Construction underbillings are the dollar value of work a contractor has already performed but has not yet invoiced to the customer, and under ASC 606 that gap is recorded as a contract asset on the balance sheet. A small underbilling on any given job is normal. A pattern of large or growing underbillings across a portfolio is a warning that cash flow, project controls, or cost estimates are off, and it can quietly erode bonding capacity long before the problem shows up in net income.
Where Underbillings Sit on the Balance Sheet
The Financial Accounting Standards Board’s ASC 606 framework requires contractors to recognize revenue as they transfer promised goods or services to the customer. When work has been performed but no invoice has been issued, the value of that work still has to appear in the financial statements. It lands in current assets, classified as a contract asset.1FASB. Revenue from Contracts with Customers (Topic 606)
A contract asset is not the same thing as an account receivable, and the difference matters. A receivable is an unconditional right to payment; only time separates the contractor from cash. A contract asset is a conditional right, meaning additional performance or a milestone must be reached before the contractor can formally bill. Lenders and sureties know the difference and treat the two line items differently when they size up a contractor’s financial health.
Recording underbillings as assets reflects the legal right to receive payment for work already performed under the contract. Labor and materials have been consumed to create value, and failing to record that value would understate income and distort the company’s worth. Auditors watch these entries closely because misclassifying or inflating contract assets is one of the more common ways construction financial statements go wrong.
How to Calculate Underbillings
The percentage of completion method is the standard way to measure how much revenue a contractor has earned at any point on a long-term project. It uses three inputs: total estimated contract costs, actual costs incurred to date, and the amount already billed to the client.
- Completion percentage: costs incurred to date ÷ total estimated costs
- Earned revenue: completion percentage × total contract price
- Underbilling: earned revenue − amount billed (a positive result is an underbilling)
Take a project with a $1,200,000 contract price and $1,000,000 in estimated costs. If the contractor has spent $400,000 so far, the job is 40% complete and earned revenue is $480,000. If only $400,000 has been billed, the $80,000 difference is an underbilling and is recorded as a contract asset.
The whole calculation rests on the cost estimate. If total estimated costs are set too low, the formula overstates the completion percentage and makes the project look further along than it is. Estimates need to be revised as the job progresses. When months pass without an update, the balance sheet drifts from reality, and the correction, when it finally arrives, tends to be ugly.
Underbillings vs. Overbillings
Overbillings are the mirror image: the contractor has billed more than the value of work completed. Overbillings sit on the balance sheet as contract liabilities because the contractor still owes future performance to justify payments already collected. ASC 606 requires each contract to be evaluated individually, with the billing position netted against retainage to determine whether the project produces a net contract asset or a net contract liability.1FASB. Revenue from Contracts with Customers (Topic 606)
A healthy contractor usually carries a mix of both across active projects. Trouble shows up at the extremes. Heavy overbilling generates short-term cash but creates a future obligation, and if that cash gets spent elsewhere the contractor ends up short when the overbilled project demands the work it has already been paid for. Heavy underbilling does the opposite: it starves the business of cash while piling up paper assets that may never convert.
A contractor that is simultaneously overbilled on older projects and underbilled on newer ones is often using cash from the overbilled jobs to fund the underbilled ones. Analysts reading a work-in-progress schedule look for that pattern early, because it rarely resolves on its own.
Red Flags When Underbillings Keep Growing
Unapproved Change Orders
Unapproved change orders are one of the most common drivers of persistent underbillings. A contractor performs extra work to keep the project moving, but no signed agreement authorizes billing for the additional cost. ASC 606 recognizes that a contract modification can be established through written approval, oral agreement, or customary business practices, but in practice contractors who proceed on a handshake often struggle to collect. When change orders stay unsigned for months, the underbilling figure grows while the odds of ever converting that asset to cash shrink.
Billing Cycle Delays
Consistent delays in the monthly billing cycle are another warning sign. When project managers don’t submit progress reports on time, accounting can’t issue invoices, and earned revenue stays parked as a contract asset instead of moving into receivables where it can be collected. Chronic delays also point to weak internal controls and make accurate cash flow forecasting nearly impossible.
Inaccurate Cost Estimates and Profit Fade
Underestimating project costs at the start is the most dangerous trigger because it creates a false picture of progress. If the original budget was too low, actual costs consume a larger share of the contract value than expected, and the percentage of completion formula reports more earned revenue than the job can support. When the estimate finally gets corrected, expected margin evaporates as the project nears completion. That is profit fade, and a run of rising underbillings over several consecutive quarters is often the earliest visible warning.
One surety industry example involved a project that was 97% complete at year-end with $296,000 in underbillings. Six months later, at 99% completion, underbillings had grown to $419,000 despite ongoing losses. The surety disallowed those amounts entirely from the contractor’s working capital calculation because the likelihood of collection was effectively zero.
What Chronic Underbillings Cost You
High underbillings undermine the liquidity ratios lenders use to evaluate a contractor. Contract assets technically count as current assets, but banks routinely discount them when calculating available working capital. The logic is straightforward: if revenue has been earned but not yet billed, disputes or collection problems can delay cash indefinitely. A company with large underbillings can look healthy on paper and still lack the cash to make next week’s payroll.
Sureties are tougher still. A contractor showing a pattern of underbilling reads as a higher risk for performance bonds because the pattern suggests poor project management, impending losses, or both. Most sureties apply their own formulas to haircut underbillings from working capital, and firms whose underbillings represent a substantial share of equity face unfavorable rates or outright denials. When bonding capacity drops, access to larger projects goes with it, and growth can stall for years.
Retainage Netting
Retainage adds a layer of complexity. Owners commonly withhold 5% to 10% of each progress payment until a defined milestone or final completion. ASC 606 requires retainage to be netted against the billing position on each individual contract, so a project that looks overbilled on a gross basis might actually be a net contract asset once retainage is factored in, or vice versa. Contractors who skip this netting step misstate their financial position in both directions, and that inconsistency is exactly the kind of thing auditors and lenders notice.
The Tax Side: Section 460
Federal tax law imposes its own rules on long-term contracts, and they don’t always line up with GAAP. Section 460 of the Internal Revenue Code requires taxable income from any long-term contract to be determined using the percentage of completion method.2Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts A long-term contract is any contract for building, installation, or construction of property that won’t be completed in the same tax year it’s entered into.
The tax computation mirrors the accounting one, and underbillings show up as a timing difference. The contractor owes tax on revenue earned under the percentage of completion formula even if it hasn’t billed or collected anything. For firms with large underbillings, that produces a real cash squeeze: the tax bill arrives before the cash does.
The Look-Back Rule
When a long-term contract is finally completed, Section 460 requires the contractor to apply a look-back method. The contractor recalculates what income should have been reported in each prior year using actual costs and the actual contract price rather than the estimates used at the time. If earlier years were underpaid, the contractor owes interest on the shortfall. If they were overpaid, interest comes back the other way. The computation is filed on IRS Form 8697 and uses the overpayment rate under IRC Section 6621, compounded daily.3Internal Revenue Service. Examination and Closing Procedures Form 8697, Look-Back Interest
The look-back rule has exceptions. It doesn’t apply to home construction contracts. It also doesn’t apply to contracts completed within two years that have a gross price not exceeding the lesser of $1,000,000 or 1% of the contractor’s average annual gross receipts for the three preceding tax years.2Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts
Small Contractor Exemption
Not every contractor has to use PCM for taxes. Section 460 exempts certain construction contracts if two conditions are met: the contractor estimates the contract will be completed within two years, and the contractor meets the gross receipts test under Section 448(c).2Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts That test requires average annual gross receipts of $25 million or less, adjusted for inflation, over the three preceding tax years.4Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting The inflation-adjusted threshold has risen to approximately $31 million in recent years.5Internal Revenue Service. Tax Guide for Small Business Contractors within the exemption can use the completed contract method, which defers all revenue until the project is done and eliminates underbillings from the tax calculation. Residential construction contracts are exempt regardless of the contractor’s size.
How to Bring Underbillings Down
The single most effective fix is boring but reliable: shorten the billing cycle. Contractors who bill on a fixed calendar date each month regardless of when work is completed almost always carry unnecessary underbillings. Aligning invoice submission with actual milestones, and requiring project managers to submit progress reports within days of period-end, closes the gap between earned and billed.
Change order discipline is next. Every scope change should be documented and submitted for approval before the extra work begins, or at least within the same billing period. Contractors who accumulate months of unapproved change orders are building a balance sheet asset no one has agreed to pay for. Even when the work was clearly authorized verbally, the absence of written approval makes those amounts functionally uncollectible in a dispute.
Cost estimate reviews deserve the same urgency. Project managers should update total estimated costs at least quarterly and compare original budgets to actual spending trends. When a revision reveals costs running ahead of plan, the percentage of completion calculation self-corrects, and the financial statements start reflecting reality rather than the optimistic budget from six months earlier. Firms blindsided by profit fade are almost always the ones that let estimates go stale.
Finally, the schedule of values submitted at the start of a project sets the billing framework for the entire job. Front-loading the schedule to accelerate early cash flow is common, but if the project hits problems later, the contractor may have collected most of the contract value and lack the funds to finish. On federal projects, excessive front-loading can trigger scrutiny under the False Claims Act. A schedule of values that distributes overhead and profit proportionally across work items produces billing amounts that track earned revenue and keeps the swings in both directions small.