Construction Industry Accounting (#224)
/In this podcast industry, we discuss the accounting for the construction industry. Key points made are noted below.
Unique Construction Issues
The construction industry is unusual in several ways. Pretty much every project is unique, so it varies from the usual business, where there’s a standard product. Also, the level of demand can go from really high to really low within a few months, so a construction company tends not to keep too many people on staff – instead, it relies on subcontractors for a lot of the work. And it can be difficult to schedule the subcontractors. It’s also hard to track resources, because specialist workers and specialized construction equipment may be moving among several job sites. All of these factors make it easy for expenses to get out of control fast.
To make matters worse, contracts with clients may be on a fixed fee basis, so the contractor has to absorb any cost overruns – and that means it’s unusually easy to lose money on a construction project.
Change Orders
To deal with these conditions, the accounting staff tends to be unusually large. It has to closely track the work hours of the staff, and the hours being charged to jobs for equipment usage. And an item unique to this industry is change orders, which are adjustments to the baseline contract for alterations to a project. The accounting staff needs to compile the cost of each change, give input on what kind of price to charge for the change, and then negotiate with the customer to have the change accepted. And then bill the change. If change orders aren’t handled properly, the company will almost certainly lose money on a job. These activities take a lot of time, which is why construction requires so much accounting labor. It’s also difficult to streamline the process, because each job is unique. In fact, a larger job may require its own accounting staff.
Cost Tracking
And then we have the cost tracking. There needs to be a job cost ledger, which is a subsidiary ledger that feeds into the general ledger. The job cost ledger compiles all of the costs for each individual job. The accounting staff makes sure that each cost incurred is assigned to the correct job. In addition, each client may have different rules for what types of overhead costs are allowed to be charged to their job, in cases where they’re being billed for the costs incurred. So the accounting staff needs to maintain a separate cost allocation calculation for each job.
Equipment Ledger
There may also be an equipment ledger. Each piece of construction equipment has its own account in the equipment ledger, so that costs incurred can be charged to each piece of equipment. You need this information in order to figure out what hourly or daily equipment rate to charge to each job.
Revenue Recognition
And then there’s the revenue recognition. For the longer-duration projects, the percentage of completion is calculated, which can be based the proportion of costs incurred to date, or the proportion of labor hours incurred, or some similar measure. Based on this percentage, the accounting staff determines what percentage of job revenues and costs it can recognize in the reporting period. If the amount actually billed is less than this amount, then the contractor recognizes an asset called costs and profits in excess of billings. If the reverse is the case, where the amount billed is more than is indicated by the percentage of completion calculation, then the contractor recognizes a liability, which is called billings in excess of costs and profits.
And in case the situation already sounded complex, let’s get back to those change orders. The contractor may also have a bunch of claims that it wants the client to pay, and which the client hasn’t agreed to yet. For example, maybe the client had agreed to have a portion of the job site cleaned up by the time the contractor sent in a work crew, and it wasn’t – so the work crew had to spend time unexpectedly doing cleanup work. So the project manager files a claim with the client to have this cleanup cost reimbursed. There can be a mass of these claims percolating in the background throughout a job, and they may not be settled for a long time, as the parties bicker about who is responsible for payment. You can’t recognize the revenue associated with claims, because payment is too uncertain, so the accounting staff is always pushing for resolution. Which means documenting claims and attending meetings with the client to go over these items.
Estimated Project Profitability
The accounting staff also has to run an ongoing estimate of the project profitability, based on the percentage complete and the amount of costs incurred to date.
If this analysis results in a projected loss, then the loss has to be recognized right away. This can require some pretty detailed cost estimating work, especially early in a contract when most of the costs haven’t been incurred yet. This analysis also puts the controller under quite a bit of management pressure, since they don’t want to recognize any losses, and especially well before a job has even been completed.
Retention
And yet another item is the retention. This is a percentage of the contract price that the client will not pay until after the job is complete and it’s accepted the job. The amount of the retention is usually in the range of five to ten percent, which can be a lot of money that’s not coming in to pay bills. So, the accounting staff needs to track the amount of these retentions and factor them into the cash forecast. And then to complicate matters further, the contractor might do the same thing to its subcontractors and impose retentions on them – which calls for splitting out the retention amount in accounts payable and figuring out when these items are supposed to be paid – which is a manual tracking process.
Construction Controls
Construction also needs a bunch of controls that you just don’t find anywhere else. For example, fixed fee bids have to be accurate, or else you either lose a project because the bid was too high, or lose a lot of money because you incorrectly bid too low. To counteract this, contractors use a cost checklist to make sure they didn’t forget to include any costs, as well as multiple reviews of the initial bid.
As another control example, construction equipment is frequently rented, and the daily rental rates are high. This equipment may be used on multiple job sites, so it’s easy to lose track of where it is, which means that the contractor keeps piling up rental fees. So, there’s a control to monitor where equipment is located and whether it’s being used.
Yet another area for controls is the job cost ledger. A job needs to be shut down in the ledger as soon as the job is finished. Otherwise, costs for other projects might be coded into this old job, which incorrectly makes other jobs look more profitable than they really are. Some project managers look for these old, open jobs and stuff expenses into them in order to make their own projects look better.
Another good place for controls is the job site. It’s fairly easy to steal materials from a job site unless you fence it in and maybe use a security guard.
And finally, a great place for controls is change orders. There should be a change order log that’s used to track the approval status of every change order, as well as a change order committee that meets regularly to discuss and approve change orders. Otherwise, there’s a real risk for the contractor of losing money on unapproved change orders.