Q: In the presentation you discussed A/R Days. However, there was no mention of retention accounts. Often times our contractors have large accounts in retention, so how should we view these accounts which would increase A/R Days and working capital? If they are removed, would this be understating the A/R Days since it is most likely retention accounts will be paid at the end of a large project?
A: The short answer is a) include the “A/R – Retention” balance in computing A/R Days and b) exclude “A/R – Retention” from Working Capital.
A retention is intended to encourage, or compel, contractors and subcontractors to complete a project on time and on budget. To that end, the client will frequently hold back – or retain – a percent of the total contract that is due and payable on completion of the project to the client’s satisfaction. Both parties agree to the retention provision in the contract.
As a contractor invoices a client for project progress payments, it classifies a percent of the invoice as a retention posted to an “A/R – Retention” account on its balance sheet. The invoice to the client does not include any reference to the percent of the invoice designated as retention. The client customarily withholds payment of invoices from the contractor until the billings equal the agreed upon retention amount. From that point on, the client is obligated to honor the periodic billings from the contractor.
Upon completion of the project, the contractor bills the client for the final time and states the amount within the invoice total necessary to fully pay the retention. The amount due could be the full amount of the retention or some portion of it, depending on the cumulative payments made by the client up to receiving the final invoice.
The are a couple of points to keep in mind:
It is common for contractors to forego use of a retention account even though the contract provides for it. In such circumstances, there is no “A/R – Retention” balance to use in computing A/R Days. It is hidden in the general “A/R – Contracts” balance, and the full balance is used in computing A/R Days for contractors.
A few contractors will set up a current asset account, such as “Retentions Held” and a current liability account, such as “Liability for Defects”, and bill the client over the life of the project for the total contract amount less the retention. Upon completion of the project, the contractor will debit the balance in the “Liability for Defects” account (eliminate the balance) and credit the “Retentions Held” account by the same amount (eliminate the balance). As part of this transaction, the contractor will also credit (increase) “Revenue” on its income statement and debit (increase) “Accounts Receivable – Contracts” by the same amounts. Retentions are now recognized as revenue and included in “Accounts Receivable – Contracts” in computing A/R Days for contractors.
To summarize, “A/R – Retention” should be included in the A/R Days computation since the amount posted to that account has been recognized by the contractor as revenue under the percentage of completion method of accounting. To exclude it would result in an underestimate of A/R Days.
With respect to “A/R – Retention” and Working Capital, it is customary to exclude “A/R – Retention” from Working Capital computations. There is little assurance the full amount of “A/R – Retention” balance will be collected in cash in the next operating period since collection depends on the progress of the projects and the ultimate satisfaction of the clients.
Course overview: Spreading Financial Statements