Paying for a construction job is a lot different from most purchases. It's not just the big purchase price, but the long time it takes to erect a building. The contractor doesn't want to do all the work without pay, but the customer doesn't want to pay until the work is done. The customer typically hangs on to some of the money until the work is complete. That final amount is known as retainage in accountant-speak.
Retainage is money held back by a customer until a job is done. It is generally used for larger projects, such as construction.
Accounts Receivable Retention
For a contractor, retainage works two ways. Accounts receivable retention refers to money the customer holds back that they'll eventually pay to the contractor. Accounts payable retention is the money the contractor retains until disbursing it to subcontractors.
Suppose your contracting firm is building a new shipping center for a wholesale company. The cost: $225,000. The wholesaler makes regular payments as you complete significant parts of the project, such as pouring the foundations or installing the wiring and plumbing. The last 10 percent, $22,500, won't arrive until the project is complete.
When you start the project, you list $202,500 as accounts receivable. The $22,500 goes into accounts receivable retainage or retainage due. It's important to separate out retainage from other receivables. If you combine it with regular receivables, it'll look like your customer isn't paying you on time, which reflects poorly on your company. You report retainage on the balance sheet as a current asset.
Retainage in Accounts Payable
Like your customer, you won't want to pay your subcontractors, such as plumbers, electricians and insulators, for work that isn't done. The last part of the payment, due after you accept their finished work, is also retainage. You list it in your books as accounts payable retainage. If you expect to make the payment in the next 12 months, you report retainage payable as a current liability on the balance sheet.
Billing More Than the Cost
Construction doesn't always proceed smoothly. A contractor's expenses at any given point may be more or less than the amount the customer has paid. Construction accounting has to reflect this. Billings more than costs and estimated earnings are payments that outstrip the costs and earnings for the work done so far. As the contractor has to do enough work to justify the billing, accountants treat this as a liability; the company owes the customer the work. Costs and estimated earnings in excess of billing works the other way; the customer owes the contractor. This goes on the books as an asset, like accounts receivable.
Both of these situations apply to uncompleted contracts. When the contract is complete, and the customer accepts the work, the customer should release the final retainage payment. At that point expenses and earnings should equal billing.