In addition I’ll explain its importance related to either the completed contract or percentage of completion method. As additional information I’m going to explain how this is done with QuickBooks as many small business contractors use QuickBooks as their accounting software.
Introduction to the Concept of Progress Billings
In a traditional business relationship the customer purchases a service or product and the seller immediately invoices the customer for the total value of the service or product. Well, that works well with lesser expensive items. But what happens when the particular item gets into the several thousands of dollars or as in residential construction/remodeling tens or 100’s of thousands of dollars. The contractor doesn’t have that kind of capital to front for a project. To alleviate this capital intensive burden, contractors progress bill for their services.
In general the contract dictates certain milestones of accomplishment to issue an invoice to the customer. Most often it is controlled by the mortgage lender via the concept of construction draws. The common draw schedule allows for four or five draws throughout the contract once certain points of construction are complete.
Once these points of construction are complete the contractor issues an invoice for the services and materials to date. This invoice is the progress billing for a particular percentage completed to date.
Smaller construction contracts such as remodeling or renovation work have a verbal agreement between the homeowner and the contractor. The more common format is to have a five to ten percent deposit and a significant installment once the materials are delivered to the house. Then another installment is billed upon completed framing and drying in of the project. The final payment is received once the homeowner signs off as agreeing the project is complete.
In more intensive and time consuming projects the contract will dictate the respective billing points. The overall goal is to reduce the capital outlay of the contractor for services and material in each respective project.
In the next section I’ll explain the balance sheet presentation format related to construction projects.
Balance Sheet Format
In general there are two distinct account groups on the balance sheet that illustrate the status of the respective projects in progress. The first is referred to as the Construction in Process or Progress and is shortened to CIP. This is a current asset and is generally the total value of all direct costs of construction for all projects combined.
The second group is referred to as Project Billings or some contractors use the term Progress Billings. Either is fine. This account group is located in the current liabilities section of the balance sheet. Project Billings also includes deposits from customers on the contract. So some contractors label this account Billings/Deposits to clue the reader that the account also includes deposits made by customers for their contracts.
So overall the balance sheet will look something like this for a contractor:
Now for a little help with understanding the situation. First thing is that let’s think about this for a moment. Notice how Project Billings exceeds Construction in Process? It is $56,937 greater than CIP. Why do you think this is this way? Well, the answer is simple; every time you invoice a portion of a job it covers two important items. The first are your actual costs related to that percentage of the project billed and your margin (indirect costs, overhead and profit). Whereas in CIP, the only values accumulating are the actual direct costs to build the house.
Makes sense doesn’t it?
This is not always true because Construction in Process works like a pool. You are constantly filling it up with direct costs of construction. As the accumulated amount increases it will from time to time exceed the value in Project Billings to date. This is because as the costs accumulate, you haven’t billed for them yet. At some point in time in the near future, once you achieve that particular point in the contract for the right to invoice, you’ll invoice the project and now Project Billings will exceed total costs. Remember, the value in Project Billings includes the margins for your projects.
Many of your better run construction contractors invoice their projects at the end of the month and therefore the Project Billings account will always exceed CIP at the end of the month (accounting cycle).
In general, Project Billings to date should always exceed Construction in Process to date. If not, then you may have a problem or it may be time to generate another invoice to cover those accumulated costs in CIP that have not been billed yet.
This also generates an interesting ratio issue. Because Project Billings exceeds CIP, the current ratio is often less than 1:1. So a banker often misunderstands construction company balance sheets. In the example above, the ratio is actually .95. Fascinating isn’t it? In construction evaluation you should remove both the CIP and the Project Billings values from the formula to get a more accurate current or quick ratio. So if somebody ever tells you that your current ratio is poor; shake your head in dismay and explain to them that in construction accounting, it is really a good thing! Seriously, I’ve explained this to CPA’s and many of them still don’t understand. This is because construction accounting is different than traditional accounting.
Finally I want to point out a couple of smaller line item issues. Notice how I have Supplier Payables? This is the amount due to suppliers and subcontractors related to the respective construction in process. Your traditional payables such as office supplies, insurance and rent are separated into a distinct separate group on the balance sheet. This benefits you as a reader to understand how much money is owed for construction against other general operating bills.
Also, look up in current assets and you’ll notice there is a receivable due to the contractor. This is project billing (invoice to the customer) where the customer has not paid yet. Most likely it relates to some draw on the project whereby the mortgage company or bank hasn’t completed the paperwork to pay the invoice. This is normal in construction. In effect at the moment you created the bill to the customer, the receivables go up too. When the customer pays, the receivables balance goes down and cash goes up.
Aw yes, the wonderful world of accounting.
OK, now that I’ve explained this balance sheet interpretation to you, you are probably wondering does the completed contract or percentage of completion method affect the balance sheet information and/or the format? Let’s find out.
Completed Contract or Percentage of Completion
There are various forms of both methods used by many industries.
In general, the completed contract method means that once the project is complete, the accountant transfers all costs and all project billings to the profit and loss statement at the same time. With the percentage of completion method, the project’s costs and project billings are transferred at the end of an accounting cycle (typically monthly or quarterly). However there are MODIFIED VERSIONS of both incorporating attributes of the other method. So I want the reader to understand all four different combinations. In general the balance sheet method for the percentage of completion is the best for most contractors reading this article.
In construction the following are the four different combinations of these two methods:
- Completed Contract (Very Small Contracts) – for those of you in construction that do jobs that are generally less than $15,000 in value and are completed in less than 30 days, this is the best method. Basically you bypass the balance sheet completely and take both costs and billings straight to the profit and loss statement. Since the jobs are relatively small and have no significantly impact upon your financial status (in the overall scheme of things, $15,000 contracts are not going to make or break you as an individual) it is best to skip the balance sheet and go straight to the income statement with the information. Therefore the above information has no real meaningful value to you and this is by far the simplest and most effective method of accounting for this level of services. If your construction company does both really large jobs ($100,000’s in size) and really small jobs such as maybe an $8,000 flooring job I encourage you to use both methods. Simply expense small job costs to the direct costs of construction in the profit and loss statement along with that job’s corresponding invoices to customers. For the larger jobs, place the associated costs into CIP and the billings in Project Billings.
- Completed Contract Method – if you select the completed contract method of accounting then once the job is complete, all the CIP and the Project Billings are transferred to the profit and loss statement at the same time; i.e. at the very end of the project. In the interim, you may still bill the project at various steps of completion. The completed contract method refers to how the information associated with the job is transferred to the income statement. With this method, it is transferred at the very end of the project. So on the balance sheet the CIP can get to be a big number and so can the Project Billings. This method is best for those projects requiring less than three months of work. In many of these contracts the project is invoiced based on certain steps similar to what I discussed above: a deposit, a significant payment upon delivery of material, a payment upon completion of framing/drying in the house and upon completion. With this method, the contractor doesn’t necessarily have to generate an invoice as the customer pays in accordance with the terms set upon signing of the contract.
- Percentage of Completion Method (Profit and Loss Accounting) – this is the best method for the truly larger projects especially for those contractors with several projects ongoing. I’m talking about having three or more $1,000,000 projects in progress. At the end of each month the job progression is evaluated and then the project is billed for the percentage completed that month. Your contract may indicate that the corresponding receivable is carried forward until a draw is allowed by the bank or it may indicate a period of so many days to pay the bill. No matter what, the progress billing is generated and the corresponding costs and invoice value is then transferred to the profit and loss statement. This is the best tool for the really large projects, those getting into the millions of dollars because each month will see a significantly value earned on the project. The key for this to work is to have a good accountant that understands construction accounting.
- Percentage of Completion Method (Balance Sheet Accounting) – this method is the most common for your average contractor. Your projects range from $30,000 upwards to $1,000,000 each. In addition, these contracts have extended periods of time to complete, upwards of 15 months. With this method, all the costs are accumulated onto the balance sheet and the project billings are accumulated onto the balance sheet. As you complete certain milestones in the project as noted in your contract (bank authorizes a draw once the site is developed, footer is set, foundation is laid and concrete slab is poured) you progress bill the project. So as exemplified you are allowed a 20% draw, therefore you invoice 20% to the project and the bank transfers the money a couple of weeks later. This method is similar to the monthly accounting concept as explained in the prior example except that the project is not transferred to the profit and loss statement until the project is completed. This allows for the contractor to have a non-formal educated accountant on staff to do the accounting as the final step is completed at the very end of the project. Notice how similar this is to the Completed Contract Method explained above. The difference between the two relates to the determining factor of when the project is allowed a project billing. This method more closely follows the draw schedule of the bank. The drawback to this method is educating management on how to read and interpret the respective project financial reports. Most contractors are not financial guys and they have difficult time understanding the information. I will generate another article explaining how to read and interpret the reports.
For the reader, we are accumulating costs in CIP and accumulating the deposits and the corresponding progress billings in another account. If you look at the balance sheet above, if this were one project you could easily see that the contractor is indeed making money for the project. What you can’t tell is where in the percentage of completion the project stands. In addition if you are using phase accounting as I encourage you too, you want to know where you stand within each phase of construction and how much money have you generated as a profit for each phase.
The best software for your average contractor is QuickBooks and for those of using QuickBooks, the next section explains and illustrates how to use this software to generate Progress Billings and how to look at the profitability for each phase of construction.
For those of you using QuickBooks as your construction accounting software there are multiple versions in existence. Many of you purchase QB’s Contractor’s Version. Honestly, it wasn’t written by an accountant but some QB coding guy with some knowledge of accounting. Enough knowledge to be truly dangerous, me, I prefer the Pro version for several reasons. First you get the same results for a lot less money and secondly, there are many for trained bookkeepers familiar with the Pro version than with the Contractors version. So this section is really oriented towards those using the Pro version. However, this still works with the Contractor’s version.
The secret to all this is to understand the relationship involved between the various accounting functions. So I’m going to work from the core items right up to the final balance sheet relationship. Then I’ll explain how to make the entries and you’ll understand why I explained each function.
In general most contractors perform more than one type of service. So you should use ‘Class Accounting’ in construction. To keep this simple, let’s assume our company does new home and remodeling work. So every job is created through the lists section of QB’s. For you, the job is really a customer and I really encourage you to use a numbering system that incorporates the year, month and date of the contract signed e.g. 150427 means this job contract was signed on April 27, 2015. So you enter the project identifier as the customer name and you’ll see on the edit customer tab how to insert the real customer’s name and contact information.
In addition to using class accounting I highly encourage using phase accounting. This breaks out a job into nine phases (my preferred maximum number of phases). When you estimate a job you estimate each of the nine phases. The reason you are doing this is identify that phase or group of phases that you either underperformed or made good money for your services. In addition, in the future, you can compare a single phase of work over several jobs and figure out which jobs performed well and why.
When the costs are book via accounting, each cost whether materials, labor, or subcontractor is assigned a phase and a class of construction in addition to the respective job name. Now we can break out our costs by classes, jobs, phases or any combination of these we desire. All these costs accumulate in the CIP account on the balance sheet. Remember, for accounting purposes, CIP is an asset customarily referred to as Debits in accounting lingo. So for an asset to increase in value on the balance sheet, more debits are added to that account.
OK, now with this basic understanding lets progress bill a job.
In general, what you would like to do is to simply create one dollar value for a job and the value is assigned to the Progress Billings account down in liabilities. But for you, you are interested in knowing how much money earned relates to each class of construction and of course each phase (item code). To accomplish this, you will need to assign a phase id number to each line item of entry associated with the particular job (customer). When you do this, this earned value is then assigned as a Credit to the CIP account because the item code is preset to the CIP account when it is set up.
THIS IS OK!
We want to know how much is earned for the respective phase and how much is spent for each phase and for the class as a whole. The problem is that the total credit is assigned to the CIP account and not down in Progress Billings as we desire. Darn it! So for relationship understanding let’s assume that prior to billing $50,000 for a job our balance sheet looks like this (this is the balance sheet from above).
Now, if we create an invoice (project bill) for $50,000, the credit value will decrease the CIP account by $50,000 because we are assigning credits to this account. Ugh…. How do we fix it? Simple, step two; create a general journal entry whereby we debit CIP $50,000 and credit Project Billings $50,000. Remember from above I said that when we debit an asset account, the value goes up just like it does when you enter in direct costs. Down in the liabilities section, when you enter a credit the value goes up.
Now the CIP account will go back to the $269,808 value and the Project Billings account will increase to $376,745. Remember the A/R goes up $50,000 when we first created the Project Billing (invoice to the customer).
Now for the secret to all this; when you create the general journal entry, DO NOT ASSIGN A CLASS OR JOB ID TO THE ENTRY. I’m going to write this again: DO NOT ASSIGN A CLASS OR JOB ID TO THE ENTRY. One more time for clarification and I’ll bold it to make my point: DO NOT ASSIGN A CLASS OR JOB ID TO THE ENTRY. It is simply a general journal entry without details and with only two lines of information. The first line is the debit to CIP for the total invoice and the second is a credit to Project Billings for the total amount of the invoice.
Why do we do this?
Simple, it sets the balance of the CIP to the correct aggregated dollar value and keeps the credit information related to the job with the respective phases with the job. Now you can pull reports based on phases and the negative number in the report is the value we earned on our project billing. The positive numbers reflect the direct costs via debits and if your phase has a final negative number, you made money on that phase. If your job as a whole has a negative number you made money! Remember, the negative number reflects the credits from progress billings or basically the amount you earned from each respective phase or job as a whole.
It seems weird, but credits are a good thing when looking at job reports.
I encourage you to run a simple test with a simple invoice and to keep it simple, earn $100,000 and allocate this amount over 3 phases to a job. Look at the balance sheet and notice the CIP goes down by $100,000. The A/R increases by $100,000. Make a journal entry as I illustrated above and you’ll see the CIP go back to original balance. Now pull some reports for those phases and for that job. Do you see the value inserted? If this works and you are satisfied with the outcome, simply delete the invoice and the journal entry because their FAKE entries. Now you know it works.
Now we are ready for the really best part and that are job reports and details, the stuff that makes you a better businessman. I’ll cover these in another article. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.