To effectively deliver construction projects, all while managing job costs and budgets to ensure you maximize ROI can be challenging, however, this is feasible through construction accounting — a specialized, project-centric approach to finances. Unlike its general counterpart, this form of treats each construction project as a unique entity, adapting to its project-specific revenue, expenses, and profit parameters. The sheer depth of its methods, from recognizing revenue based on project stages to managing a spectrum of project costs, showcases its value.
There are, of course, tangible benefits of embracing such an advanced approach. After adopting construction-specific accounting software, an astounding 67% of firms reported an uptick in profitability by an average of 14%.
Not only does it lead to increased profitability, but it also contributes to better decision-making, compliance, customer satisfaction, and holistic project management.
The Basics of Construction Accounting
Construction accounting has been developed to aid contractors in monitoring individual projects and understanding their overall impact on the company.
Here are some key terms that are used within construction accounting:
Contract Revenue: The revenue generated from the construction contract.
Contract Costs: Expenses associated with fulfilling contract obligations.
Gross Profit: Revenue after deducting the costs related to a particular project.
Work in Progress: Ongoing projects and their accumulated costs.
Overbilling and Underbilling: Charging more or less than the work performed.
Retention: The amount withheld until the project has been completed satisfactorily.
Change Orders: Modifications to the original contract, which often impacts costs.
Bookkeeping and Financial Management
At its core, construction accounting hinges on two essential processes: bookkeeping and financial management. While bookkeeping meticulously logs financial transactions, financial management delves deeper into analyzing these transactions. This dual process guarantees a robust check on cash flow, profitability and ensures compliance with stringent tax and legal obligations.
Job Costing
Job costing is essentially charting out a project’s financial roadmap — a comprehensive exercise that tabulates the entire cost landscape of a project. As such, accurate job costing involves a categorical allocation of costs, distinguishing between direct expenses like labor and materials and indirect overheads. The insights gleaned from job costing empower contractors to maintain budgetary constraints, gauge project profitability, and anticipate potential financial challenges.
Understanding Construction Accounting Concepts
Here are some critical concepts:
1. Project-based Accounting
Definition: A technique that assigns financial transactions to individual projects, enabling businesses to monitor the profitability and progress of each venture.
Impact: Construction professionals can gain a granular understanding of costs and revenue associated with every project. This requires meticulous estimating, budgeting, invoicing, and reporting.
2. Decentralized Production
The Challenge: Unlike other industries with a single manufacturing hub, construction activities are scattered across multiple sites. The challenge, therefore, lies in managing costs linked to transferring resources and varying input prices at each location.
Impact: This dispersal adds layers of intricacy to the financial processes, demanding skillfulness in navigating the unpredictability present in construction accounting.
3. Long-term Contracts
Many construction projects extend beyond a single financial period. Consequently, understanding the percentage of completion method becomes critical. It entails recognition based on the degree of work finished within a period.
4. Change Orders
The Challenge: Alterations to the initial project scope, whether in specifications or terms, can significantly alter costs, timelines, and quality standards. These changes necessitate skillful adjustments in estimates, budgets, and financial reports.
5. Profitability Prediction
Overview: Forecasting potential profits or losses of a construction project is an intricate process factoring in variables such as costs, risks, and projected revenue.
Benefits: These forecasts empower companies with insights, allowing them to make informed decisions. From bidding on a project to its eventual completion, these forecasts guide every phase.
Construction Accounting Methods
Revenue recognition is fundamental in construction accounting, determining how income appears on financial statements. Effectively managing this aspect is crucial for maintaining profitability and complying with tax laws and accounting standards.
Types of Revenue Recognition Methods
1. Cash Basis
Income is registered when cash transactions occur, irrespective of a project’s actual progression. For instance, a contractor might receive a significant upfront payment, which under cash basis appears as high revenue, even if minimal work has been done.
2. Percentage of Completion
This method provides a more granular view, tallying revenue with ongoing progress, be it through cost-to-cost or units-of-delivery evaluations. However, its weakness lies in demanding precise predictions of overall costs and revenues, potentially leading to future revisions. Consider a scenario where a project is 50% complete and has incurred 40% of the expected costs. Using the cost-to-cost method, 50% of the expected revenue would be recognized.
3. Completed Contract
This essentially means waiting until a contract is near completion or delivered. While it minimizes factoring in uncertainties and changes, it will pose challenges when developing forecasts.
ASC 606
Enter ASC 606, a collaborative brainchild of FASB and IASB, unveiled in 2014. Championing transparency and consistency, it involves a standardized five-step model for revenue recognition, ranging from contract identification to revenue recognition per performance obligation.
This, in essence, translates to a thorough re-evaluation. Construction companies must now wear the hats of diligent auditors, scrutinizing contracts, redefining accounting policies, and ensuring a smooth transition aligned with ASC 606. Further, this framework can reshape perceptions on variable considerations, warranties, and more.
While this appears to be challenging, industry-specific solutions such as CMiC are helping accounting teams navigate through ASC 606. This technology equips contractors with the tools to optimize this transition by providing a single database platform that integrates accounting features and supports the entire project lifecycle.
Contract Retainage and Construction Billing
Retainage can be best explained as a safety net — a certain percentage of the contract’s total value (typically 5% to 10%) is held back until project completion or a pre-decided date. This mechanism is developed with precision, ensuring contractors and subcontractors stay committed to fulfilling their obligations, therefore, upholding the quality and timeliness of the work.
On the other hand, selecting the right billing method is pivotal, not merely as a transactional detail. It serves as a strategy that influences cash flow, risk assessment, and ultimately, profitability. To break it down:
Fixed Price: Here, risk and reward reside primarily with the contractor. They commit to a predefined price, irrespective of the actual costs. While this can lead to greater profits if managed well, it equally bears the potential for losses.
Time and Materials: This is akin to an open ledger. Customers are charged based on labor, equipment, and material costs, with an additional markup.
Unit Price: This method charges customers by the unit of work. Whether it’s per cubic yard of excavation or per square foot of painting, it thrives where tasks are repetitive.
AIA Progress Billing: Steeped in the standards of the American Institute of Architects (AIA), this is commonly used for commercial and public projects. Contractors periodically invoice based on the work completion percentage, aligned to a detailed schedule of values. This schedule is a blueprint, breaking down the contract price into granular components like labor, materials, or subcontracting costs.
Construction Payroll
In construction, payroll is a multifaceted endeavor where numerous variables interact. Key components include:
Prevailing Wage Requirements: This is the benchmark salary that workers undertaking public projects must receive. Factors such as location, trade, and expertise dictate this wage, ensuring it mirrors prevailing market conditions.
Union Payroll: For workers who are affiliated with labor unions, their payroll is a managed differently. Governed by collective bargaining agreements, union payrolls involve unique pay scales, perks, deductions, and accountability measures.
Multi-state Payroll: This involves employees working across different states. Here, multiple state-specific tax regimes, withholding norms, and other legislative requirements come into play.
Compliance: The Silent Watchdog
Oversight and adherence are vital in construction payroll. Falling short have significant ramifications, both in reputation and finances. Key reports include:
Certified Payroll Reports: Serving as a record of the wages, hours, and benefits of workers on specific projects, these mandatory reports offer transparency and ensure that workers are properly compensated.
Tax Reports: Beyond just detailing the taxes deducted, these reports ensure timely submission and payment to various governmental agencies.
Miscellaneous Reports: Depending on project or regional specifics, there might be reports addressing workers’ compensation, unemployment benefits, union contributions, among others.
Leveraging ERP software like CMiC’s Accounting application can be a game-changer. With its ability to effectively manage complex calculations and varying reporting requirements, CMiC brings efficiency and precision, streamlining complicated process.
As noted by John Reinard, Construction Technology Manager, Buffalo Construction Consultants, “Every week, processing payroll was a burden. It would take me hours to correct timesheets in Excel and then make corresponding job cost entries in QuickBooks. When we switched to CMiC, that process turned into seconds.”
Advanced Construction Accounting Concepts
1. Percentage of Completion Method
The Percentage of Completion Method matching revenue and expenses with the work completed. A project that’s 40% complete would, in theory, see 40% of its total anticipated revenue and expenses recognized. However, it’s not without challenges. Professionals must employ robust estimation skills, understanding that every brick laid or beam installed equates to financial implications.
2. Completed Contract Method
Within the Completed Contract Method revenue, expenses, and profits are not factored into the equation until the project wraps up. While it guards inflating forecasts, it might not best serve those wanting a periodic grasp on their project’s monetary flow.
3. Navigating Change Orders and Contract Claims
In the ever-evolving construction landscape, unpriced change orders can have material impacts to a project. At the same time, contract claims — the formal requests for damage compensation due to unforeseen disruptions — are critical items that can impact a project’s bottom line. Both demand careful evaluation and robust documentation.
4. Overbilling Liabilities and Contract Retainage
While overbilling can boost immediate cash flow, it can pose challenges in the future. While contract retainage — i.e., the assurance held back until a project’s completion — can delay present cash flow, it can safeguard against potential shortcomings in the future.
Common Errors
These include:
Mixing up terms like margin and markup or percent spent and percent complete.
Not checking Work in Progress (WIP) reports frequently enough.
Missing WIP adjustments in the Profit & Loss statements.
Forgetting to track committed costs on a daily basis.
Not keeping track of what’s spent on tools, equipment, and other things.
Overlooking payroll details and waiting too long to document labor hours.
Best Practices in Construction Accounting
The following are the best practices that have been proven to elevate performance within accounting teams:
Job Costing: Assign all costs, whether direct or indirect, to the right projects. This helps in knowing how profitable each job is.
Cash Basis Accounting: This method documents transactions (coming in or going out).
The Role of ERP in Construction Accounting
Enterprise Resource Planning (ERP) has become invaluable to the construction industry. This software integrates various business functions such as accounting, project management, procurement, and supply chain. The technology offers many business benefits, which includes:
Unified project management: ERP dissolves communication barriers, ushering in seamless project coordination and management.
Accuracy and precision in financial forecasts: Accurately estimating and tracking both costs and revenue becomes streamlined.
Collaboration and interdepartmental data use: An ERP system enhances the fluidity of data transfer, ensuring that critical information is accessible across departments and remote locations.
Data-driven decision-making: With augmented reporting capabilities, construction professionals can make decisions that are both timely and backed by data.
Financial mastery: In a Software Advice survey, an impressive 60% of ERP-using construction professionals reported improved financial management. *
Enhanced project outcomes: The same survey revealed that 66% noticed a significant uptick in project performance.
Regulatory adherence: ERP not only drives efficiency but ensures that construction operations align with stringent standards such as Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Optimal resource allocation: Leveraging an ERP optimizes resource planning for projects.
*Software Advice
CMiC: Changing the Way We See Construction Accounting
In construction, managing money is about making every step of the project work smoothly. This is where CMiC, an ERP software designed specifically for construction, comes in.
CMiC offers a unique blend of project management and financial tools, aiming to improve the return on investment (ROI) through:
Strategic financial analytics: By providing financial insights, CMiC helps professionals to dig deep into every financial aspect of a project, ensuring they always stay in the green.
Project lifecycle mastery: From procurement and bidding to revenue and budget management, the software simplifies and streamlines operations. This efficiency translates into projects that are delivered on time and within budget.
The Financials module of CMiC stands out as an essential tool for construction firms. It ensures effortless management of:
Integrated accounting functions: With robust features ranging from Accounts Payable and Receivable to Billing and a Consolidated General Ledger, professionals can achieve a unified view of their finances.
Human capital and resources: Beyond traditional accounting, it also handles aspects such as payroll, inventory, and equipment management.
The Future of Construction Accounting
Technology has emerged as a pivotal driver, revolutionizing construction accounting in various ways.
1. Cloud Computing in Construction Accounting
Ubiquity and flexibility: The emergence of cloud-based accounting software empowers construction professionals to retrieve real-time data, anytime and anywhere, providing unparalleled convenience.
Collaboration and integration: The cloud fosters seamless integration among diverse stakeholders like contractors, subcontractors, and clients, enhancing teamwork and efficiency.
2. The Power of Artificial Intelligence (AI)
Automation and precision: By automating mundane tasks such as data entry, AI not only reduces manual errors but also refines efficiency in invoicing and reporting.
Predictive insights: AI delves deep into data, offering invaluable foresight, from cash flow forecasts to pinpointing project risks.
3. Building Information Modeling (BIM)
Improved cost management: Through BIM, a comprehensive digital blueprint of a project, construction accountants can attain pinpoint accuracy in cost estimations and budget controls.
Enhanced collaboration: With BIM as the communication fulcrum, project participants can synchronize effortlessly, ensuring projects are compliant with prevailing standards.
Construction Accounting FAQs
What exactly is Construction Accounting?
Construction Accounting is a special stream of financial management developed for construction financial professionals. It uses unique methods like the Percentage-of-Completion Method and Completed Contract Method to figure out the exact time to record earnings and costs.
What is the difference between Construction Accounting and standard accounting?
Construction accounting is different from standard accounting as it deals with long-term projects that have uncertain results, changing costs, and complex contracts. On the other hand, standard accounting is about short-term deals, simple contracts, and set prices. Plus, construction accounting requires a detailed look at each project, checking its money flow, how well it's doing, and how profitable it is.
What is retention in Construction Accounting?
Retention, also known as retainage, is like a safety net. It's a small part of the payment held back to make sure contractors and subcontractors do the job right and follow the project's specifications. Usually, this amount is about 5% to 10% of the total contract price, and it's given out either after a set time or when the project is finished.
What should I look for in Construction Accounting software?
Optimal construction accounting software should offer:
Seamless integration capabilities with systems like project management, payroll, and inventory.
Adaptability to diverse projects, contracts, and accounting methodologies.
Real-time project insights via customizable dashboards and reports.
Adherence to construction-specific tax legislations and regulations.
Uncompromising data security and reliable backup provisions.
While there isn't a "one-size-fits-all" solution, considering your firm's size, resources, business and technical requirements can guide your decision.
What accounting methods do construction companies use?
The most common are:
Cash method: Simple but doesn't represent project progress.
Accrual method: More representative but demands extensive bookkeeping.
Percentage of completion method: Matches revenues and costs but requires intricate estimations.
Completed contract method: Stabilizes income reporting but may not be reflective of ongoing project status.
What is Construction Contract Accounting?
This is a branch of construction accounting that deals with the recognition, measurement, presentation, and disclosure of revenues and costs associated with construction contracts. Construction contract accounting follows the principles and standards set by various authoritative bodies, such as the International Accounting Standards Board (IASB), the Financial Accounting Standards Board (FASB), or the Internal Revenue Service (IRS).
What is Work in Progress (WIP) in Construction Accounting?
WIP is like a tally of costs for a project that haven't been billed or paid yet. It includes both direct costs (such as materials, workers, and subcontractors) and indirect (like office expenses, insurance, and interest). On the balance sheet, WIP is listed as something valuable, showing the money a project is expected to bring in.
Why is the Percentage of Completion method of accounting used in the construction industry?
This accounting method is praised because it gives a more accurate picture of how long-term projects are doing. It makes sure that costs and earnings are logged at the same time, helping to avoid any mix-ups with the revenue being generated.
