Financial Memos

Introduction to Construction Accounting Construction accounting differs from typical business accounting due to the long-term nature of construction projects, the complexity of contracts, and the way revenue and expenses are recognized. Instead of recognizing revenue when a product is delivered, construction companies must account for revenue and costs over the life of a project. This approach ensures financial statements accurately reflect the company’s progress and performance on long-term contracts. In this tutorial, we will break down the key concepts, introduce you to various methods used in construction accounting, and provide examples with journal entries and financial statements. Key Concepts of Construction Accounting Before diving into specific journal entries, let’s establish a few critical concepts: Revenue Recognition: In construction, revenue is not always recognized upon delivery of a product or completion of a project. Companies use different methods, such as percentage-of-completion or completed-contract methods, to recognize revenue based on project progress. Job Costing: This refers to tracking the costs associated with a specific construction project, including labor, materials, overhead, and subcontractor costs. Job costing allows companies to measure profitability on a per-project basis. Construction in Progress (CIP): CIP is an asset account that reflects the costs incurred on a project until the project is complete. Once the project is finished, costs are transferred to fixed assets or cost of goods sold, depending on the nature of the contract. Retainage: Retainage is a portion of the contract price (usually 5–10%) that the customer holds back until the project is completed satisfactorily. It is meant to ensure that the contractor finishes the project as agreed. Billings in Excess of Costs: This is a liability account that reflects when a construction company has billed its customer more than it has incurred in costs for a particular project. Costs in Excess of Billings: This is an asset account that indicates when a company has incurred more costs on a project than it has billed the customer for. Revenue Recognition Methods in Construction Accounting Two primary methods of recognizing revenue in construction are Percentage-of-Completion and Completed-Contract. Let’s explain each method, followed by examples with journal entries and financial statements. Percentage-of-Completion Method In the percentage-of-completion method, revenue and expenses are recognized based on the percentage of work completed during a given period. This method is particularly useful for long-term projects that span multiple accounting periods. Example: Let’s assume ABC Construction Co. is working on a $1,000,000 project expected to last 2 years. ABC incurs $200,000 of costs in the first year and estimates that total costs for the project will be $800,000. Therefore, ABC estimates that 25% of the project is complete in Year 1 (calculated as $200,000 / $800,000). Revenue Recognition for Year 1: Revenue recognized = Total Contract Value × Percentage of Completion= $1,000,000 × 25%= $250,000 Journal Entries for Year 1: To Record Costs Incurred: Construction in Progress (CIP) $200,000 Cash/Accounts Payable $200,000 This entry reflects the costs that ABC has incurred in Year 1 for labor, materials, and overhead. To Record Revenue Recognition: Construction in Progress (CIP) $50,000 Construction Revenue $250,000 Construction Expenses $200,000 This entry records the revenue and expenses recognized based on the percentage of completion. The $50,000 difference (revenue recognized less expenses) increases the CIP account. To Record Billings to the Client: Let’s assume ABC billed the client $300,000 during Year 1: Accounts Receivable $300,000 Billings on Construction Contracts $300,000 This entry records the amount billed to the client. The $300,000 is added to the receivables and liabilities until the client pays. Financial Statement Presentation for Year 1: At the end of Year 1, ABC's balance sheet would show: Construction in Progress (CIP): $250,000 (the cost of the project plus recognized profit) Accounts Receivable: $300,000 (billed but unpaid by the client) Billings in Excess of Costs: $50,000 (billed more than costs incurred) The income statement for Year 1 would show: Revenue: $250,000 Expenses: $200,000 Profit: $50,000 Completed-Contract Method In the completed-contract method, revenue and expenses are recognized only when the project is fully completed. This method is typically used when the outcome of the project cannot be reliably estimated, or for smaller projects that can be completed within a short period. Example: Let’s continue with the same example as before but assume that ABC Construction Co. uses the completed-contract method. Under this method, no revenue or expenses are recognized until the entire project is finished. Journal Entries During the Construction Period: To Record Costs Incurred: Construction in Progress (CIP) $200,000 Cash/Accounts Payable $200,000 This entry reflects the costs that ABC has incurred in Year 1, similar to the percentage-of-completion method. However, no revenue is recognized at this point. To Record Billings to the Client: Let’s assume ABC billed the client $300,000 during Year 1: Accounts Receivable $300,000 Billings on Construction Contracts $300,000 This entry records the amount billed to the client, but no revenue is recognized yet. Financial Statement Presentation for Year 1: On the balance sheet: Construction in Progress (CIP): $200,000 (the costs incurred so far) Accounts Receivable: $300,000 (billed but unpaid by the client) Billings in Excess of Costs: $100,000 (the difference between billed amounts and costs incurred) The income statement will not reflect any revenue or expenses for Year 1. When the Project Is Completed (Year 2) When the project is finished in Year 2, ABC can recognize all revenue and expenses at once under the completed-contract method. Journal Entries in Year 2 (Completion Year): To Record Costs Incurred in Year 2: Let’s assume ABC incurs another $600,000 in costs in Year 2, bringing the total to $800,000: Construction in Progress (CIP) $600,000 Cash/Accounts Payable $600,000 To Record Revenue and Expense Recognition: Now that the project is complete, ABC can recognize the total revenue and expenses: Construction Revenue $1,000,000 Construction Expenses $800,000 Construction in Progress (CIP) $200,000 This entry clears out the CIP account and recognizes $200,000 in profit on the income statement. Accounting for Retainage In many construction contracts, the customer withholds a percentage of payment (retainage) until the project is fully completed to ensure the contractor meets all requirements. Here’s how to account for retainage: Example: Let’s assume ABC Construction Co. is building a bridge for a client with a total contract value of $1,000,000. The client holds back 10% retainage, so $100,000 will not be paid until the project is completed. Journal Entries to Record Retainage: To Record Initial Billing: Let’s assume ABC billed $900,000 to the client, keeping $100,000 as retainage: Accounts Receivable $900,000 Billings on Construction Contracts $900,000 To Record Retainage: Retainage Receivable $100,000 Billings on Construction Contracts $100,000 This entry reflects the retainage held by the client. The retainage receivable is shown as an asset on the balance sheet. When Retainage is Paid Upon Completion: Once the project is complete and the client pays the retainage: Cash $100,000 Retainage Receivable $100,000 Billings in Excess of Costs vs. Costs in Excess of Billings In construction accounting, it’s important to track whether a company has billed its clients more or less than it has incurred in costs. Billings in Excess of Costs occurs when the company bills more than it has incurred in costs. This is recorded as a liability. Costs in Excess of Billings happens when the company incurs more costs than it has billed. This is recorded as an asset. Example: Let’s assume ABC Construction Co. has incurred $800,000 in costs but has only billed $700,000 to the client by year-end. ABC needs to account for the $100,000 of costs in excess of billings. Journal Entry to Record Costs in Excess of Billings: Costs in Excess of Billings $100,000 Construction in Progress (CIP) $100,000 This entry shows the additional costs incurred that have not yet been billed to the client. Conclusion Construction accounting is unique and requires careful tracking of costs, revenue recognition, and project progress. The use of methods like percentage-of-completion and completed-contract ensures that financial statements reflect the true economic performance of a construction company. In summary: Percentage-of-Completion method is useful for long-term projects, recognizing revenue and expenses as work is completed. Completed-Contract method defers revenue and expenses until the entire project is finished. Retainage needs special treatment in accounts receivable, ensuring you track money held back by clients. Billings in Excess of Costs and Costs in Excess of Billings must be carefully monitored to avoid over-billing or under-billing clients. Understanding these principles will help you successfully account for construction contracts, ensuring accurate and transparent financial reporting.