 250,000.00 325,000.00 450,000.00 - 285,714.00
3,050,000.00 2,585,000.00 465,000.00 1,043,000.00 1,300,000.00 652,000.00 1,651,145.00 1,229,519.00

Estimated Management’s Revenue Revenue

Total Contract (Actual) Costs Estimated Costs Incurred Customer Estimate of Cost Recognized Recognized %
Projects Year 4 Amount as per Quote (Actual) Profit During the Year Billings to Complete Completed Contract Completion
Word Pharmacy (Project Closed) 350,000.00 315,000.00 35,000.00
Excel Manufacturing (100% complete) 1,600,000.00 1,300,000.00 300,000.00 40,000.00 50,000.00 - 48,855.00 48,855.00
Time Foods (Project Closed) 100,000.00 90,000.00 10,000.00 -
Web Design (100% complete) 200,000.00 180,000.00 20,000.00 183,000.00 175,000.00 - 200,000.00 180,000.00
Outlook Manufacturing (70% complete) 800,000.00 700,000.00 100,000.00 240,000.00 250,000.00 210,000.00 - 274,286.00
AdWare Enterprises (60% complete) 1,500,000.00 1,275,000.00 225,000.00 765,000.00 1,000,000.00 510,000.00 - 900,000.00
4,550,000.00 3,860,000.00 690,000.00 1,228,000.00 1,475,000.00 720,000.00 248,855.00 1,403,141.00

GUIDE ON REVENUE RECOGNITION

APPENDIX A-1-2

XYZ Construction
Completed Contract vs Percentage of Completion
Journal Entries Year 1 to 4
Year 1 Year 2
Entries Required (Completed Contract): Entries Required (Completed Contract):
Dr. Direct Wages, Benefits & Materials 200,000.00 Dr. Direct Wages, Benefits & Materials 200,000.00
Cr. Cash/Accounts Payable 200,000.00 Cr. Work in Process (Inventory) 200,000.00
To record the payment of wages, benefits and material cost of sales for the Word To reallocate first year costs to cost of sales for Word Pharmacy contract.
Pharmacy contract during the year.
Dr. Direct Wages, Benefits & Materials 115,000.00
Dr Work in Process (Inventory) 200,000.00 Cr. Cash/Accounts Payable 115,000.00
Cr. Direct Wages, Benefits & Materials 200,000.00 To record second year costs in cost of sales for Word Pharmacy contract; project 100%
To reallocate direct costs for the Word Pharmacy contract to Inventory. complete.
Dr. Cash 230,000.00 Dr. Cash/Accounts Receivable 120,000.00
Cr. Deferred Revenue 230,000.00 Dr. Deferred Revenue 230,000.00
To record progress billing re Word Pharmacy. Cr. Sales 350,000.00
Entries Required (% Completion): To reallocate first year Deferred Revenue to sales and record second years sale re Word
Dr. Direct Wages, Benefits & Materials 200,000.00 Pharmacy contract.
Cr. Cash/Accounts Payable 200,000.00 Dr. Direct Wages, Benefits & Materials 585,000.00
To record the payment of wages, benefits and material cost of sales for the Word Cr. Cash/Accounts Payable 585,000.00
Pharmacy contract during the year. To record the payment of wages, benefits and material cost of sales for the Excel &
Dr. Cash 230,000.00 Time contracts.
Cr. Deferred Revenue 230,000.00 Dr Work in Process (Inventory) 585,000.00
To record progress billing re Word Pharmacy. Cr. Direct Wages, Benefits & Materials 585,000.00
Dr. Deferred Revenue 222,222.00 To reallocate direct costs for the Excel & Time contracts to Inventory in first year of
Cr. Sales 222,222.00 these contracts.
To record sales based on the Word Pharmacy contract which is 63.5% complete at year Dr. Cash 700,000.00
end. Cr. Deferred Revenue 700,000.00
Dr. Income Taxes 4,444.40 To record progress billing re Excel and Time contracts in the first year of these contracts.
Cr. Income Tax Payable 4,444.40 Dr. Income Taxes 7,000.00
To record current income taxes payable at 20%. Cr. Income Tax Payable 7,000.00
To record current income taxes payable at 20%.
Entries Required (% Completion):
Dr. Direct Wages, Benefits & Materials 115,000.00
Cr. Cash/Accounts Payable 115,000.00
To record second year costs in cost of sales for Word Pharmacy contract; project 100%
complete.
Dr. Cash/Accounts Receivable 120,000.00
Dr. Deferred Revenue 7,778.00
Cr. Sales 127,778.00
To reallocate first year Deferred Revenue to sales and record the second year’s sale re
Word Pharmacy contract.
Dr. Direct Wages, Benefits & Materials 585,000.00
Cr. Cash/Accounts Payable 585,000.00
To record the payment of wages, benefits and material cost of sales for the Excel &
Time contracts.
Dr. Cash/Accounts Receivable 700,000.00
Cr. Deferred Revenue 700,000.00
To record progress billings re Excel and Time contracts in the first year of these contracts.
Dr. Deferred Revenue 727,340.00
Cr. Sales 727,340.00
To record sales for the Excel and Time contracts which iare 40.9% and 72.2% complete.
Dr. Income Taxes Payable 4,444.40
Cr. Cash 4,444.40
To record income taxes paid.
Dr. Income Taxes 31,023.60
Cr. Income Tax Payable 31,023.60
To record current income taxes payable at 20%.
continued on next page

CONSTRUCTION ACCOUNTING BEST PRACTICES 18 GUIDE ON REVENUE RECOGNITION

APPENDIX A-1-2 continued
Year 3 Year 4
Entries Required (Completed Contract): Entries Required (Completed Contract):
Dr. Direct Wages, Benefits & Materials 585,000.00 Dr. Direct Wages, Benefits & Materials 18,000.00
Cr. Work in Process (Inventory) 585,000.00 Cr. Work in Process (Inventory) 18,000.00
To reallocate first year costs to cost of sales for Excel and Time contracts, projects To reallocate first year costs to cost of sales for Web contract, projects complete.
complete or virtually complete. Dr. Direct Wages, Benefits & Materials 223,000.00
Dr. Direct Wages, Benefits & Materials 775,000.00 Cr. Cash/Accounts Payable 223,000.00
Cr. Cash/Accounts Payable 775,000.00 To record second year costs in cost of sales for Excel and Web contracts; projects 100%
To record second year costs in cost of sales for Excel and Time contracts; project 100% complete.
complete or virtually complete Dr. Cash/Accounts Receivable 225,000.00
Dr. Cash/Accounts Receivable 950,000.00 Dr. Deferred Revenue 23,855.00
Dr. Deferred Revenue 700,000.00 Cr. Sales 248,855.00
Cr. Sales 1,650,000.00 To reallocate first year deferred revenue to sales and record second years sale re Excel
To reallocate first year deferred revenue to sales and record second years sale re Excel and Web contracts.
& Time contracts. Dr. Direct Wages, Benefits & Materials 1,005,000.00
Dr. Deferred Revenue 1,145.00 Cr. Cash/Accounts Payable 1,005,000.00
Cr. Sales 1,145.00 To record the payment of wages, benefits and material cost of sales for the Outlook
To adjust sales for Excel contract that is virtually complete (96.9%) at year end. and AdWare contracts.
Dr. Direct Wages, Benefits & Materials 268,000.00 Dr Work in Process (Inventory) 1,005,000.00
Cr. Cash/Accounts Payable 268,000.00 Cr. Direct Wages, Benefits & Materials 1,005,000.00
To record the payment of wages, benefits & material cost of sales for the Web & To reallocate direct costs for the Outlook and AdWaAre contracts to Inventory in first
Outlook contracts. and second years of these contracts.
Dr Work in Process (Inventory) 268,000.00 Dr. Cash/Accounts Receivable 1,250,000.00
Cr. Direct Wages, Benefits & Materials 268,000.00 Cr. Deferred Revenue 1,250,000.00
To reallocate direct costs for the Web & Outlook contracts to Inventory in first year of To record progress billing re Outlook & AdWare contracts in the first year of these
contracts. contracts.
Dr. Cash/Accounts Receivable 350,000.00 Dr. Income Taxes Payable 58,229.00
Cr. Deferred Revenue 350,000.00 Cr. Cash 58,229.00
To record progress billing re Web & Outlook contracts in the first year of these contracts. To record income taxes paid.
Dr. Income Taxes Payable 7,000.00 Dr. Income Taxes 1,571.00
Cr. Cash 7,000.00 Cr. Income Tax Payable 1,571.00
To record income taxes paid. To record current income taxes payable at 20%.
Dr. Income Taxes 58,229.00 Entries Required (% Completion):
Cr. Income Tax Payable 58,229.00 Dr. Direct Wages, Benefits & Materials 223,000.00
To record current income taxes payable at 20%. Cr. Cash/Accounts Payable 223,000.00
Entries Required (% Completion): To record third/second year costs in cost of sales for Excel and Web contracts.
Dr. Direct Wages, Benefits & Materials 775,000.00 Dr. Cash/Accounts Receivable 225,000.00
Cr. Cash/Accounts Payable 775,000.00 Dr. Deferred Revenue 3,855.00
To record second year costs in cost of sales for Excel and Time contracts. Cr. Sales 228,855.00
Dr. Cash/Accounts Receivable 950,000.00 To reallocate first year Deferred Revenue to sales and record second year sale re Excel
Cr. Deferred Revenue 26,195.00 and Web contracts.
Cr. Sales 923,805.00 Dr. Direct Wages, Benefits & Materials 1,005,000.00
To reallocate first year deferred revenue to sales and record second year sale re Excel Cr. Cash/Accounts Payable 1,005,000.00
and Time contracts. To record the payment of wages, benefits and material cost of sales for the Outlook
Dr. Direct Wages, Benefits & Materials 268,000.00 and AdWare contracts.
Cr. Cash/Accounts Payable 268,000.00 Dr. Cash/Accounts Receivable 1,250,000.00
To record the payment of wages, benefits & material cost of sales for the Web & Cr. Deferred Revenue 1,250,000.00
Outlook contracts. To record progress billings re Outlook and AdWare contracts in the second/first year of
Dr. Cash/Accounts Receivable 350,000.00 these contracts.
Cr. Deferred Revenue 350,000.00 Dr. Deferred Revenue 1,174,286.00
To record progress billings re Web and Outlook contracts in the first year of these Cr. Sales 1,174,286.00
contracts. To record sales for the Outlook and Adware contracts which are 70% and 60%
Dr. Deferred Revenue 305,714.00 complete (respectively) at year end.
Cr. Sales 305,714.00 Dr. Income Taxes Payable 37,303.80
To record sales for the Web and Outlook contracts which are 10% and 35.7% complete Cr. Cash 37,303.80
(respectively) at year end. To record income taxes paid.
Dr. Income Taxes Payable 31,023.60 Dr. Income Taxes 35,028.20
Cr. Cash 31,023.60 Cr. Income Tax Payable 35,028.20
To record income taxes paid. To record current income taxes payable at 20%.
Dr. Income Taxes 37,303.80
Cr. Income Tax Payable 37,303.80
To record current income taxes payable at 20%.

CONSTRUCTION ACCOUNTING BEST PRACTICES 19 GUIDE ON REVENUE RECOGNITION

 APPENDIX A-2

XYZ Construction
Balance Sheet % of Completion

Billings Basis Cost Basis

Cash/Receivables $ 627,000.00 $ 627,000.00

$ 627,000.00 $ 627,000.00

Taxes Payable $ 125,400.00 $ 92,811.34

Deferred Revenue 162,943.29
Retained Earnings 501,600.00 371,245.37
$ 627,000.00 $ 627,000.00

XYZ Construction
Income Statement % of Completion

Revenue $ 3,130,000.00 $ 2,967,056.71

Wages, Benefits & Materials 2,503,000.00 2,503,000.00

Net Income Before Taxes 627,000.00 464,056.71

Income Taxes 125,400.00 92,811.34
Net Income $ 501,600.00 $ 371,245.37

Gross Profit % 20.0% 15.6%

Although the cost basis requires that management estimate the cost to complete it imposes a discipline for
management to revisit the profitability around its contracts, providing the opportunity to take remedial action to
avoid losses. There are, however, other serious shortfalls of using billings as basis for recording revenue:
1. Not acceptable under GAAP as it does not reflect “extent of accomplishment”.
2. Overstates revenue.
3. Distorts the true gross profit that will be earned on the contracts - misleading.
4. Results in the prepayment of income taxes.
With regard to distorting the true gross profit, the billings basis suggests a gross profit of 20%, when in fact
management estimates the overall gross profit for these projects at 14.3% (see Appendix A-2-1) when they are all
completed. The 15.6% above, using the cost basis is closer, to reality.
Note that the cash balance under the billings and cost basis are the same. The intent is not to change how
management progress bills its contracts. The practice of billing to ensure good cash flow would continue.

CONSTRUCTION ACCOUNTING BEST PRACTICES 20 GUIDE ON REVENUE RECOGNITION

 XYZ Construction
Percentage of Completion
APPENDIX A-2-1

Billings Base vs Cost Base

Customer Revenue
Costs Incurred Billings Management’s Total Revenue Recognized %
Total Estimated Contract Contract Estimate of Revised Recognized % Completion (Under)
Contract Costs as per Estimated Inception to Inception to Cost to Costs at % Completion Cost Over

CONSTRUCTION ACCOUNTING BEST PRACTICES

Amount Quote Profit Date Date Complete Completion Complete Billings Basis Basis Billing
Projects (1) (2) (3) (2)+(3)=(4) (2)/(4)=(5) (1)x(5)=(6)

Word Pharmacy 350,000.00 297,500.00 52,500.00 200,000.00 230,000.00 115,000.00 315,000.00 63.5% 230,000.00 222,222.22 7,777.78

Excel

21
Manufacturing 1,600,000.00 1,300,000.00 300,000.00 1,270,000.00 1,550,000.00 40,000.00 1,310,000.00 96.9% 1,550,000.00 1,551,145.04 (1,145.04)

Web Design 200,000.00 180,000.00 20,000.00 18,000.00 25,000.00 185,000.00 203,000.00 8.9% 25,000.00 17,733.99 7,266.01

Outlook
Manufacturing 800,000.00 700,000.00 100,000.00 250,000.00 325,000.00 440,000.00 690,000.00 36.2% 325,000.00 289,855.07 35,144.93

AdWare
Enterprises 1,500,000.00 1,275,000.00 225,000.00 765,000.00 1,000,000.00 530,000.00 1,295,000.00 59.1% 1,000,000.00 886,100.39 113,899.61
4,450,000.00 3,752,500.00 697,500.00 2,503,000.00 3,130,000.00 1,310,000.00 3,813,000.00 3,130,000.00 2,967,056.71 162,943.29

GUIDE ON REVENUE RECOGNITION