As a contractor trying to run a profitable construction firm or a project manager looking to keep costs in check, understanding construction accounting is essential. However, accounting for long-term, high-value construction projects carries many complexities. From recognizing revenues accurately to tracking costs and maintaining cash flow, it’s crucial to have rock-solid finance processes.
This all-inclusive guide is designed to provide a comprehensive understanding of accounting for construction projects, with the aim of facilitating sound financial decision-making and mitigating costly errors. Within this guide, I will provide a detailed overview of the key aspects of construction project accounting, covering essential topics such as project costing, revenue recognition, and financial reporting.
By the end of this guide, you will have a solid grasp of the principles and concepts that underpin construction project accounting, empowering you to make informed decisions and manage your financial resources with greater confidence and precision.
When working on projects spanning several months or years, recognizing revenues as work gets completed is vital. Construction accounting provides two main “percentage-of-completion” methods for this:
Percentage of Completion Method
The percentage-of-completion (POC) method recognizes revenues continuously based on work progress. It provides better matching of revenues with expenses incurred in each period. There are a few ways to calculate the percentage complete:
Calculating Percentage of Completion
Costs incurred to date ÷ Total estimated costs
This approach is easiest when you have reliable cost estimates. Calculate this percentage each period and recognize the corresponding percentage of total contract revenue.
Physical completion
For simpler projects, estimate the physical proportion completed to date. If 40% of the work is done, recognize 40% of total contract revenue.
Units completed
For projects delivering identical units, calculate the number of units completed as a percentage of total units per the contract. Recognize that percentage of total revenue.
As you can see, the POC method aligns revenues with project progress. But it requires reasonably accurate cost estimates upfront.
Recognizing Revenue Based on Percentage Complete
Once the percentage completion is calculated each period using one of the above methods, you can book revenues as follows:
Percentage complete x Total contract price = Revenue to recognize
So if at the end of Year 1, a $1M contract is 25% complete, recognize $250K of revenue in Year 1 financials.
The POC method gives a useful indicator of profitability to date and allows better project forecasting for budgeting and cash planning.
Completed Contract Method
Unlike POC, this method waits until the entire project is complete before recognizing revenues. Expenses accumulate over the project, and revenues get booked in one go at completion.
Revenue Recognition Criteria
For revenues to qualify for recognition, the contract must meet set criteria like:
- Being completed as per terms
- Receipt of client acceptance paperwork
- Reasonable certainty of receipt of payment
This matters most for complex projects with approval milestones. Revenues can only be taken once all criteria are fully met.
Contract Cancellations and Terminations
If contracts get canceled before completion or terminate unexpectedly, the completed contract method requires writing off all associated costs. No revenues can be recognized at all.
As you can see, this method relies heavily on the project finishing properly. It also provides less visibility into financial performance over the project duration.
Selecting the Appropriate Method
Choosing between POC and a completed contract requires understanding the contract terms and project scope.
Fixed-Price vs. Cost-Reimbursable Contracts
Fixed or lump-sum price contracts are best suited for POC revenue recognition. Since the total revenue is pre-defined, the focus is on tracking the percentage of work completed to recognize corresponding revenue amounts.
Cost-reimbursable contracts have revenues tied to allowable costs incurred, making revenues harder to estimate upfront. So, the completed contract method allows accumulating costs first before final revenue booking.
Short-Term vs. Long-Term Contracts
Short-term contracts lasting less than a year can use either approach based on ease of implementation. No interim reporting is required.
For long-term contracts spanning multiple years, POC better aligns with ongoing percentage work completed and profitability tracking needs.
Now that we’ve covered revenues let’s look at managing costs.
Construction Cost Accounting
From materials to equipment rentals, construction involves continuous outflows needing tight oversight. Accurately tracking costs is crucial for avoiding negative surprises that erode profits.
Tracking and Allocating Costs
Cost accounting helps accurately allocate expenditures to specific projects and cost categories.
Materials, Labor, Equipment
Careful tracking of major project expenses like building materials purchased, labor hours logged, and heavy equipment rented per project is essential.
Construction accounting software can automate the capture of supplier invoices, staff timesheets, and equipment rental costs for allocation to relevant projects and cost buckets.
Overhead and Indirect Costs
Beyond direct costs, projects also incur indirect overheads like:
- Insurance
- Rentals for office space, temporary storage facilities, etc.
- Utilities like electricity and water at construction sites
- Administrative and office staff salaries
Such overhead costs accumulate enterprise-wide across all projects. Using allocation metrics like dollars spent or hours logged, overheads can be proportionately allocated to specific projects each month.
Software for Cost Accounting
Using spreadsheets becomes messy for large projects. Purpose-built construction accounting systems like Sage 100 Contractor and Viewpoint handle:
- Multi-project cost tracking
- Customizable allocation rules
- Overhead cost pools
- Automated reporting for profitability analysis
As costs accumulate, drill-downs help scrutinize variances to uncover inefficiencies. Periodic analytics using job costing principles can guide better bidding and budgeting for future projects.
Managing Change Orders and Cost Overruns
Change orders are almost inevitable in large construction programs. Scope changes can stem from necessary design modifications, unforeseen site conditions, client requirement changes, and various other factors.
Managing the impact of change orders and unexpected overruns is vital for avoiding profit erosion.
Change Order Approval Process
Formal change order management procedures typically involve:
- Identify change requirement
- Analyze the impact on cost/schedule
- Prepare change estimate + supporting documents
- Submit for internal review
- Present to the client for approval signatures
Maintaining structured approval and client signoff controls is crucial before proceeding with any changes.
Accounting Treatment of Change Orders
Pending approval: Temporarily track as “unbilled receivables” to avoid revenue recognition
Approved: Recognize any incremental revenue if this impacts contract value
For cost overruns, track against “work in progress” accounts as a project expense item. Doing so provides better profitability tracking than letting costs inflate general overheads.
Contingencies for Cost Overruns
Building modest contingency reserves within project budgets is prudent to absorb certain overruns. Formal “change control boards” often approve contingency drawdowns for public sector projects if executed per governance policies.
Overall, proactively managing change orders and getting client approvals is key to preventing major cost overruns.
Having covered revenue and cost tracking methods, let’s explore construction billing and payment cycles…
Progress Billing and Payment Terms
While revenue recognition depends on percentage completion, progress billing relies on clearly defined milestones and schedules listed within contract terms.
Invoicing Based on Percentage Complete
Typically, contracts stipulate periodic invoices (e.g., monthly or quarterly) as projects hit specific percentage completion milestones per the payment schedule.
Appropriate cut-off controls before period-end can enable accurate invoicing of work completed at month-end. Common measures for percentage completion match those used for recognizing revenue discussed earlier.
Most contracts also specify supporting documents like certified progress reports that must accompany invoices submitted.
Retentions and Release Schedules
Construction billing includes managing client retentions to provide financial protection against potential defects.
Typical retention terms require holding back 10% of all progress invoice amounts until final project completion and sign-off. The full retention amount gets released to you post-completion based on an agreed schedule (e.g., 50% upon provisional completion, balance 50% after 12 months).
Proper tracking of retention balances against your AR balances and WIP accounts is important.
Managing Subcontractor Payments
To optimize working capital, align subcontractor payment outflows with expected client payment inflows based on progress billing.
Review subcontract agreements before project commencement to ensure optimal cash flow cycles. Using retention provisions in your contracts with subcontractors also prevents overpayment.
Financial Reporting for Construction Contracts
Construction accounting has many unique reporting requirements spanning revenue recognition, unbilled WIP tracking, and percentage completion disclosures.
Tax Considerations and IRS Compliance
As per IRS code Section 460, construction companies must determine taxable income using percentage of completion accounting regardless of their GAAP method. Careful reconciliation between tax treatments and financial reporting is crucial.
Tight controls in SUB and UNBILLED sub-ledgers also help accurately report income for revised tax liability assessments each period, avoiding penalties.
Adhering to IFRS and AICPA Standards
Publicly listed construction firms must adhere to the international revenue recognition standard IFRS 15 while domestic U.S. companies follow AICPA’s ASC 606 “Revenue from Contracts with Customers.”
Key disclosures associated with construction projects typically cover:
- Contract balances, e.g., unbilled receivables
- Revenue recognition method used
- Changes in contract estimates
- Assets related to costs for securing contracts
Such robust reporting requires mature processes and systems.
Key Performance Indicators and Metrics
Tracking not just project costs but also operational drivers allows for assessing true performance.
Essential KPIs like schedule performance index, work-in-progress turnover ratios, and overheads as a percentage of direct costs provide better insights.
Evaluating trends in such metrics can guide long-term profit optimization through efficiency gains.
Risk Management Strategies
In an industry fraught with uncertainties, having savvy risk management strategies for construction projects is a must.
Insurance and Bonding Requirements
Carrying adequate builder’s risk, public liability, workers’ compensation, and specialist insurance coverage provide financial mitigation against mishaps. Contractual provisions also mandate committing performance bonds upfront, which clients can encash if work timelines are breached.
Maintaining correct policy schedules and adequate coverage levels avoids gaps. Checking bonding requirements during bidding avoids losses from underfunded bonds later.
Dispute Resolution Processes
Despite best efforts, disputes can still arise if project expectations aren’t well-managed. Common factors include a lack of decision-making authority, poor communication, and the absence of formal change procedures.
Having clear dispute resolution processes as part of contracts helps greatly. Typically, it starts with mediation attempts or structured negotiations for an optimal settlement. If unresolved, binding arbitration or recourse to legal remedies may get triggered based on contract terms.
Staying contractually protected while maintaining positive client relationships requires nuanced management of expectations throughout the project. Open and transparent communication from the start helps prevent most disputes.
Internal Controls and Audit Best Practices
As stewards responsible for overall governance, company leadership must establish financial discipline through robust internal controls. Common best practices include:
- Physical inventory routines for construction materials, tools, and equipment
- Surprise site audits for work certification
- Reviewing material requisitions and overtime approvals
- Mandating two signatures for large invoices and contract changes
- Enforcing approval limits and code of conduct policies
- Making prompt invoice, supplier, and subcontractor payments
Getting internal audit teams or external consultants to periodically evaluate the effectiveness of controls provides objective feedback to keep governance tight.
Construction Accounting Software Solutions
Trying to manage all the above using Excel or traditional accounting systems has a high risk of lapses. Specialized construction accounting systems seamlessly handle such intricate needs.
Core Software Capabilities
- Multi-project management
- Percentage completion tracking
- Automated revenue recognition
- Robust contract, budget, and change controls
- Subcontractor payment tracking
- Cost allocation and job costing
- Central document repository
- Real-time reporting of KPIs
Leading software products like Viewpoint, Sage 100 Contractor, Jonas Premier, Procore, and eCMS v2 also have integrated document management for progress reports, change orders, submittals, etc.
Business insights delivered through dashboards, analytics, and flexible reporting enable data-driven decisions. Smith, Acumatica, and QuickBooks are some other popular platforms based on business size and requirements.
Vendor and Solution Evaluation
Beyond evaluating software features, assess each vendor’s service reliability, implementation support, training services, and technological capacity.
Their experience managing scale and complexity for firms in your niche also matters greatly. Getting peer referrals provides reassurance.
Test-driving solutions hands-on before purchase, especially using your actual project data for simulation, prevents surprises post-implementation.
Take the Next Steps Confidently
I hope this detailed primer has demystified key practices needed to master construction accounting. As your processes mature in sophistication, don’t hesitate to contact specialist finance consulting firms like PVM Accounting for additional advice.
Now equipped with robust methods for revenue recognition, cost management, progress billing, and risk monitoring – you can confidently scale your construction firm while optimizing profits.
Here’s wishing you continued success ahead. Let me know if any questions arise when implementing these best practices for your projects!
