Retention in Construction Contracts

Types, Impacts, and Use Cases

Retention in construction contracts is a widely used financial mechanism where a portion of the contractor's payments is withheld by the employer. This ensures the contractor fulfills their obligations, including rectifying defects and completing the project to the agreed standards. This article explores the different types of retention, their effects on project cash flow and contractor performance, the rationale behind their application, and provides illustrative use cases.

Types of Retention in Construction Contracts

1. Fixed Retention Percentage

A fixed percentage of each interim payment is retained until the project reaches specific milestones or completion.

Formula:

Example: If a contractor is due $100,000 and the retention percentage is 10%, the retained amount is $10,000.

2. Capped Retention

In this arrangement, retention deductions stop once a maximum cap is reached. This cap is pre-determined in the contract to balance employer security and contractor cash flow.

Formula:

Example: For a project with a retention cap of $50,000 and a 10% retention rate, retention deductions cease once the cap is reached.

3. Dual Release Retention

Retention is released in two stages:

• Practical Completion: A portion (e.g., 50%) is released upon project completion.
• Defect Liability Period (DLP): The remaining amount is released after the DLP ends and defects are addressed.

Formula:

$$\text{Retention at Practical Completion}$$

Example: For a total retention of $20,000, $10,000 is released upon practical completion, and $10,000 is released after the DLP.

4. Sliding Scale Retention

The retention percentage decreases as the project progresses or milestones are achieved.

Formula:

Example: A project with retention of 10% for the first 50% of work, 5% for the next 30%, and 0% for the final 20% adjusts the retention rate based on progress.

5. Retention Bond

Instead of withholding cash, the contractor provides a retention bond from a bank or insurer. This bond guarantees the employer’s security without affecting the contractor’s cash flow.

Formula:

Example: If the retention cap is $50,000, the contractor provides a bond for this amount instead of having cash withheld.

Effects on Project Cash Flow and Contractor Performance

1. Cash Flow Constraints

Retention reduces immediate cash flow, affecting the contractor’s ability to pay suppliers, labor, and subcontractors. For smaller contractors, this can lead to financial strain or project delays.

2. Working Capital Needs

Retention often necessitates additional working capital or financing to maintain operations, especially in long-term projects.

3. Incentive for Quality Work

Retention motivates contractors to deliver high-quality work and remain engaged until all obligations, including defect rectification, are fulfilled.

4. Risk of Compromised Relationships

Excessive retention percentages or delays in release can strain the contractor-employer relationship and negatively impact future collaborations.

Why Retention is Applied

1. Quality Assurance: Ensures the contractor addresses defects or incomplete work during the Defect Liability Period.
2. Risk Mitigation: Protects the employer against financial loss if the contractor defaults or fails to deliver.
3. Encouraging Accountability: Acts as leverage to ensure the contractor completes the work to the agreed standard.

Use Cases of Retention

1. Residential Projects

Retention is commonly applied in residential projects to ensure the contractor rectifies minor defects (e.g., faulty plumbing or wiring) post-handover.

2. Infrastructure Projects

Large-scale infrastructure projects often use capped retention to manage contractor cash flow while ensuring quality. For example, retaining $1 million in a $100 million highway project provides security for defect rectification without overly constraining the contractor’s finances.

3. Commercial Developments

Sliding scale retention can be applied in commercial projects to incentivize steady progress while easing financial pressures as the project nears completion.

4. High-Risk Projects

Retention bonds are preferred in high-value, high-risk projects such as airports or industrial plants, where contractor cash flow liquidity is critical for timely completion.

5. Public Sector Contracts

Public works often apply fixed retention percentages with dual release to safeguard public funds while ensuring contractor performance.

Accounting for Retention in Financial Records

Accounting for retention requires accurate tracking and reporting in both the employer’s and contractor’s books. Below are key practices for retention accounting:

For Employers

1. Recording Retention Payable: Retention amounts withheld should be recorded as a liability under "Retention Payable" in the employer’s books.

   Journal Entry:

   • Debit: Construction Expense (or Project Account)
   • Credit: Retention Payable

2. Releasing Retention: Upon completion of the project or the Defect Liability Period, the employer releases the retention amount.

   Journal Entry:

   • Debit: Retention Payable
   • Credit: Cash/Bank

For Contractors

1. Recording Retention Receivable: Retention amounts withheld by the employer should be recorded as a current asset under "Retention Receivable."

   Journal Entry:

   • Debit: Retention Receivable
   • Credit: Revenue (or Progress Billings)

2. Releasing Retention: When the retention amount is released, the contractor updates their books to reflect receipt of payment.

   Journal Entry:

   • Debit: Cash/Bank
   • Credit: Retention Receivable

Periodic Review:

Both parties should review retention accounts periodically to ensure accurate reconciliation with contract terms.

References

1. Gould, N., & Joyce, R. (2017). Construction Law: Retention and Payment Security. Routledge.
2. RICS (2020). Retention in Construction Contracts: Current Practices and Impacts. Royal Institution of Chartered Surveyors.
3. CIOB (2021). Retention Policies in the Construction Industry: Balancing Employer and Contractor Interests. Chartered Institute of Building.
4. FIDIC (2017). Conditions of Contract for Construction. International Federation of Consulting Engineers.
5. Quollnet.com DLP (2024): What is construction Defect Liability Period - DLP

Retention practices provide a balance between ensuring employer security and maintaining contractor cash flow. Proper structuring, negotiation, and use of alternative mechanisms like retention bonds can mitigate adverse impacts while achieving project goals efficiently.