As if managing cash flow for your construction company isn’t difficult enough, if you’re working on a commercial project, you may also have to deal with retainage. The practice of short-paying contractors’ invoices to secure completion of the work started as early as the 1800s. These days it’s a part of the law in most states. We’ve got more information on this strange practice, including when retention is released and how to record it in your accounting system.
What is retainage?
Retainage, or retention, is an amount of money that is withheld from each payment to contractors on a construction project. It is most common in commercial construction. Owners and contractors withhold funds to provide an incentive to finish the project according to the owner’s specifications and to serve as funding if there is a problem on the job.
In most states, retention is mandated on certain projects by state law. In addition, the law often caps the amount that can be withheld on projects in that state.
Retainage for a specific project is stipulated in the prime contract between the project owner and the general contractor. Often the retention rate and terms of payment flow down through the general contractor’s contract with each subcontractor.
Why Is Retainage Important?
Retainage, also known as retention, is a common practice in the construction industry where a portion of the payment due to the contractor is withheld by the client until the project is completed satisfactorily. This practice is important for several reasons:
- Ensures Quality and Completion: Retainage acts as an incentive for contractors to complete the project according to the agreed-upon standards and timelines. Since a portion of their payment is contingent on successful completion, contractors are motivated to meet or exceed quality expectations.
- Protects the Client: It provides a form of financial protection for the client. If the work is not completed as per the contract or if there are defects in the construction, the withheld funds can be used to rectify these issues without additional cost to the client.
- Guarantees Against Liens: Retainage can be used to settle any liens placed on the project by subcontractors or suppliers who may not have been paid by the primary contractor. This helps ensure that all parties involved in the project are compensated.
- Manages Cash Flow: For clients, especially in large projects, retainage helps in managing cash flow by deferring full payment until project completion. This can be particularly important in projects where the client’s cash flow is dependent on the project’s progress or other financial commitments.
- Encourages Completion of Minor Tasks: Often in construction projects, minor tasks and finishing touches are left towards the end. Retainage encourages contractors to complete these often-overlooked aspects to receive their full payment.
- Acts as a Dispute Resolution Tool: In cases where there are disputes about the quality or scope of work, retainage provides a financial leverage to the client. It can be a negotiating tool to ensure that the contractor addresses any concerns before the final payment is released.
- Standard Industry Practice: Retainage is a widely accepted and standard practice in the construction industry. It provides a structured approach to payment and project completion, which is familiar to contractors, subcontractors, and clients.
In summary, retainage is a critical element in construction contracts that helps ensure project completion to the required standards, provides financial security to the client, and ensures that all parties involved in the project are fairly compensated.
What Are the Rules of Retainage?
The rules of retainage in construction can vary depending on the jurisdiction, the specific contract, and the nature of the project. However, there are some general principles and guidelines that are commonly followed:
- Percentage of Retainage: The typical retainage amount is usually between 5% and 10% of each payment due to the contractor. This percentage can vary based on the contract terms and local laws.
- Duration of Retainage: Retainage is generally held until the project is substantially complete. “Substantial completion” means the project is finished enough to be used for its intended purpose, although minor tasks may still be outstanding.
- Release of Retainage: The release of retainage often occurs after the contractor has corrected any deficiencies and the project has passed final inspection. Sometimes, partial release of retainage can occur as different phases of the project are completed.
- State Laws and Regulations: Many states in the U.S. have specific laws governing retainage on construction projects, including limits on the percentage that can be withheld and the conditions for its release. It’s important to be aware of and comply with these laws.
- Federal Projects: For federal construction projects, the rules for retainage may be different and are often governed by federal regulations.
- Contractual Agreements: The specific terms of a construction contract can set forth the rules for retainage, including the percentage, conditions for withholding, and conditions for release. These terms must be agreed upon by both parties before the commencement of the project.
- Interest on Retainage: In some cases, the retainage may accrue interest, which is payable to the contractor upon release. This is dependent on the contract terms and local laws.
- Subcontractor Retainage: General contractors may also withhold retainage from their subcontractors. The rules for this are often similar to those between the client and the general contractor but should be explicitly stated in the subcontractor agreement.
- Dispute Resolution: In the event of a dispute over retainage, the contract typically outlines the resolution process. This may involve mediation, arbitration, or legal action.
- Special Provisions for Small Businesses: Some jurisdictions have special rules for retainage when dealing with small businesses, often allowing for lower retainage rates or quicker release to ease financial strain.
It’s crucial for both contractors and clients to understand the rules of retainage applicable to their project and jurisdiction, as these rules are designed to protect both parties’ interests and ensure the successful completion of the construction project. Legal advice may be necessary to navigate these rules effectively, especially in complex projects or when disputes arise.
Who holds retention?
Generally, withholding retention flows down through a project’s contracts. The prime contract stipulates the amount that will be withheld from the general contractor’s payments, and each subcontract the general has also stipulates the amount that will be withheld (usually the same amount as the prime contract).
In most projects, the owner and general contractor withhold retention and are responsible for paying it out once the project is complete.
How much is withheld?
The retainage rate, or how much is withheld, can vary by project. It is usually calculated as a percentage of each payment, usually 5 or 10%. The rate is specified in each contract. Some states have limits on how much can be withheld. For example, in Oregon the limit is 5% and in New Mexico retainage
is not allowed.
Say a general contractor has billed its customer $100,000 for a project. With 5% retention the contractor will receive a payment of $95,000. With 10% retention the payment will be $90,000. The balance
is tracked until the final payment is made once the work is complete.
When is retention released?
Most contracts stipulate that retention is paid at final completion, once the punchlist work has been finished and the owner has moved in or taken ownership of the project. On large projects this final payment can be quite substantial, so it is in the contractor’s best interest to finish the project quickly
so they can get paid.
Some contracts allow contractors to apply for early payment of some retention funds. This can usually be done after the project meets a milestone of completion, usually 50% complete. The contractor sends the owner an application for payment requesting the funds, and when it is approved, the owner makes the payment.
How to record construction retainage
The concept of retainage is unique to the construction industry. Because of this, most general accounting programs do not know how to handle it. That’s why it pays to use software that is designed for the industry. However, it is possible to record retainage using general accounting software if you know how to do it.
Recording retainage held on your invoice
If you are a general contractor or a subcontractor billing a general contractor, you will need to record the amount of retainage that will not be paid until the end of the project. This is done through a separate general ledger account called Retention Receivable. When an invoice is recorded, the retention will go to this account, with the balance going to Accounts Receivable.
Retainage held on your subcontractor’s invoice
If you are a project owner or general contractor with a contractor or subcontractor that has sent you an invoice, you will need to record the retainage that you will not be paying until the work is completed. This is done through a general ledger account called Retention Payable. When an invoice from your vendor is recorded, the retention will go to this account, with the balance going to Accounts Payable.
Calculating retainage in a construction project involves setting aside a percentage of the total contract amount or each payment made to the contractor. This amount is withheld until certain conditions of the contract are met, typically the completion of the project or a specific phase of it. Here’s how to calculate retainage:
- Determine the Retainage Rate: First, identify the retainage rate as specified in the contract. Common rates are usually between 5% and 10%.
- Apply the Rate to Payments:
- For Total Contract Value: If the retainage is calculated on the total contract value, multiply the total contract amount by the retainage rate. For example, for a $100,000 contract with a 10% retainage rate, the total retainage would be $100,000 x 10% = $10,000.
- For Individual Payments: If the retainage is calculated on each payment, apply the retainage rate to each payment amount. For instance, if you have a payment of $20,000 and a retainage rate of 5%, the retainage for that payment would be $20,000 x 5% = $1,000.
- Track Cumulative Retainage: Keep a running total of the retainage amount withheld over the course of the project. This is important for knowing how much is owed to the contractor upon completion.
- Adjust for Partial Releases: In some contracts, a portion of the retainage may be released upon reaching certain milestones. Adjust your calculations accordingly if partial releases occur.
- Consider Any Caps: Some contracts or local regulations may include a cap on the total amount of retainage. Ensure that your calculations do not exceed these limits.
- Final Calculation at Completion: Once the project reaches substantial completion, calculate the total retainage held and prepare to release it according to the contract terms, assuming all contractual obligations are met.
- Include in Invoicing: Ensure that retainage amounts are clearly indicated in all invoicing to maintain transparency and accurate financial records.
It’s important to note that retainage practices can vary based on local laws, industry standards, and specific contract terms. Always refer to the contract and relevant regulations to ensure correct calculation and compliance.
Advantages and Disadvantages of Retainage
Retainage, a common practice in the construction industry, involves withholding a portion of the payment due to a contractor until certain parts of the work are satisfactorily completed. This practice has both advantages and disadvantages:
Advantages of Retainage
- Quality Assurance: Retainage provides a financial incentive for contractors to complete the project according to the specified standards and timelines, ensuring quality work.
- Financial Security for Clients: It offers clients a form of financial protection. If the work is not completed as agreed or if there are defects, the withheld funds can be used to make necessary corrections.
- Leverage in Dispute Resolution: Retainage gives clients leverage in resolving disputes related to the quality or scope of work. It can be a negotiating tool to ensure contractors address any concerns before receiving full payment.
- Ensures Project Completion: It motivates contractors to fully complete the project, including minor and often overlooked tasks, to receive the full payment.
- Risk Mitigation: Retainage can help mitigate the risk of contractor non-performance or financial insolvency by ensuring that funds are available to complete the project if the original contractor cannot.
Disadvantages of Retainage
- Cash Flow Challenges for Contractors: Retainage can strain a contractor’s cash flow, especially for small businesses or those working on multiple projects with retainage requirements.
- Administrative Burden: Managing retainage can add administrative complexity and costs for both clients and contractors, requiring careful tracking and accounting.
- Potential for Delays: If contractors are experiencing cash flow problems due to retainage, this could lead to delays in project completion.
- Impact on Project Cost: Contractors may increase their bid prices to account for the impact of retainage on their cash flow, potentially increasing the overall cost of the project.
- Relationship Strain: The practice of retainage can sometimes strain the relationship between clients and contractors, especially if there are disagreements over the quality of work or the timing of releasing the retained funds.
- Legal and Regulatory Compliance: Navigating the legal and regulatory aspects of retainage can be complex, as rules and limits can vary significantly by jurisdiction.
Hopefully this article has helped you understand retainage and retention better. Unfortunately, it’s almost unescapable in the commercial construction sector. Be sure to take it into consideration when you do your cash flow planning, as it can significantly affect the amount of money you receive throughout a project.