Construction Business Owner, March 2008

Many business owners view accounting as nothing more than an administrative headache. But good accounting systems and practices are powerful tools for managing your business. Accurate and timely financial reports can help you monitor your performance, control costs, improve profitability and manage cash flow.

This is important for any business, but it’s particularly critical in the construction industry, which, by its nature, is subject to a great deal of uncertainty. Good accounting practices provide a snapshot of where each project stands at any given time, allowing management to detect problems and make necessary adjustments before it is too late.

Construction Accounting 101

Construction accounting is distinct from other types of accounting because of the long-term nature of many construction contracts. Revenue recognition is one of the main principles of generally accepted accounting principles (GAAP), which strives to match revenues with the expenses that generate them. However, this matching of revenues with expenses can be a challenge over the earnings process spans a long period of time.  

Typically, revenues and costs are recognized when the earnings process is complete or virtually complete and an exchange has taken place. Consider the typical retail transaction in which a buyer exchanges money for a product. Both recognition criteria are satisfied and the seller’s profits can be calculated immediately by subtracting the product’s cost from the sale price.

With a long-term construction project, on the other hand, a contractor performs work over several months or even years. A project’s scope, costs and revenues may fluctuate over the contract’s term, so the precise profit or loss associated with a job will not be known with certainty until project completion.

GAAP recognizes that the usual rules of revenue realization don’t necessarily apply to long-term construction contracts. If revenue isn’t recognized until the earnings process is complete and an “exchange” has taken place, then the contractor’s financial results will be distorted during the life of the contract.

Suppose, for example, that a newly established contractor with a calendar year-end begins work on its only project—a $1 million contract—on July 1, 2007. The project is expected to be completed by June 30, 2008, at a cost of $900,000. If the contractor’s revenues and costs aren’t recognized until the project is complete, its 2007 financial statements will show zero revenue, cost and profit, regardless of the amount of construction costs incurred during 2007. This situation can be troublesome if the contractor is attempting to get bonded work or secure bank credit during the construction period.

To present a more accurate picture of a contractor’s financial performance, GAAP provides for revenues and costs to be recognized as construction progresses.

Two Acceptable Methods

The American Institute of CPAs, in its Statement of Position (SOP) 81-1, describes the two generally accepted methods of accounting for long-term construction contracts: The percentage-of-completion method and the completed contract method. The percentage-of-completion method recognizes income as a contract progresses toward completion, while the completed contract method does not recognize revenues or expenses until a project is substantially complete.  

These are not alternative methods, however, from which contractors are free to choose regardless of the circumstances. For the reasons discussed above, the percentage-of-completion method is preferred and should be used whenever the conditions for its use are satisfied.

The percentage-of-completion method is appropriate when all of the following conditions exist:

• It is possible to make “reasonably dependable estimates” of contract revenues, contract costs and progress toward completion
• The contract clearly specifies the parties’ enforceable rights, the consideration to be exchanged and the manner and terms of settlement
• The owner can be expected to satisfy its contractual obligations
• The contractor can be expected to complete the work

Generally, the completed contract method should be used only if reasonably dependable estimates cannot be made or if it would not produce materially different results from the percentage-of-completion method (for example, if most of a contractor’s projects involve short-term contracts).

In most cases, commercial contractors should use the percentage-of-completion method. After all, as noted in SOP 81-1, “The ability to produce reasonably dependable estimates is an essential element of the contracting business.” In addition, most lenders and sureties demand percentage-of-completion reporting, and the method is required for income tax purposes for larger contractors (those whose average annual gross receipts for the preceding three years exceed $10 million).