Guide to Accounting for Retention Payment in the Building & Construction Industry

retention payments (1)

Retention payments are very common in the building and construction industry and involve the customer retaining a portion of the contract amount until a time after completion of the project. The retention acts as a security that the job is done well and free of defects. Once the liability for defects period has passed, the retention is paid to the supplier.

The reason that retention payments are worthy of discussion, is that the period of between the completion of a job and the payment of the final retention component can be many months or even years.

If retention payments are being used in a project, they should always be disclosed on the contract in a clause that describes:

 

  • How much will be retained,
  • The criteria to be achieved for final payment, and
  • When it will be paid.

 

Because of the potential to span across GST periods and financial years, accounting for retention payment can be confusing for businesses in the building and construction industry. It is essential that transactions are recorded correctly to avoid paying tax on income unnecessarily or at least earlier than absolutely necessary.

 

The Incorrect Method

It is often the case that the business will issue an invoice for the full amount and code it to Sales in their books. This means the full amount is taxable income in that year, and the full amount is recorded in trade debtors.

The customer will pay the amount, less the agreed retention. This will leave the retention showing unpaid in trade debtor and can remain there for many months or years.

Often retention payments are never paid, and this ‘unpaid’ amount may never be cleared however the full amount has still been recorded up as taxable income.

By accounting for retention payments this way, businesses are paying more tax than they should, if not sooner than they need to.

 

The Correct Method

Below is the best practice method to account for retention payments. We have used Xero as the accounting system for demonstration purposes.

 

Recording Initial Invoices

  1. Create a current asset account “Retentions Held” and a current liability account “Liability for Defects”. Both use BAS Excluded for the Tax Rate.
  2. In this example, we assume that the project is $100,000 and 20% is retained for some time in the future. When creating an invoice for this job, this is how the invoice should look like:
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The retention portion is an amount we are not yet entitled to, so we don’t recognise this as assessable income at this stage. Customer only pays $88,000.

 

Balance Sheet

  1. On the Balance Sheet this is what you should see:
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Receiving Payment

  1. When a retention payment is due, an invoice is created, and GST is recorded at this point. This is also the point where the Retentions Held & Liability for Defects amounts for this project are cleared.
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Writing off Retentions

  1. If business is no longer entitled to the payment (ie there is a defect that needs to be addressed), we simply journal it out. A nil invoice is recorded against the customer to record the write off of the retention and liability.
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Tips for Remembering Retentions

One way to keep track of retention payments which are that is not yet due, is to create draft invoices in Xero. Regularly review this list and approve them so that they are recorded in the ledger when the time comes. It is essential to leave them as draft so as not to include them in the Profit & Loss or Balance Sheet prematurely.

 

GST Treatment

If the business accounts for GST on an accruals basis, the business is required to account for GST on the total invoice value (including the retention payments) in the period which the business receives any consideration. This means the business is required to remit GST on the full value of the invoice even if part of the payment is not received until a later time.

If the business reports for GST on a cash basis, it would remit GST to the ATO when the cash is received.

 

Do you have retention payments in your business?

If you have retention payments in your business, reach out to Link Advisors to ensure these are being accounted for correctly so that you are not paying more tax than is absolutely necessary.