Construction Accounting: A Solid Foundation for Your Business

Many business owners view accounting as nothing more than an administrative headache.

But good construction accounting systems and practices are powerful tools for managing your business. Accurate and timely construction 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).

Applying the Percentage-of-Completion Method

Typically, contractors calculate a project’s percentage of completion based on the ratio of incurred cost to estimated final cost. For example, suppose you are hired to construct a $1 million office building at an estimated cost of $900,000. At the end of year one, you have incurred $300,000 in costs and believe that your original cost estimate of $900,000 is still accurate, so the project is 33.3 percent complete.  You recognize 33.3 percent of the $1 million contract price as revenue, or $333,000, in year one. By subtracting your $300,000 of incurred costs, you arrive at a first-year profit of $33,000.

Monitoring Work in Progress

Solid construction accounting practices do much more than provide lenders and sureties with an accurate picture of your financial performance. They also provide you with a valuable management tool. To prepare financial statements using the percentage-of-completion method, you need to track key information for each job, including contract price, projected final costs, estimated gross profits, costs incurred to date and amounts billed to date. By compiling this information in regular work-in-progress (WIP) reports, you can spot important trends that have an impact on your profitability and cash flow.  For example, WIP reports that show a pattern of shrinking gross profits (“profit fade”) may reflect poor estimating, lax project management or other problems. Billings that lag behind a job’s progress (“underbilling”) may be a sign of cost overruns, management inefficiencies or slipshod billing practices, all of which can hurt your cash flow. Properly prepared and analyzed, the WIP report can provide more insight into a construction company’s financial performance than the balance sheet or income statement. Monitoring this information on a continual basis allows you to identify and address weaknesses in project management, estimating and administrative practices before they do lasting damage.

Understanding the True Cost of Jobs

One of the greatest benefits of an effective construction accounting system is that it lets you know the true cost of each job, enabling you to measure job profitability more accurately and put together more reliable bids.  The key is to develop a system for properly allocating costs—both direct and indirect—to specific jobs. Direct costs are straightforward: They include those generated by and directly traceable to a project, such as direct labor, subcontractor expenses, materials, equipment and tools. But to get an accurate picture of job profitability, you also need to analyze your indirect costs and allocate them to specific jobs whenever possible. Indirect costs—often referred to as “overhead”—are those that are a part of the construction process and benefit all of your jobs. Examples include quality control and supervision, supplies, insurance, tools and equipment and, in some circumstances, support costs such as payroll processing. By developing a reasonable method for allocating these indirect costs among the jobs that drive them, you can track profitability more accurately while jobs are in progress. If you don’t assign indirect costs to jobs, large amounts of “unabsorbed overhead” can result in inaccurate information about your company’s job profitability during the year. A common method is to allocate indirect costs on the basis of direct labor hours. But this approach isn’t always the best. Consider equipment costs, for example. Contractors who own their equipment often include the costs—such as depreciation, maintenance and repairs—in overhead. But unless all of a contractor’s jobs are equally “equipment-intensive,” allocating equipment costs on the basis of direct labor hours can result in a distorted picture of individual job profitability. Suppose, for example, that a contractor has two jobs in 2008: Each job has a $1 million contract price and direct costs of $800,000. However, Job 1 is more labor intensive (requiring two-thirds of the contractor’s total direct labor hours), and Job 2 is more equipment- and materials-intensive. The contractor owns its equipment, for which it will incur $150,000 in costs during 2008. It includes these costs in overhead, together with another $150,000 in indirect costs. If the contractor allocates its $300,000 in indirect costs based on direct labor, then $200,000 will be assigned to Job 1, wiping out that job’s profits. The remaining $100,000 will be assigned to Job 2, resulting in a profit of $100,000. But assume that Job 2 accounts for 80 percent of the contractor’s equipment usage. In that case, it would be more accurate to allocate 80 percent of the equipment costs, or $120,000 to Job 2 and 20 percent, or $30,000, to Job 1. Assuming that the remaining $150,000 in indirect costs are allocated based on direct labor hours, profits on the two jobs are calculated as follows: Job 1:   $1 million -$800,000 (direct costs) -30,000 (equipment costs) -$100,000 (indirect costs) = $70,000 (profit)   Job 2: $1 million -$800,000 (direct costs) -$120,000 (equipment costs) -$50,000 (indirect costs) =$30,000 (profit) As you can see, allocating equipment costs based on actual equipment usage results in a dramatically different financial picture. However, whatever the method of allocating indirect costs, the choice depends on the circumstances and must be reasonable. Proper accounting for job costs provides many benefits. It tells you the true cost and, therefore, profitability of each job; it enables you to develop more accurate bids, thereby helping you avoid unprofitable jobs; and it gives you the information you need to control your costs more effectively.

Dealing with Change

Change orders are a normal part of the construction business, and change order administration can have a major impact on the way you account for jobs. It is critical to include clear change-order approval terms in your contracts and to implement procedures for obtaining signed change orders on a timely basis.  Without properly authorized change orders, in some cases it may not be possible to recognize additional revenue in the same accounting period in which you incur costs to perform the additional work. This situation can have a negative impact on your financial statements and their evaluation by your banker and surety.

Cash Is Still King

A solid accounting system provides many benefits, but no matter how good or profitable your business looks on paper, it can still fail if you overlook cash flow. You should consider cash flow management when you negotiate contract provisions, such as retainage and payment terms.  You should ensure that everyone in your company understands the importance of cash flow and takes steps to submit paperwork, issue invoices and make collection efforts on a timely basis. Some contractors offer bonuses or other incentives to project managers who manage job cash flow effectively. Effective cash management is essential to maintaining a construction company’s financial health.

Give Your Construction Accounting System a Checkup

It’s important to review your accounting system, procedures and reports regularly to ensure that the system produces timely and accurate information company owners can use to manage the business effectively. A solid accounting system also inspires confidence in the lenders and sureties that underwrite the business and are so vital to its financial health. Construction Business Owner, March 2008