The ULTIMATE GUIDE to Construction Accounting

Being a commercial general contractor can be incredibly challenging as building projects require careful coordination and collaboration with multiple vendors and subcontractors, delivering work that must fully comply with detailed plans and specifications as well as local government building codes. They also are responsible for ensuring their “means and methods” and business practices comply with Federal and local government regulations regarding health, safety, and compensation. On top of all that pressure, construction companies have to manage cash flow, detailed project budgets, subcontractor invoices, owner billing, which is why good construction accounting is another priority commercial contractors have to manage. There are many software designed for the construction industry like Quickbooks Online for contractors, Sage 100 Contractor, and Sage 300 CRE.

In practice, accounting plays a vital role in running every business organization. Construction firms benefit when they maintain good construction accounting practices to help communicate clearly and effectively with internal and external stakeholders, support business decisions and administer ongoing incentives and metrics for teams to optimize their performance. 

This article will provide a high-level overview of how construction accounting supports the business of commercial construction contractors.

What is Accounting?

Accounting is the “language of business,” and it’s essential for measuring the results of any organization’s economic activities. Most of us have some basic understanding of accounting and our accounting colleagues’ roles within our respective business organizations. We relate to what they do from our experience managing our financial responsibilities. To understand accounting for business, it is essential first to recognize three primary types of accounting that apply to business management. Each type should be well understood by business managers, as they contribute in unique ways to the success of your organization’s financial accounting, managerial accounting, and cost accounting.

Financial Accounting

The purpose of Financial Accounting is to fairly represent the economic worth and performance of your business in a format that complies with industry professional standards known as Generally Accepted Accounting Principles (“GAAP”) and International Financial Reporting Standards (“IFRS”). Financial Accounting (also known as Financial Reporting) closely conforms to regulatory and professional standards. It is used to communicate worth and performance to investors, creditors, partners, employees, management, and various regulatory agencies.

Cost Accounting

Cost Accounting is focused on the assignment of “true” costs to products and revenue-generating activities. Cost Accounting is very tactical and the most theoretical of the three types of construction accounting. It focuses on understanding the direct and indirect costs associated with the things our business produces.

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Managerial Accounting

Managerial Accounting involves measuring costs associated with internal business operations to optimize performance. Managerial Accounting is the most strategic of the three types of accounting, less constrained by regulatory and professional rules applicable to Financial Accounting, and applied to encourage behaviors that best contribute to the organization’s success.

Accounting Basics

Accounting has existed in various forms throughout history. Modern accounting systems rely on what is referred to as “double-entry” accounting, the most common and universal methodology for recording financial transactions. The double-entry accounting system in use today was developed in medieval Europe, particularly in Venice, and is most often attributed to an Italian mathematician and Franciscan friar named Luca Pacioli.

The double-entry system requires two equal and corresponding entries, known as either a debit or a credit. The left-hand side is debit, and the right-hand side is credit. Every transaction affects at least two accounts, always includes at least one debit and one credit, and always has total debits and total credits that are equal.

A debit increases the account value in a normally debited account, such as an asset account or an expense account, and a credit decreases the value. Conversely, for an account that is usually credited, such as a liability account or a revenue account, credits increase the account value and debits decrease the value.

Construction Accounting 101

What is it about Construction that makes Construction Accounting unique?

Construction Accounting is particularly challenging because construction projects often span multiple reporting periods, necessitating estimates of future project revenue and costs to determine amounts of revenue earned (and associated profit) in any given accounting period.

There are four critical aspects of construction accounting that contractors and their accountants must understand, including:

  1. Job Costing
  2. Revenue Recognition
  3. Retainage
  4. Accruals for Anticipated Losses

Job Costing

The most critical function within your construction business accounting system is producing detailed job cost reports. Job cost is a form of cost accounting that captures the cost of performing a particular job, usually referred to as a “project” in the construction industry. 

For most businesses, grouping costs into a single bucket of “costs of goods sold” is all they need. For project-oriented construction companies, for whom production is de-centralized and the work subject to unique site conditions, job costing is essential to survival and success. By nature, nearly every construction project is unique. Even projects with similar designs have to be adapted to special site conditions and the time made available for construction.

Job costing provides for the segregation of revenue and costs into job or project-specific accounts. More sophisticated job cost accounting systems will further segregate costs by Phases, Cost Codes, Cost Types, and Cost Categories. This hierarchical organization of job cost details is known as the Job Cost Structure.

An ideal Job Cost Structure should take into account each contractor’s particular specialty and need for detail. For self-performing trade contractors, it might make sense to capture costs down to individual component products or materials. However, it may be sufficient for general contractors to capture costs at a higher level, perhaps only by trade. A well-designed Job Cost Structure enables project teams to understand and control their production costs and estimate the likely remaining costs needed to complete their projects.

Preparation of Estimates of Cost at Complete (“ECAC”) is a critical analytical process that contractors perform, typically monthly, as such estimates are used to support the financial reporting process. Construction accountants utilize the most current ECACs prepared by project teams to calculate revenue and forecast future business performance.

The bottom line is that your job cost system should capture costs at the same level of detail that you estimate your costs. Ensuring that invoices from your vendors are correctly recorded and accumulated in their proper cost codes requires the commitment and cooperation of your entire organization. 

The following are the typical elements of a Job Cost Structure for job costing commercial construction projects.

Project Phases

For more complex projects, your job cost system should also accommodate project phases. The term phase may refer to a time dimension or some other logical or definable element of the work, such as building structure (clubhouse, pool, entrance monument, etc.) or attribute (lobby, 1st floor, 2nd floor, etc.).

Project Cost Codes

Construction companies typically break down costs based upon industry-standard categories generally referred to as Cost Codes. The most commonly used cost codes are published by the Construction Standards Institute (https://www.csiresources.org/home), known as MasterFormat® OmniClass® and UniFormat®. The use of standard industry cost codes facilitates collaboration among project team members, including designers and construction trades.

Contractors typically estimate costs by cost code because the industry-standard definitions of those codes facilitate internal organization and understanding of the estimate, as well as collaboration with third-party trades and suppliers. Best practice dictates that construction accountants capture the actual cost at the same level of detail to compare actual costs with previously estimated costs. This enables contractors to fine-tune their estimating systems to better predict similar costs for future projects.

Project Cost Categories

Most cost estimating systems support categories of resources, including labor, equipment, material, subcontract, etc. More sophisticated systems enable contractors to further segregate costs into an even lower level resource classification known as cost categories. Such functionality could allow you to break out labor costs into, for example, office employees, field employees, and contract employees. These three categories may have unique indirect efforts and associated costs to support them and may have unique cost allocation rates.

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Indirect Cost Allocations

Sophisticated job costing systems will allow you to burden resources with an overhead rate or factor that accounts for indirect costs incurred by your business for procuring such items. The most obvious example of this is a labor burden to consider the cost of providing employees to self-perform work on your project. 

Such burdens are based on actual indirect costs and should be established periodically and allocated consistently to your projects based on their direct costs. While indirect costs are unlikely to vary as a percentage of the direct costs to which they are allocated, the total amount of indirect costs allocated to any given project will vary proportionally based on each project’s actual direct costs.

Because job cost reports are a management accounting tool, they are not necessarily constrained by the rules that apply to financial accounting. The best practice is to understand and use direct and indirect costs of performing the work on each project so that your team makes the right economic decisions about how the work is procured, perhaps from third-party trades or self-performed by your team. Another example might be the cost of your team members managing your subcontract agreements. This cost can be aggregated and allocated proportionally across all of the subcontract agreements let by your company.

An ongoing and deep understanding of job costs is essential to remaining competitive and successful as a commercial construction contractor.

Revenue Recognition

Accounting standards require contract revenue to be recognized either at a Point in Time or Over a Period of Time, depending on the terms of the contract with the customer. For construction companies, given the long-term nature of jobs, it is typical for the revenue to be recognized Over a Period of Time. This is known as the percentage of completion revenue recognition, and the calculation of overall revenue for the contractor is represented on a Work in Progress (“WIP”) Schedule. This is because construction projects often span multiple reporting periods, necessitating estimates of future project revenue and costs to determine amounts of revenue earned in any given accounting period. Moreover, this method of revenue recognition has a consequential effect on a construction company’s balance sheet assets and liabilities. 

If the customer is billed before the performance obligations in the contract are satisfied, a liability on the balance sheet, known as a Contract Liability, is recorded. Conversely, if the performance obligations are met but the customer hasn’t been billed yet or is underbilled, an asset is recorded, known as a Contract Asset. These accounts act similarly to deferred revenue or accounts receivable but are specific to jobs in progress because the contract with the customer is not yet complete.

Accounting for Revenue Adjustments

Because periodic billing is driven by contract terms (and not necessarily being linked to amounts earned on a percentage of completion basis), there are inevitably differences between amounts billed and revenue earned. The difference is a result of the percentage of completion calculation that compares costs to date to the overall estimated costs of the job (“percent complete”), and is an adjustment that affects revenue. The entry that is recorded will typically be made to a contra revenue account in the general ledger, but for purposes of financial statement presentation, the amount is netted against contract revenue.

Overbillig and Underbilling

Differences between amounts billed and revenue earned are recorded as either an asset (“Costs and estimated earnings in excess of billings” or simply “Underbilling”) or a liability (“Billings in excess of costs and estimated earnings” or simply, “Overbilling”). The Underbilling and Overbilling amounts are itemized on the WIP Schedule by project and are included on the balance sheet as either Contract Assets or Contract Liabilities. These accounts act similarly to deferred revenue or unbilled accounts receivable but are specific to jobs in progress because the contract with the customer is not yet complete.

The amount of the overbilling or underbilling is calculated by taking the percent complete ratio and multiplying it against the total contract price to determine the amount of revenue that can be recognized. If the project billings to date are greater than the amount of revenue that can be recognized an overbilling exists. Conversely, if project billings to date are less than the amount of revenue that can be recognized an underbilling exists.

Accounting for Unsigned or Unpriced Change Orders

Contractors are often faced with having to perform tasks outside of the original scope of the contract. These changes are known as “variable consideration” in the accounting standards. It’s easy to identify the adjustment in the contract price when it is agreed upon by both parties on a change order. But there are times, unfortunately, when the work proceeds without a signed or unpriced change order which makes adjusting for the contract price more difficult. 

Revenue recognition standards for variable consideration require adjusting the contract amount related to unsigned or unapproved change orders to reflect the contractor’s expected value or most likely amount that will be received. The contractor’s historical experience in successfully negotiating the price under similar circumstances is key in determining that amount. For example, if the contractor is historically successful in negotiating the final price at an average rate of 75% of the asking price, it would be reasonable to adjust the contract price similarly. 

Of course, it is an estimate that is subject to change as time goes on and contract amounts are finalized, but when the work is performed, the contract price should be adjusted to the contractor’s best-estimated price. However, if it is probable that a significant reversal of the recorded variable consideration will occur, the contractor should evaluate the appropriateness of such change in the contract price and take a more conservative approach.

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Retainage

Contractors typically have an amount “held back” known as retainage on their billings to their customers. Under the revenue recognition standards, the retainage held by the customer is considered a Contract Asset until such time that the job is completed. Once completed the retainage outstanding on that job would be included in accounts receivable. 

It is also common for general contractors to hold retainage on their subcontractor billings, but there is a distinction in accounting for this form of retainage payable. The retainage that the general contractor has held from its subcontractors is not Contract Liabilities because subcontractors are vendors rather than customers. Therefore the revenue recognition standards does not apply. The retainage held on the subcontractors would be included in accounts payable and disclosed separately in the footnotes to the financial statements if not on the face of the balance sheet. 

Besides that distinction, it is essential to understand that there can only be one Contract Asset or one Contract Liability for each contract. Therefore, each job’s contract assets and contract liabilities would be netted together for financial statement presentation. For example, suppose there is retainage of $50,000 held by the customer (Contract Asset), yet the job has an overbilling of $60,000 (Contract Liability). In that case, the net effect is a Contract Liability for that specific job of $10,000.

Accruals for Anticipated Losses

Inevitably, not all projects are profitable for contractors. For financial reporting purposes, contractors must accrue anticipated project losses at the end of each reporting period. Because this is a Financial Accounting adjustment, the loss is equal to the expected negative gross profit at complete for such projects. The entry to record the anticipated loss would be to debit a job cost expense called “Provision for Losses on Uncompleted Contracts”, and credit a liability account such as “Accrued Provision for Anticipated Losses on Uncompleted Contracts”. As the job progress and actual costs are incurred, the provision would be reversed to the extent that actual costs incurred exceed the contract price for that job.

Construction Accounting Software

RedTeam integrates with the most popular construction accounting applications in the market, with solutions to meet your business at any scale.

QuickBooks Online

RedTeam may be connected to QuickBooks Online (“QBO”) for a complete construction accounting solution. RedTeam handles all aspects of construction accounting, including progress billing, construction payments, cost of employee time and expenses, and tracks Work in Progress (“WIP”) in real-time. 

Use Quickbooks to make payments, record receipts, general ledger, bank reconciliations, and produce periodic financial statements. RedTeam automatically inserts project-related transactions into QBO, including Customers, Vendors, Projects, Cost Codes, Employee Time and Expenses, and Vendor Invoices. Transactions posted by RedTeam remain linked, so the latest information from Quickbooks (payments and receipts) will be reflected in RedTeam.

QuickBooks for Contractors (Desktop)

RedTeam supports export via IIF (Intuit Interchange Format) essential transactions, including vendor invoices, customer billing, and employee time and expenses.

Sage 100 Contractor

Formerly known as Sage Master Builder, Sage 100 Contractor provides small to mid-sized contractors with access to critical, end-to-end business and project information, whether they are a general contractor, service or specialty contractor, or a home builder. RedTeam synchronizes vendors, cost codes, and job cost with Sage 100. RedTeam can also send vendor commitments, commitment changes, and vendor invoices to Sage and import vendor payments to provide a comprehensive view of financial performance for project teams working in RedTeam. 

Sage 300 CRE

Formerly Sage Timberline Office, Sage 300 CRE provides construction and real estate firms with the complete solution for managing the entire project or property lifecycle with confidence, precision, and efficiency. RedTeam synchronizes vendors, cost codes, and job cost with Sage 300 CRE. RedTeam can also send vendor commitments, commitment changes, and vendor invoices to Sage and import vendor payments to provide a comprehensive view of financial performance for project teams working in RedTeam.

Conclusion

Accounting is an important function within every business. Planning ahead for how your teams will make decisions will help you structure your accounting system to produce the right information when it’s needed. Construction accounting is an important key for the success of your projects and your business, providing ongoing operational insights and clear communication with internal and external stakeholders.

For more content, be sure to visit https://www.redteam.com/rt-resources/.

 

About Ray D. Bastin

Based in the Firm’s Orlando, FL, office, Ray is a partner with over 25 years of experience providing professional accounting services to a wide range of industries. He has extensive experience providing services to construction companies, common interest realty associations, government agencies, and not-for-profit organizations. He is the team leader of the Orlando Construction practice and also leads the Owner Associations team in Withum’s Hospitality Services Group. In addition, Ray has 6 years of experience as a controller of a large multi-office construction subcontractor and is proficient with construction accounting software and job costing schedules.

About WITHUM

Withum is a forward-thinking, technology-driven advisory and accounting firm, helping clients to Be in a Position of StrengthSM in today’s complex business environment. As a member of HLB, The Global Advisory and Accounting Network, we’re able to connect you with trusted, strategic advisors who assist in building and expanding in the global marketplace.

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