Retention payments and how to account for them

Whilst retention payments are very common in the building and construction industry we continually see them being incorrectly accounted for, or not accounted for, and therefore often overlooked, resulting in advance payment of taxes and/or lost income.

What are Retention Payments

Retention payments involve the customer retaining a portion of the contract amount until a time after completion of the project based on the terms in the contract, which can often be 6, 12 or in some cases 24 months. The retention acts as a “security” that the project is completed and free of any defects. Once the retention period has passed, the retained funds are paid to the builder.

If the project has retentions, this will be disclosed in the contract, so it is important you read all contracts prior to signing as many builders have been caught out when they did not realise there was a retention in the contract. This can cause unexpected cashflow challenges as often the retentions are where the profit for the project is. The contract should outline:

The amount that will be retained (often shown as a %),
What is expected for release of the retention, and
Timing of when the retention will be paid.

What issues do we frequently see?

Advance payment of GST & Income taxes due to incorrect accounting where the retention amount is recorded as part of the total sales invoice, and the customer pays the invoice less the retention amount resulting in an outstanding amount on the sales invoice. This means inadvertently income tax may be paid on this income as your tax return must be prepared on an accrual’s basis.
If you are on a c
asor GST there will be no impact, but if you are in an accrual’s basis for GST, you will also pay GST on income that you have not received and may not receive for a long time, again causing unexpected cash flow challenges.
No recordin g

system to ensure collection of the Retention

How should retentions be accounted for?

Answer
We have two approaches we recommend, depending on your situation and how you wish to see the retention in your accounting records. Both result in the same overall outcome however some clients have a preference as to how the invoices are recorded, and therefore accounting for the retention amount.

Client wants an invoice for the project amount EXCLUDING the Retention

This is when your client wants an invoice for the final project payment excluding the retention amount. We don’t want you to forget about the retention!

Firstly you issue the invoice to the client, say the final project invoice was $100,000 and the retention was 10%, then the invoice would be issued as $90,000. You show the retention on the sales invoice as two line items and the client pays the $90,000

Your sales invoice use two lines in the invoice and record to these accounts

Construction Revenue Account (PL) $90,000

Retention (PL) ($10,000)

TOTAL INVOICE $90,000

Retention payments and how to account for them