As a construction project manager, tracking the intricate financial details across various ongoing projects can quickly become arduous. Choosing suitable accounting approaches, recognizing costs and revenues accurately, streamlining expense allocations, ensuring accounting compliance, and mitigating project risks require diligent record-keeping and a keen understanding of construction accounting intricacies.
This comprehensive guide on construction in progress (“CIP”) accounting equips managers with a robust financial toolkit to elevate project profitability, decision-making, and stakeholder trust throughout a construction undertaking. We will examine critical facets like contracts, cost management, revenue recognition principles, financial statements, risk management best practices, and technological integrations for simplifying construction financial management.
Understanding Construction Project Financial Lifecycle And Contracts
Construction projects involve significant investments of time and capital across several complex stages spanning planning, execution, closure, and maintenance. Grasping the financial implications across this lifecycle sets the stage for optimal CIP accounting.
Typical Stages Of A Construction Project Lifecycle
Depending on scope and scale, construction projects progress through four primary phases:
Planning And Design
Involves feasibility studies, architectural plans, surveying, zoning permits, and finalizing project specifications before construction begins.
Expenses incurred – lawyer fees, survey charges, design and plan revisions.
Bidding And Negotiations
General contractors and subcontractors submit competitive bids and negotiate pricing. Contract terms are finalized aligning client requirements with builders’ capabilities.
Expenses incurred – Bid invitation costs, negotiations expenses, furnishing contract securities.
Construction And Inspections
Physical structures are built by general and specialty contractors based on the approved plans, adhering to local codes and quality benchmarks via inspections.
The bulk of project expenses incurred – materials, equipment, labor, site preparation, utilities, etc. Revenue recognition begins based on percentage completion.
Project Completion And Warranties
Final inspections prelude to occupancy permits and project handover. Legally binding warranties cover defects for a defined period.
Revenue recognition hits peak while last expenses booked—retentions released post handover.
Clearly documenting and tracking expenses across these stages enables precise revenue forecasts, budgeting control, accounting compliance, and decision-making for construction firms.
Popular Construction Contract Types
The construction industry relies extensively on contracting agreements that dictate project scope, pricing terms, risk allocation, and payment plans aligned to work completion stages.
Grasping nuances of different contract types allows optimal CIP accounting approaches to be structured. Let us examine key variants:
Fixed Price Contracts
Also labeled lumpsum turnkey, stipulate a firm project price covering all contractor costs and profits. Common in commercial building projects.
Accounting Impact – Cost overruns risk borne wholly by the contractor. The percentage completion method is optimal for revenue recognition.
Cost-Plus Contracts
Compensate contractors for actual costs incurred plus predetermined profit margin percentage. Used in complex projects with unpredictable costs.
Accounting Impact – Lower risk for contractors. Accurate cost tracking is critical. Revenue is recognized as costs incurred.
Time And Materials Contracts
Pay contractors based on costs arising from time and materials expended. Labor and resources are paid at negotiated or market rates respectfully.
Accounting Impact – Highest risk for client. Precise cost accounting and project control are essential.
Design-Build Contracts
Single contract for both architectural design and construction by the same entity. Reduces conflicts but concentrated risk.
Accounting Impact – Revenue recognition aligned to overall percentage completion. Controlled design expense tracking is needed.
Construction Management Contracts
The construction manager oversees project execution via multiple trade contracts without self-performing the work. Fee payment bases vary.
Accounting Impact – Progress tracking, trade contractor relationships, and fee reconciliation are important.
Insight into these contract types and their accounting implications lets firms tailor approaches, systems, and controls accordingly for smooth financial management.
Choosing The Optimal Construction Accounting Method
Two primary accounting methods dominate the construction industry – the percentage of completion (POC) and completed contracts. Hybrid approaches also exist allowing combinations that align better to contract types. We evaluate each below:
Percentage of Completion Method
The preferred approach for builders focused on progressive revenue recognition and cash flows as construction progresses based on costs incurred relative to budgeted total costs. Effectively mirrors physical project completion.
Pros – Reflects income and asset valuation accurately per completion level. Better financial reporting to stakeholders.
Cons – Requires significant effort to continually estimate costs to complete. Profit inaccuracies are possible.
Completed Contract Method
A simple methodology that postpones recognizing any revenue until the contract is essentially complete. Better suited for short-term contracts.
Pros – Simpler application with revenue clarity at the end. No profit approximations are needed.
Cons – No progressive financial picture for stakeholders. Higher risks in long-term contracts.
Hybrid Accounting Methods
Combining features of POC and completed contracts to deliver tailored recognition aligned with risk profiles and contract types.
Popular variants include:
- Cost Recovery Method – Equal revenue recognition to costs incurred till breakeven then POC method for residuals.
- Site Percentage Complete – Apply the POC method separately for distinct sites than the entire contract.
- Unit Price Contracts – Recognize revenue progressively based on contract rates and units completed.
Factors Impacting Accounting Method Selection
While the percentage of completion is widely preferred for revenue reflection, several aspects should drive one’s decision:
Contract Type Considerations
Cost plus and time and materials contracts favor POC. Fixed price contracts open to completed contracts based on risks borne. Progress milestones enable hybrid model adoption.
Project Size And Duration
Completed contracts are better for short-term projects below 12 months while lengthier undertakings justify progressive monitoring from the POC method.
Risk Profile And Uncertainties
High risks from contract disputes, design delays, etc lean towards a completed approach. POC models need extensive project control for accuracy.
By aligning methods to these influencing factors, construction accounting stays attuned to ground realities for financial excellence.
Managing Construction Costs And Expenses
With material and labor expenses contributing over 85% of construction project costs, managing such spending via meticulous tracking and allocation aligned to sound accounting principles is mission-critical.
Direct Construction Cost Tracking
Direct costs traceable to projects without allocations are pivotal in recognizing revenue accurately. These include:
- Materials procured specifically for the project
- Rented equipment utilized only for associated contracts
- Wages paid to field construction workers deployed on respective sites
Stringent controls like material requisitions, equipment rental logs, and worker timesheets therefore become vital for controlling and capturing direct costs consistently.
Indirect Cost Allocation
Project-associated indirect expenses incurred for field offices, tools, quality testing, etc need reasonable allocation across ongoing jobs. Interpreting key allocation criteria prevents incorrect loading:
- Cause and effect principle ensures expenses are apportioned to benefited projects based on usage metrics like months, labor hours, etc.
- IRS-accepted formulae prevent disproportionate allocations raising red flags in case of audits or cost investigations.
Such mechanisms accurately link overhead spends for reflection in financial statements.
Labor Cost Management
Managing construction crew time and resource planning efficiently has a two-fold financial benefit:
- Optimized Resource Planning – Budgeted costs get translated to execution with minimal wastages when crew mixes align to construction schedules via daily progress tracking.
- Precise Cost Accounting – Direct tracing of man-hours to respective projects fed by timesheets and integrated project schedules maximizes accuracy.
Controlling field productivity thereby enhances project profitability and financial precision.
Material And Equipment Expenditure Controls
Given huge material expenses in contracting, significant savings accrue from contractor-friendly procurement frameworks with trusted vendors and reasonable contingencies for unanticipated purchases.
Equipment costs form sizeable project spends to mandating maintenance logs to determine capitalization vs expense decisions with depreciation impact appropriately reflected.
Such spending visibility allows informed trade-offs between buying and renting options balancing ownership tax benefits against idle resource risks throughout infrastructure build cycles.
Getting these cost allocation principles right thus sets up robust foundations for accurate financial picture depictions.
Recognizing Construction Revenue Accurately
In tandem with diligent cost accounting, appropriate revenue recognition principles become integral to prevent incorrect profit takes due to mismatch. Industry regulations mandate certain key tenets:
Key Tenets Of Revenue Recognition
- Based on definitive completion milestones or percentage thresholds defined in contracts avoiding subjectivity or manipulation for advanced takes.
- Change orders and pending claims are incorporated only on actual approvals or dispute settlements respectively.
- Aligned to complex accounting standards like ASC 606 and IFRS 15 factoring in cost budgets, margins, etc.
- Supported by invoicing done on accurate work certification avoiding cash flow gaps or risks.
Timing Differences: Percentage of Completion vs Completed Contract
POC Basis – Invoices are raised progressively as per contract clauses with revenue realization based on cost tables, physical completion, etc.
Accrual accounting entries raised for work done beyond invoiced amounts with balancing via contract assets and liabilities respectively preventing fictitious profits
Completed Contract – Single revenue recognition moment when a client accepts the finished project after inspection. Prior stage-wise accrual accounting is absent.
Cash Considerations – Completed contracts better for negative cash flows during the project. POC accrual accounting demands robust coverage for positive cash flows on progressive income.
Thus aligning revenue recognition to construction realities ensures sustained health and growth.
Change Order Revenue Treatment
Variations from the original contract scope often necessitate change orders which call for careful revenue treatment:
- Changes approved promptly – Recognize as normal revenue aligned to POC
- Pending approvals – Create contract asset for the completed portion with no profits taken till confirmed
- Customer disputes – Classified separately under IFRS 15 with no profits accounted.
Prudent change order accounting prevents premature or inconsistent revenue recognition.
Construction In Progress Financial Reporting
With multi-year projects, presenting the true financial picture demands accurate construction-in-progress reporting across key financial statements as examined below:
Balance Sheet Presentation Of Ongoing Construction
All costs accrued on uncompleted contracts get consolidated under the Construction in Progress asset accounts head and further sub-classified across relevant projects using WBS codes.
Upon completion, the aggregated costs either capitalize into production assets like buildings or transfer to client asset accounts in case of construction management contracts.
Income Statement: Project Expenses And Revenue
Expenses and revenues attributable to construction projects need coding under suitable heads in alignment with accounting standards like IFRS and GAAP.
ASC 606 demands further disaggregation in notes like opening balances, invoicing milestones, change orders, etc. for investor transparency.
Cash Flow Projections From Construction Activities
With sizeable funds tied up across existing contracts, projecting cash flows from operations mandates a detailed assessment of the following:
- Pending construction expense accruals and reversals thereof
- Progressive billings, receivables, and collections applicable
- Retentions or contract assets still to be realized
Getting these financial statement elements right ensures accurate financial reporting.
Construction Accounting Compliance And Risk Management
Complex accounting standards and project uncertainties mandate tailored controls for compliance and risk mitigation as covered next.
Relevant Accounting Standard Guidelines
From revenue recognition principles to cost allocation methods, construction accounting closely hews to strict regulations like:
- IFRS 15 guidelines for customer contracts
- ASC 606 for revenue recognition approaches
- IAS 11 for production, service, and construction contracts
- Numerous IRS codes guide acceptable costing
Keeping accounting approaches aligned with evolving regulations prevents non-compliance risks while optimizing cash flows.
Essential Internal Controls And Best Practices
Well-defined processes governing key compliance areas enhance control:
- Formalized change order approvals preventing unilateral decisions
- Stringent material acceptance inspection before acceptance
- Segregation of cost monitoring and accounting responsibilities
- Manager and customer acceptance mandated for progress bills
- Multi-level invoice verifications etc.
Such good practices aid compliance.
Project Delay And Cost Overrun Risk Mitigation
Construction industry dynamics constantly necessitate proactive assessments and mitigation mechanisms for potential risks covering:
- Supply chain uncertainties – Contractual coverage for cost & time impacts
- Poor estimation practices – Analytics-driven estimation baselines
- Rework from poor quality – Improved QA/QC regimes
- Design and permit delays – Realistic scheduling with buffers
- Subcontractor failures – Robust prequalification and capacity planning
- Statutory factors like litigation – Proactive project controls and management information systems
Getting such risk management fundamentals right goes a long way in preventing major cost or schedule overruns.
Optimizing Construction Accounting With Technology
Sophisticated construction accounting software integrated with project scheduling and costing tools can prove pivotal in navigating CIP complexities.
Features Of Construction Accounting Software
Robust products integrate key functionalities for efficiency:
- Centralized cost and general ledger tracking
- Flexible revenue recognition aligned to complexity
- Accounts payable and receivable automation
- Fixed assets and depreciation handling
- Payroll integrated time and expense capture etc.
Integrating With Project Management Tools
Cutting-edge systems interface scheduling software, CAD solutions, etc. for intuitive access to:
- Live project milestone status
- Digital dashboards on cost and resource performance indexes
- Work order budgets vs actual expenditure
- Back-end scheduling corrections to prevent front-end accounting discontinuities
Such technology integration powers efficiency, agility, and cohesion vital for financial excellence.
Key Reporting Metrics And Financial Dashboards
Modern tools deliver preset and customizable reporting via:
- Audit-ready historical data on budgets, revenues, expenses
- Graphical depictions of lead KPIs across projects
- Multi-dimensional deviation analysis on costs, changes, profits
- Data extracts for financial statement consolidations
Embracing such technology transformations thus elevates construction accounting and associated stakeholder confidence dramatically. Contact PVM Accounting for more information on how we can assist your business with construction in progress best practices.
