Feb 072013
 
Completed contract method

The completed contract method of accounting recognizes revenue and the associated costs once the project is completed.  This is one of the two popular accounting methods used in the construction industry.  For residential contractors, the completed contract method has a tax advantage by deferring revenue recognition but is generally not considered the best method of accounting in the construction industry. 

The completed contract method is different than traditional accounting.  Both costs and draws are posted onto the balance sheet in the asset and liabilities section respectively.  Once the project is completed all the draws and final unpaid or earned profit is posted to the profit and loss statement along with all the associated costs.  The following describes how costs and draws are accumulated on the balance sheet and the once the project is completed, how those costs and revenues are transferred to the profit and loss statement.

Accumulation of Costs and Draws on the Balance Sheet

Once a contract is signed, the home buyer issues a deposit of some sort to the contractor.  In a traditional design/build contracts, the usual deposit is $10,000.  In most small businesses, this $10,000 is considered revenue and is posted to the profit and loss statement (income statement).  However, for a contractor using the completed contract method, he posts this deposit as cash against a project.  So an account is created in the liabilities section of the balance sheet.  Why liabilities?  Well, simply put, the contractor hasn’t really done anything yet to have earned any money.  All he has done is sign a contract.  Read  http://businessecon.org/2012/12/what-is-a-contract/ for a better understanding of how a contract works and the terms used for contracts.

So the contractor labels this account Project Draws and creates a sub account for this project.  So the balance will look like this if this is the only transaction recorded for this contractor to date:

 XYZ, Construction

Balance Sheet

Today’s Date

Cash                                                     $10,000

Total Assets                                                                  $10,000

 Liabilities:

            Project Draws

                        Project ‘A’                            10,000

        Total Liabilities and Equity                                           $10,000

Remember, the balance sheet has two equal sides (thus the term balance) of $10,000 each.  If you need to understand a basic simply formatted balance sheet read http://businessecon.org/2012/12/how-to-read-a-balance-sheet-simple-format/ .  This article explains the basics of balance sheets and why they are prepared this way.

Now that the contractor has a legal obligation to begin work, he needs to start the process.  So let’s assume he heads on down to Codes and Compliance and gets a building permit.  He pays $50 for this permit.  The transaction is coded to phase one in the accounting software, coded as other types of costs (See http://businessecon.org/2012/12/use-phase-accounting-in-construction-part-i/) and this cost is accumulated as an asset on the books of the company on the balance sheet.  Think of it as a company paying for inventory (i.e. the house).  Accountants use the term Work in Progress (WIP) and a project is assigned, in this case it’s the same project name or number used in the liabilities section.  That is Project ‘A’.  So now the balance sheet looks like this:

XYZ, Construction

Balance Sheet

Today’s Date

Cash                                                     $9,950

Work in Progress

            Project ‘A’                                         50

Total Assets                                                                  $10,000

Liabilities:

            Project Draws

                        Project ‘A’                      10,000

Total Liabilities and Equity                                           $10,000

As more costs are accumulated for site development and the footer, odds are that the costs associated with the project will exceed the draws received to date.  This is really no different than having the customer owe the contractor money.  The law is relatively clear here, if you perform services under a contract, then you are entitled for compensation or the amount you earn for those services or costs borne by you.  Unfortunately, this contactor doesn’t have enough cash to pay for these costs.  So I will keep this simple and basically have the contractor post his equity purchase of $100,000 so that cash is available to purchase the materials and pay the subcontractors for work completed.  So, at this point, the contractor, purchases the land, develops the site, puts in a foundation, installs the block for the foundation and pours the garage concrete pad.  All together he has completed about 20% of the work (the well is dug, the septic tank installed, grade is complete, driveway is paved, etc.).  The contract is for $500,000 and the contractor has paid out $72,000 for materials and subs.  So the balance sheet should reflect $72,000 in project costs to date, about $38,000 of cash (the original $10,000 deposit plus his $100,000 equity purchase, less the $72,000 of cash spent to get the work done to date).  Now the balance sheet will look like this:

XYZ, Construction

Balance Sheet

Today’s Date

 

Cash                                                     $38,000

Work in Progress

            Project ‘A’                                  72,000     

Total Assets                                                                 $110,000

 Liabilities:

            Project Draws

                        Project ‘A’                      10,000

 Equity                                                  100,000

        Total Liabilities and Equity                                         $110,000

 Now let’s pause for a moment and look at the big picture.  We have completed 20% of the project.  If this is a $500,000 project, the contractor has earned $100,000 total to date.  He has spent $72,000 to date.  Therefore, his project margin at this moment is $28,000.  In addition, he is owed $100,000 total less the deposit of $10,000.  So right now, if the project came to a halt, he is entitled to the $90,000 owed to him ($100,000 earned less the $10,000 paid).  But at this moment, the records reflect $72,000 spent and no project profit has been recorded.  At this point, the contractor can take one of two directions.  The first is to make no record of the profit earned to date (I recommend doing this for the small contractors that are doing less than 10 houses per year) or secondly, he can record the profit he is entitled to onto the balance sheet.  To record this profit, he would enter profit as a receivable and the offset would be recorded as Project ‘A’ Draws & Earnings.  In effect you change the account name from ‘Project Draws’ to ‘Project Draws & Earnings’.  Again, I don’t endorse this for two reasons, first, it presents an illusion that you have earned this money when in reality, it might be that in future time, you generate losses.  Well, to record those losses are difficult for the bookkeeper.  Most accountants have difficulty dealing with this type of entry for completed contract methods.  Secondly, it adds to the overall administration costs due to the intellectual level of the accounting staff you will need to stay on top of this entry.  If it is calculated incorrectly it leads to misinterpretation of the financials which is a real problem for most small business operations.  So the best course of action is to not record the profit, but keep a list on a spreadsheet identifying where the project stands in totality, and calculate the profit as illustrated in this paragraph.

The next step is request and receive a draw from the bank/mortgage company for the work completed to date (this assumes draws in 20% increments).  Remember, the block work is done, so the next few steps are the really expensive steps.  Material for framing is delivered and the carpenter shows up to fabricate the house.  In addition, windows are installed, the fascia/soffit is cut and mounted and the roof is shingled.  Once those doors are installed, the house is generally considered dried in and this will cost over 25% of the total cost of constructing the house.  So a lot of money is getting ready to be spent for this next phase of work and it’s a long time between draws. 

Once the block for the foundation is done and the site work is complete, the bank sends an inspector for proof to transfer funds.  In most situations, they are funding 80% of the project, and the home buyers are funding the other 20%.  It is important to have a good contract between the home buyer and you.  You should have a clause in the contract that in effect requires the home buyer to carry the $10,000 deposit all the way to the end of the project.  So at this point, the bank and homeowner combined owe $100,000 due to the fact that the contract requires a $10,000 deposit on hand at all times.  Since the bank will pay $80,000, the home buyer should pay the next $20,000 to cover the entire $100,000 to date of the project work.  It is important to tie the contract to the draw schedule to clearly identify the different percentages of completion as the project moves forward.  See http://businessecon.org/2013/01/construction-draw-schedule/ for more information about draw schedules.

Normally, there is no invoice presented to the bank, the homeowner makes the call and authorizes the inspection and draw.  They have to sign the draw release prior to you getting your money.  So you draft an invoice to the customer for the entire $100,000 per the contract draw schedule.  Once paid, the balance sheet will look like the following:

XYZ, Construction

Balance Sheet

Today’s Date

Cash                                                     $138,000

Work in Progress

            Project ‘A’                                  72,000     

Total Assets                                                                 $210,000

Liabilities:

            Project Draws

                        Project ‘A’                    110,000

Equity                                                  100,000

Total Liabilities and Equity                                         $210,000

This pattern continues until you receive the occupancy permit.  Now the project is done and the last draw is paid.  The homeowner’s go to the closing table and complete the purchase of the home.  In many situations, the homeowner is allowed to hold back about $10,000 for the punch list issues or the 30 day inspection and final delivery.  So at final closing, the project costs are tallied and for the purpose of this article come to $374,000.  In addition, the contractor estimates an additional $7,500 of costs to complete the punch list.  Therefore, the total project costs included the estimated amount to complete is $381,500.  Total draws to date equals $490,000.  Remember, $10,000 is still owed to the contractor at the completion of the punch list issues.  To make sure that everyone understands, since the contractor believes that the costs to complete the work are $7,500; he thinks he will spend this money to finish.  So this is a liability.  Furthermore, the customer owes the contractor $10,000.  This is considered a receivable.  The easiest solution is to post the amount owed to the company and record it to the draws even though we did not receive the final $10,000 as cash.  This keeps this simple.  So now let’s illustrate the balance sheet and evaluate the project before going to the final step.

XYZ, Construction

Balance Sheet

Today’s Date

 Cash                                                     $216,000

Account Receivable Project ‘A’                 10,000

Work in Progress

            Project ‘A’                                 381,500     

Total Assets                                                                 $607,500

Liabilities:

            Estimated Costs to Complete         7,500

Project Draws

                        Project ‘A’                    500,000

Equity                                                  100,000

Total Liabilities and Equity                                         $607,500

Does anything stand out like a sore thumb?  Cash, wow, how did we end up with so much cash?  Well, let’s walk through the math.  The sources of cash are the $100,000 invested by the contractor and the $490,000 paid by the home buyer.  Total cash deposited will equal $590,000.  The contractor has physically paid out $374,000 in costs (see above).  So, $590,000 less $374,000 equals $216,000.  The project costs total $381,500 which equals the $374,000 physically paid from the cash account and an estimated $7,500 to finish the project.  The final asset is the $10,000 the customer still owes the contractor.   Once that dollar amount is actually received, there will be $226,000 in the bank account.  However, the contractor will first write checks for $7,500 to cover the punch list items.  So in reality, the final cash balance will equal $218,500.  One hundred thousand of this dollar amount is his original equity investment.  So this project should have a profit of $118,500.  Total revenues will equal the $500,000 contract less costs of $381,500.  This happens to equal the $118,500 matching the increase in cash to the bank account.  Isn’t this fun?  This will not happen in reality because there are costs including indirect costs for transportation, taxes, management costs etc.  But for the purpose of illustrating the completed contract method of accounting in construction, I assumed the contractor paid these costs out of his personal bank account as a gesture of how nice of guy he is.

Now that the project is complete, the contractor can go onto the next step in the completed contract method and transfer the draws and the costs to the profit and loss statement.

Transfer of Revenues and Costs to the Profit and Loss Statement

Once the project is complete, the contractor transfers both revenues (the draws) and the corresponding costs of that project to the profit and loss statement.  The entry transfers the draws of $500,000 to the revenue section of the P&L.  The costs of $381,500 are then transferred to the direct costs and grouped based on the direct costs format as follows:

  • ·        Land
  • ·        Materials
  • ·        Subcontractors
  • ·        Labor
  • ·        Other

The combined total is the $381,500.  Now your Profit and Loss Statement will look like this:

XYZ, Construction

Profit and Loss Statement

Completed Contract Method

Today’s Date

 Completed Contract Revenues                          $500,000

 Direct Costs:

            Land                             ZZ,ZZZ

            Materials                      ZZZ,ZZZ

            Subcontractors              ZZZ,ZZZ

            Labor                              ZZ,ZZZ

            Other                              ZZ,ZZZ

            Total Direct Costs                                   381,500

Direct Profit                                                                             $118,500

The balance sheet will look like this at the exact same moment:

XYZ, Construction

Balance Sheet

Today’s Date

 Cash                                                     $216,000

Account Receivable Project ‘A’                 10,000

Total Assets                                                                 $226,000

Liabilities:

            Estimated Costs to Complete         7,500

Equity                                                 

Stock & Capital Contributed     100,000

Profit to Date                            118,500

Total Liabilities and Equity                                         $226,000

Notice that the balance sheet is simple and the profit and loss statement clearly identifies the profit earned on this project.  Once the actual costs to complete are spent and the customer pays their bill, cash will equal $218,500 (current balance of $216,000 plus the $10,000 paid by the customer less the $7,500 paid out to finish the work) which will match the capital contribution from the owner and the profit earned on the project.

Naturally the balance sheet will be much more complicated than this example because of ongoing projects, the use of accrual accounting, and other types of obligations typically borne by small companies.  The Profit and Loss Statement will also be more complicated but the purpose of this article is to illustrate the completed contract method of accounting in construction.  Knowledge is Power.

Other articles of interested related to the completed contract method of accounting include:

Percentage of Completion Method for Accounting in Construction - there are two methods to account for the revenues and expenses associated with a construction project.  The first and simpler format is the completed contract method as described above.  The second is the percentage of completion method as illustrated and explained in this article.

How to Calculate the Best Markup for a Construction Project –  every contractor should understand how to calculate the real profit needed in his business.  From this value, the contractor can then work backwards and determine the best markup for each respective project.  This article illustrates the method and math associated with determining the best mark for each project.