Question

We run a construction company and regularly sign contracts for the construction of buildings for our customers. The customers usually pay us at different points of time defined in the contracts (“milestones”). These milestones and payments usually reflect the progress towards completion and we recognize revenue over time.

According to all our contracts, the customer has the right to retain 5% of the invoiced amount. This amount is due when we complete the construction, the building is inspected and handed over to our customer.

How shall we account for the retained amounts? Is there a significant financing component since often these payments are retained by the clients for more than one year?
 

Answer

The primary aim of the retention amount is to provide a sort of a security to the customer that the building will be finished, inspected and handed over.

The goal is not to provide a financing benefit, thus there is no significant financing component as defined in IFRS 15 and these retention payments should not be accounted for as such.

The retention payments should be recognized as a trade receivable, because the supplier has the right to invoice the amount to a customer based on the completion of a certain milestone.

Let me give you the illustration:

Let’s say you agreed to build a house with total contract price of CU 100 000 on 1 August 20X1. On 31 December 20X1, your client agreed to pay CU 30 000 based on the completion of walls and roof; with retention of 5% held until the building is handed over.

You assessed that the building is 35% complete at 31 December 20X1.

The journal entries at 31 December 20X1 are as follows:

  1. Recognition of revenue
    Firstly, you should recognize a revenue based on the progress towards completion. The project is 35% complete, thus you would recognize the revenue of CU 35 000:

    • Debit Contract assets: CU 35 000

    • Credit Revenues from contracts with customers: CU 35 000

  2. Amount billed to the customer
    Secondly, you are entitled to bill CU 30 000 to the client (let’s assume the walls and roof are completed).

    • Debit Trade receivables: CU 30 000

    • Credit Contract assets: CU 30 000

  3. Cash paid by the client
    The client has the right to retain 5%, thus he pays CU 28 500 (95% of CU 30 000).

    • Debit Bank account: CU 28 500

    • Credit Trade receivables: CU 28 500

As you can see, after the payment, your client still owes you CU 1 500 being the retention amount. Since there is no significant financing component, this is simply deemed as long-term receivable (depending on the expected date of settlement) and it will be cleared when the client pays it.

One final note: it is OK to have a contract asset of CU 5 000 because the project is completed at 35%, but repaid only at 30%. It will be cleared out as the project continues and completes.