Bank Guarantees or Retentions
To ensure that a Contractor in the Building and Construction Industry performs in accordance with the signed Contract, the Principal typically requests an appropriate form of guarantee from the Contractor or they deduct monies from the payments they make.
The forms of guarantee that are most common are Retentions and Bank Guarantees. The Bank Guarantee or Security option requires the subcontractor to have equity in property that they are prepared to provide to their Bank so that a security amount typically equal to 5% of the Contract Sum is held as security in two equal parts.
A Retention (or Retaining as they are sometimes called) refers to the money construction companies withhold from the progress payments made to the Contractor. The total Retention would equal a percentage of the Contract Sum – again, normally not exceeding 5%.
In fact the rates are more usually described as “10% to 5%” as there is a loading on the early payments made to Subcontractors to help build a Retention reserve. So the Retention is calculated at 10% of each progress payment until the total retained is equal to 5% of the Contract Sum.
Bank Guarantees are better for Subcontractors while a Retention is more beneficial for the Construction Company – the reason is cash-flow. (Muli Users can see a sample Bank Guarantee in the secured INDUSTRY DOCUMENTATION SECTION of this website)
The Principal’s right to retain amounts from progress payments, and the Contractor’s entitlement to the release of their money is generally outlined in the agreement between the parties. A Contractor may be entitled to the release of part of the retention amounts held upon practical completion of the construction, and the release of the balance upon expiration of a defects liability period.
Most agreements allow the Principal recourse to the retention monies in the event that the Contractor is liable to the Principal for a default under the contract. The Contractor may default by failing to complete work to a required standard or by failing to rectify defects.
Retention amounts may therefore be used to offset the liability of the Contractor. As such the Contractor may not receive the full amount retained from the progress payments. For example, if a Contractor fails to rectify certain defects, the Principal may pay a third party to do so, using part of the retained amounts.
Standard Retention Rates
Muli Software is supplied with a pre-loaded Rate table that can be modified by the user. The standard data has 12 rates and covers all possibilities. There are the common percentage rates and it even includes codes for “No Retentions” and “Bank Guarantee”.
The table allows for a Maximum Rate % and a Maximum Retention %. The ten percentage rates that are included start with “2.5%”, “5% to 2.5%”, “5%”, “7.5% to 5%” etc, plus of course the most commonly employed rate of “10% to 5%”.
Muli will automatically apply the rate selected in a subcontract and calculate the deduction required when processing a progress claim. If an amendment is made to the total contract sum then Muli will take this into account when next calculating the retention.
Australian Taxation Office Rulings on Retentions and Goods & Services Tax (GST)
When the Retention amounts are released to the Contractor, GST is applied the same as it is during the processing of progress claims.
Refer to Paragraphs 172 to 189 of RULING 20.
Refer to Paragraphs 121 to 123 of RULING 35.
Refer to Paragraphs 37 to 43 of RULING 18.
The following example shows the calculation of Subcontractor deductions and the appropriate GST:-
A builder may engage an air-conditioning subcontractor to supply and install a system for a total of $200,000.
During the installation the subcontractor makes a progress claim of $50,000 based on an assessment of work to date. The builder agrees with the figure but contractually needs to retain 5% of the $200,000 against satisfactory completion.
The agreement quotes a retention rate of “10% to 5%” so to build a retention reserve the builder would retain 10% of the first claim. Therefore the builders records would show:
Invoice Value $50,000
Less Retention $5,000
Value approved for payment $45,000
Plus GST $4,500
Cheque Amount $49,500
Liability on completion $5,000
(and the GST on this $ 5000 will be levied at some time in the future when the monies are released to the subcontractor)
Accounts Payable? Accounts Receivable? Maybe Both?
The example above shows how retentions are handled in an Accounts Payable system – when you pay your subcontractors.
However if you are a General Contractor or the Construction Company, then in addition to engaging Subcontractors you will also have monies withheld from your payments by your client – so it affects your Accounts Receivable.
Visibility of Retentions improves Liquidity and Profitability
You don’t want to be using accounting software that uses “work-arounds” like Negative Inventory to handle Retentions.
You do want:
- A User Maintainable Rate Table.
- Visible and automatically calculated deductions when processing Subcontractor Progress Claims.
- The ability to input Retentions in your Client Progress Claims.
- Retentions rolled over to the new financial year.
- Retentions clearly visible in all Accounts Receivable, Accounts Payable and Project Review reports.
Without visibility you will become one of the contractors who “forfeit” the money withheld through their own neglect.