Income Recognition Methods for Contractors: Which one should you be using?
There are four income recognition methods for contractors that consist of:
Percentage of Completion Method
Cash Method
Accrual Method
Completed Contract Method
Percentage of Completion Method
A majority of sureties prefer for principals to use the percentage of completion (POC) method for their financial statements; however, it does not mean that they will not accept the other methods. The percentage of completion method depicts the most accurate representation of the financial position of the company. The POC method calculates revenue recognition throughout the term of a project and is based upon the amount of work completed. This allows the principal to recognize a gain or loss throughout each accounting period. Using the percentage of completion method also helps a principal evaluate and assess the quality and effectiveness of the project estimator because the gain or loss on a project is recognized right away. If there is a profit fade on a job, using this method gives the principal time to attempt to save the profit or at least break-even.
Cash Method
The cash income recognition method requires a sale to be recognized when the cash payment is received by the principal. This method also requires that expenses are recognized when the account payable is satisfied with payment. The reason why sureties do not prefer this method is due the ease of being able to manipulate the financial statements for tax reasons. The cash method is appealing to small businesses that rely on year-end seasonal sales because they are more likely to receive payment for their products/services after the fiscal year end, moving the taxable income to the following year.
Accrual Method
The accrual income recognition method allows a principal to recognize revenue prior to receiving payment as well as expenses incurred before they are paid. This method is a representation of a company’s financial performance when a sale is made. Revenue is recognized the date the company makes a sale and is added to the company’s gross revenue. The accrual method is complicated due to revenue having to be reported with documentation. The accounts receivable process must also be tracked and reported accordingly. Since this method allows a principal to recognize the revenue prior to receiving payment, the principal must also ration a portion of the accounts receivable as doubtful accounts, anticipating some customers will fail to pay. The allowance for doubtful accounts will appear on the balance sheet. If an aging receivables report is available, sureties typically will discount the accounts that are 90+ days overdue. If an aging receivables report is not available, sureties will use a percentage of the accounts receivable and discount it by calculated amount.
Completed Contract Method
The completed contract recognition method allows the principal to defer revenue and expenses until the contract requirements are satisfied; therefore, all costs will be known at the end of the contract. This method helps avoid project estimating and can defer tax liabilities. Although this method can be beneficial, due to the uncertainty of when the project will be completed, when the principal might be paid, and any potential project delays, it can be tougher to establish a relationship with a surety.
Conclusion
Principals should consult with a Certified Public Accountant before deciding which accounting method is best for their company. At Parrot Surety Services we have a referral network that includes the professionals our clients need to help them succeed, such as construction CPA’s.
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