In business, security is highly crucial in avoiding unwanted risks. This security may come in many forms. In some cases, it may also include assets as collateral between two parties.
Security may consist of payments to another party in advance. For example, prepaid expenses or advances constitute a type of security.
Sometimes, this security may act as a token of good faith between two parties. In others, it may be mandatory.
In the construction industry, receiving timely customer payments may be challenging. Most contractors face this issue.
One of the challenges that most construction companies face when dealing with customers is tracking their payments.
Some established companies may tackle this issue by requesting the customer pay in advance. This advance provides the guarantee for future payments. The company can then start working on the project.
However, companies may not receive the full amounts from their customers. While the contractor requires security to guarantee the contract, the customer may also want assurance.
Retention funds are prevalent in construction. The accounting for these funds is crucial for all companies operating in the field. Before discussing that, however, it is critical to understand what these funds are and how they work.
What is Retention Fund in Construction?
In construction, security between two parties is highly crucial. Usually, the contractor receives an advance from the party they provide services to.
This security allows the contractor to begin working on the project and complete it within time. Gradually, the contractor will receive more payments from the customer. However, the customer may withhold from paying them in full as a form of security.
Retention funds are a percentage of the total contract amount to a contractor. Customers withhold this amount and do not pay the contractor until a specific period. Usually, these payments get withheld pending full practical completion.
Similarly, they may be subject to a resolution of any deficits. In other words, customers do not pay this amount until the contract gets completed. On top of that, they may also withhold retention funds until they inspect the delivered work.
Retention funds serve as security for the customer to reduce risks associated with the contract. It allows them to withhold contractors’ payments until they ensure the quality of the work. In most cases, both parties agree to the percentage for these funds when they sign the initial contract.
The residual portion of the funds gets released when the contractor hands the work over to the customer.
Customers can keep retention funds for a few weeks and may last for months. Usually, contractors only receive these payments based on the date defined in the contract.
Some of these contracts may also include other conditions related to retention funds. For example, they may specify the Defects Liability Period, after which the customer releases the funds. This practice is common within many construction contracts.
Overall, a retention fund refers to the money withheld by customers on construction contracts. These funds act as security for the customer and reduce their risks.
Customers do not release these funds until they ensure the construction is complete. On top of that, they may also perform an inspection and resolution of defects before releasing retention funds.
In some cases, retention funds may also be a percentage of each progress payment made to the contractor.
What Is the Accounting For Retention Funds In Construction?
The accounting for retention funds is straightforward. However, the revenues related to these funds may be more complex to record. For most companies, retention funds cover the services provided to a customer.
As mentioned above, retention funds are a percentage of the total invoice amount withheld by customers. The accounting treatment for these funds may apply to every service provided.
The accounting treatment of retention funds is similar to accounts receivable. When companies deliver a service, they send an invoice to the customer.
This invoice forms the base to record that amount in the accounts. Usually, companies account for the invoice amount as accounts receivable while increasing revenues.
At this point, the retention funds do not require special treatment. Although, companies may treat them in a separate account.
The primary issue with retention funds is whether to record them as revenues. The treatment for this aspect relates to IFRS 15.
Usually, companies can record revenues when they send their customers an invoice. However, other factors may dictate the amount they can recognize as income in the financial statements.
For retention funds, the accounting for the underlying revenues is similar to other contractual payments.
Companies can record a customer’s related revenues when they meet the five criteria set by IFRS 15. These include establishing a contract, determining the performance obligations, and establishing the transaction price.
Once companies meet these criteria, they must allocate the transaction price to the performance obligations. This way, they can recognize revenue when they satisfy a performance obligation.
For most construction companies, the performance obligation is to deliver work to the customer. This work gets performed as they complete the contract.
On top of the above requirements, other accounting treatments may also apply to the revenues. While these revenues may require specific accounting treatments, the retention funds don’t. Companies can record them as assets or receivables on the balance sheet.
What are the Journal Entries for Retention Funds in Construction?
Once the accounting treatment for retention funds becomes clear, it is straightforward to determine its journal entries.
Usually, the journal entries for retention funds include two stages. The first is when a company sends an invoice to a customer.
At this point, the company knows the percentage that the customer will withhold. The company can record that amount as retention funds and include it in a separate account.
The second stage of journal entries covers when the customer releases the retention funds. As mentioned, customers may perform their due diligence on the delivered work first.
Once they ensure the quality of the work, they may release the funds to the company. At this point, the company must record the receipt of those funds from the customer.
When a company sends an invoice to a customer, it must record it as accounts receivable. The company must separate the amount in a separate account if it includes retention funds.
Usually, the first journal entries for retention funds include the following.
|Retention funds receivable||XXXX|
When the customer releases the retention funds, companies must record them as a receipt. This transaction will only impact the retention funds receivable account.
On the other hand, the revenues will not change. The journal entries for the receipt of retention funds are below.
|Cash or bank||XXXX|
|Retention funds receivable||XXXX|
These entries will conclude the accounting treatment for retention funds.
A company, ABC Co., starts building a customer’s project. Both parties agree on the retention fund percentage to be 10%.
When ABC Co. completes the first stage of the construction, it sends an invoice of $10,000 to the customer. At this point, the company must record the amount as revenues. The journal entries for ABC Co. will be as follows.
|Retention funds receivable (10%)||$1,000|
The customer pays the accounts receivable amount promptly. However, it retains the retention funds until further inspection.
Three months later, the customer releases those funds through the bank. ABC Co. receives the amount in full. Therefore, it must record it using the journal entries below.
|Retention funds receivable||$1,000|
In construction, retention funds are prevalent to ensure the quality of work done by contractors. These funds constitute an amount withheld by customers from the invoice amount.
Usually, customers only release these funds when they ensure the quality of work. The accounting for retention funds is straightforward. However, the associated revenues may require attention.