Billings in Excess

‘Billings in excess’ is a construction industry financial term referring to the dollar value of charges to customers in excess of the costs and profits earned to date.  It is reported on the balance sheet in the current liabilities section.  It is in effect, the dollar value the contractor owes back to the customer for incomplete work.

For financial purposes, this amount is important for the contractor to understand.  It is a contractual dollar value owed. If not monitored and addressed, financial backers (banks and investors) and the bonding agency may withdraw their support forcing the company into bankruptcy. Therefore, it is important to understand how the amount is calculated, monitored and resolved. 

If you are a contractor or the accountant, you must learn how to calculate this value, report the amount and control its financial impact. The following sections educates the reader by first explaining what the term means and how it is calculated. The next section illustrates how the accountant enters the value into the books of record along with reporting systems.  Finally, this article offers some advice with tools to control and maintain a reasonable dollar value for a contractor.

Definition and Formula – Billings in Excess

There are three widely accepted accounting methods in the construction industry. They are:

  1. Direct Method – This refers to straight costing of expenditures to costs of construction and recording of receipts to the revenue section in the profit and loss statement (income statement). It is most commonly used by small contractors such as restoration, remodelers and subcontractors. In general, it is the preferred method for those in the construction industry with sales less than $2,000,000 per year.
  2. Completed Contract – Both construction costs and draws against the project are recorded to the balance sheet. It is rare for draws to exceed costs as financing institutions grant draws after stages of construction for the prior stage. 
  3. Percentage of Completion – This commonly used method transfers value to the income statement and the corresponding costs as the contract proceeds throughout the project’s lifetime. It is encouraged for use with long-term construction projects, more than one year in duration, and for large contractors (those contractors with more than $10,000,000 per year in revenue).

Billings in excess is used 100% of the time with the percentage of completion method. It is used with the completed contract method if draws, customer deposits and payments exceed construction costs to date. It is rarely if ever used with the direct method. To understand this, the reader must first understand how billings in excess is defined.

Definition of Billings in Excess

When a contractor has been paid or has presented an invoice (a bill) to the customer that exceeds the dollar value along with profits earned on a project; it is said that the company has billed in excess. To illustrate, let’s look a contract at different points of progression; the financial results to date and identify if and how much the contract is billed in excess.

Example # 1

Jake is building a student center for a small college.  He signs a contract worth $2,000,000 and estimates that his hard costs to construct the center is $1,350,000.  His estimated project profit is $650,000.  As a part of the agreement, the college must pay a $150,000 mobilization payment (to cover initial costs to set up for the job, deliver equipment and order initial materials).  Jake’s accountant presents the college with an invoice (the bill) for $150,000. The college has yet to pay the bill.  What is Jake’s billings in excess dollar amount?

The balance sheet’s results related to this particular project are as follows:

Assets:
Accounts Receivable         $150,000
Liabilities:
Billings in Excess             $150,000

Notice that not one single dollar has been paid by the college; yet, Jake’s company has billings in excess. Therefore, it doesn’t matter whether the customer has paid or not, the key is that the customer has been invoiced on the contract.  

Example #2

Same contact, but now Jake has spent $280,000 on the contract for hard costs.  He estimates that his costs to date are in line with his estimated costs of completion to date.  Therefore, Jake is now 20.7% complete ($280,000 of costs against and estimated $1,350,000 of costs).  Thus, Jake’s company has earned $414,815 of the $2,000,000 contract. To date, Jake has invoiced the college $500,000 and has been paid $425,000 of this to date.  This is the balance sheet and income statement results related to the project to date.

                          Balance Sheet
Assets:
Accounts Receivable            $75,000 ($500,000 invoiced less $425,000 of payments)
Liabilities:
Billings in Excess                $85,185

                        Income Statement
Contract Billings                 $414,815
Costs of Construction           280,000
Project Profit                      $134,815

Note a few important interacting aspects of the two financial reports above:

  1. Jake has physically received $145,000 more in cash than he has expended related to this project ($425,000 paid to date less $280,000 expended to date).
  2. Of this $145,000 in cash received greater than costs, Jake has earned $134,815; thus, Jake has been paid $10,185 more than he has earned.
  3. The difference between the accounts receivable and the billings in excess is exactly $10,185 which is the actual cash received in excess of costs and earnings to date.

Therefore, billings in excess includes all outstanding receivables related to the project plus any cash received in excess of costs and profits earned to date.

The key to defining billings in excess is that the contractor has handed the customer requests for payments that exceed the dollar value of what he has paid out and earned.  This is quite common with large contracts because the contractor does not have the wherewithal to fund the project.  It is very similar to the really small contractors that say to their customer that they want 30% up front. Until that contractor has done 30% of the work, that contractor has billed in excess of his work. 

With the completed contract method, this is rare because most of the financing arrangements require the contractor to have materials and performance completed before a bank will finance that stage of construction.  Even if the completed contract method contractor is using the customer as the financier, the customer wants performance before they pay. There are times under the completed contract method whereby the customer pays a deposit on a project and the contractor has not done any of the work nor bought the materials. It is here that there will exist billings in excess.  It is uncommon to use billings in excess when the completed contract method of accounting is used, especially in the custom home construction industry. 

With the direct method of accounting, most projects are completed within 90 days of the contract signature. Therefore, accountants will rarely if ever calculate the billings in excess as it does require knowing both estimated costs and actual costs to date along with the percentage of completion. In effect, the accountant must convert the direct accounting to a percentage of completion accounting in order to determine billings in excess. Due to the costs involved, it is rarely done. Think about it for a moment, the whole project will be completed within 90 days; so why incur such costs to determine a value that will have little to no impact with decisions that the owner of the company makes?

Formula for Billings in Excess

To properly calculate billings in excess, the accountant must know four pieces of information. Without all four data points, you cannot accurately determine billings in excess. The four pertinent information sources are:

  1. Total contract value
  2. Estimated costs of construction
  3. Actual costs of construction to date
  4. Invoice values to date for the respective project

To determine billings in excess, the contractor must know how much he has paid out to date for the contract’s hard costs and his earned profit to date based on the percentage of completion. It is assumed that the estimated costs are accurate. Therefore, actual costs as a ratio of total costs determines percentage of completion. This means the contractor has a legal right to this dollar value for the work he has performed to date. Go back to Example #2 above.  Jake’s actual costs to date are $280,000 meaning he has completed 20.7% of the contract. Jake simply determines the percentage of completion by dividing actual costs by estimated costs of $1,350,000 which derives 20.7%.  Since the total contract is $2,000,000, Jake has earned a right to collect $414,815.

To determine this, Jake must know his actual and estimated costs along with the total dollar value of the contract. The final step is of course actual billings to date for the respective project. If Jake’s actual billings to date were $395,000, then Jake would have zero billings in excess for this project as he hasn’t exceeded $414,815 in invoicing to date.  He has an asset called Costs/Earnings in Excess of $19,815. He is entitled to collect this value from his customer.

Billings in excess are determined for all projects and is customarily done in a spreadsheet that looks like this:

Project      Contract     Estimated      Actual         Percentage       Earned      Billings        Billings
Name         Amount         Costs            Costs          Completion      to Date       to Date       in Excess
180307      $3,181,074    $2,342,707    $1,908,402      81.46%        $2,853,200   $2,900,000    $46,800
180716        6,085,000      4,861,300      3,502,618      72.05%          4,384,307     4,171,500   (212,807)

Each of the value columns are summed to determine the total amount of billings in excess. Some accountants will have an additional column for Costs/Earnings in Excess so any negative billings in excess values are reported as positive values in this column. This way both billings in excess and costs/earnings in excess are reported on the balance sheet as current liabilities and current assets respectively.

In general, it is considered poor business practice to have billings in excess. The reason is that it is frowned upon by bankers and bonding agencies as it means the contractor owes due diligence to the customer to get this work done. It is a legal obligation. The reality is different, if a contractor has billings in excess, then the contractor is getting the customer to pay the money up front reducing the risk of non-payment on the contract. The most common reason this value exists for most contractors is because the contractor charges mobilization to the customer as a part of the agreement. The higher the dollar value, the more likely the contractor has projects in the early stages of construction.

Accounting for Billings in Excess

There are generally two systems used to record percentage of completion with construction accounting.  Both systems result in the same outcomes at the end of the accounting period, its how the activity is handled and recorded during the interim accounting periods.  

The first method and not commonly utilized is the balance sheet method.  Both costs and billings are recorded to the balance sheet.  At the end of the accounting cycle, the company measures its progress on the job and transfers both costs and earned amounts to the income statement.

The second system records all costs and all invoices generated straight to the income statement during the interim period.  At the end of the accounting cycle the company again measures its percentage of completion and adjusts the income statement for both costs and receipts. This is the most commonly used method as the balance sheet method is slightly more sophisticated and requires an accounting staff that can create the necessary schedules and supporting documents to generated accurate results.  

Each system still utilizes the schedule as illustrated above. The difference is that the adjustment is either made to the balance sheet under the first system or to the income statement with the second system. The adjusting journal entry is called the Percentage of Completion (POC) adjustment. In general, if billings are in excess, the revenue section of the income statement is reduced by this amount (under the second system above); see below for a profit and loss illustration:

                  ABC Construction Inc.
  Income Statement (Revenue Section Only)
              Quarter Ending 03/31/19

Contract Billings                      $Z,ZZZ,ZZZ
POC Adjustment                          (ZZZ,ZZZ)
Net Contract Billings               $Z,ZZZ,ZZZ

On the balance sheet, the Billings in Excess account is adjusted to reflect this dollar value. Once done, the current liabilities section of the balance sheet will reflect any revenues recorded to customers that exceed the value the company has delivered to date. Remember, this is the definition of ‘Billings in Excess’.

Controlling Billings in Excess

Billings in excess is an interesting diametrically opposing business principle. First off, it is recorded as a liability which is correct. The contractor owes back to the customer value for invoices sent to the customer; i.e. the contractor is binding the customer to a payment which in turn binds the contractor to deliver a product.

On the other hand, when the customer makes this payment, the contractor is getting cash in advance of cash expenditures related to the project.  He is getting prepaid for his services.  This beats the heck out of going to a bank to get money as often the terms and conditions, not to mention interest and fees, are time consuming and expensive. It’s free capitalization of the project. In construction, this is really good news.  

As a business operator, having billings in excess is actually a good line item on your books. Banks and other financiers along with owner’s will not like this as it means you must spend cash to deliver the product or service.

Given all this, why is it important to be concerned with billings in excess?

From a capitalization viewpoint, having billings in excess is good news; but financially, it is detrimental to the overall financial status of the company. Go back to how this dollar value is entered into the books of record: revenue is reduced, and a liability is recorded on the balance sheet. Therefore, equity decreases reflecting the reduction in value for owners of the company.  It is merely shifting ownership of the company’s assets from the owners to a third party, i.e. the customer. 

The key is to control billings in excess; specifically, the fronted cash from customers to do this work. Anytime a customer prepays for work, the contractor should hold the cash in trust and use this cash to pay for hard costs incurred to get the work done as the project progresses.

Go back to the examples above related to Jake’s contract with the college to build a student center. In the initial transaction, the college is invoiced for mobilization, but hasn’t paid the mobilization dollar amount as of yet. Thus, the asset created, account receivable, equals the corresponding liability created for billings in excess.  As Jake incurs costs to mobilize equipment and purchase initial materials, Jake begins to accumulate costs for the respective project. These costs can either be stored in the construction in process account (CIP), if using the balance sheet system, or expensed directly to the costs of construction on the income statement. 

If using the income statement system, at the end of the accounting period, Jake’s accountant would simply transfer costs from costs of construction to a current asset called Costs in Excess or Construction in Process.  Assume Jake’s accountant uses the balance sheet system of recording costs and accumulates costs in the CIP account for the respective project.  After one month, Jake has incurred $13,800 of costs, i.e. he has either paid for it in cash or agreed to pay the amounts via vendor accounts (accounts payable).  What does Jake’s balance sheet look like related to this particular project? 

Jake’s Construction
Balance Sheet
Z/ZZ/ZZZZ

Assets:
  Construction in Process             $13,800
  Accounts Receivable                 150,000
  Total Assets for Student Center                 $163,800

Liabilities:
   Accounts Payable                      $13,800
   Billings in Excess                    $150,000
   Total Liabilities for Student Center           $163,800

Notice how the assets do not exceed the liabilities for the project? Again, Jake has spent money (committed to paying his vendors) on the project and has done some work to date. The contract has a milestone Jake must reach before he is allowed to invoice the college for a progress payment. Jake has yet to reach this point.

The next day, the college pays the mobilization invoice. Now let’s look at the balance sheet related to this project:

Jake’s Construction
Balance Sheet
Z/ZZ/ZZZZ + 1 Day

Assets:
  Cash                                         $150,000
  Construction in Process               13,800
  Accounts Receivable                     -0-
  Total Assets for Student Center              $163,800

Liabilities:
   Accounts Payable                      $13,800  
   Billings in Excess                      150,000
   Total Liabilities for Student Center        $163,800

Again, assets equal liabilities related to the student center project. Now Jake uses the cash to pay his vendors the next day. Now look at the balance sheet for this project:

Jake’s Construction
Balance Sheet
Z/ZZ/ZZZZ + 2 Days

Assets:
  Cash                                         $136,200
  Construction in Process               13,800
  Accounts Receivable                     -0-
  Total Assets for Student Center              $150,000

Liabilities:
   Accounts Payable                      $-0-  
   Billings in Excess                      150,000
   Total Liabilities for Student Center        $150,000

Again, assets equal liabilities, except now Jake has cash for his project’s payroll and to pay vendors. 

The key to managing billings in excess is having an equal or more amount in assets to meet the obligation that billings in excess creates for the contractor. If the asset value is in the form of cash, then this cash should be held in trust for the project and not to be used for other purposes. Many contractors use this cash to pay other bills not related to the contract. This is commonly referred to as ‘robbing Peter to pay Paul’. In some states, it is illegal and considered criminal. In other states, it is a civil issue and in others, there are no laws related to financial requirements. Many customers demand the contractor to carry a bond to complete the work as protection against spending cash on other projects that has been fronted by the customer.

An important part of controlling billings in excess is to not allow the value to get out of hand. When billings in excess exceed 7% of the total value of all projects combined as a portion of total contract values, the contractor increases his overall risk. Unless these fronted payments are held in a separate trust account, there is a tendency for less sophisticated contractors to feel flush with cash and they will spend the cash for other purposes such as purchasing fixed assets or issuing dividend/distribution payments to owners. This in turn creates a solvency issue when it comes time to pay for the actual work on the project. Thus, it is important to track billings in excess and have cash held in trust to offset the dollar amount related to billings in excess.

Other tools to control billings in excess include:

  • Create appropriate hard cost estimates for the projects
  • Good project management
  • Maintaining less than a 7% differential between actual costs and fronted amounts from the contract
  • Monitoring project progression against estimated hard costs as the project proceeds.

The above tools are commonly referred to as internal controls in accounting and with construction management.

Finally, there is one issue in construction that is often overlooked or misunderstood related to billings in excess. How do you calculate billings in excess or adjust the calculation when actual costs for construction begin to exceed the budgeted costs?

Remember, in the formula above, the contractor must have four pieces of information to properly calculate the value of billings in excess:

  1. Total contract value,
  2. Estimated costs of construction
  3. Actual costs of construction
  4. Amounts invoiced/paid to date by the customer

The formula requires determining the percentage of completion; in simple math it is the actual costs as a percentage of estimated costs (cost to cost method under percentage of completion). When actual costs begin to exceed the budgeted amount, the percentage of completion increases yet the actual percentage of completion is less. To compensate, the accountant must have the management team continue to update the estimated costs to complete the project. Thus, the estimated costs of the contract are adjusted higher. This in turn makes actual costs compared to the adjusted estimated budget generate a more accurate percentage of completion. The result is a lower profit for the project and a reduced amount earned to date. The difference between the amount earned to date and actual invoices (billings) sent to the customer increases. 

In effect, a greater liability is reported on the balance sheet reflecting the increased exposure for the construction company to get the work done.

Summary

Billings in excess is defined as the value in a construction contract assessed to the customer that exceeds the actual dollar amount invested in the project to date.  It is simply the liability exposure a construction contractor has related to the workload. Financially, having customers prepay for work is smart; however, without proper controls, contractors can get into financial trouble if billings in excess continue to grow as a percentage of overall contracted value. It is imperative to maintain a low percentage (less than 7%) related to billings in excess of total contract value or have cash held in reserve to offset billings in excess.

Be smart, use internal controls to 1) monitor billings in excess, 2) create accurate estimates for hard costs of construction, 3) hire project managers that can get the work done efficiently and 4) take profits once the project is done and not during construction.  ACT ON KNOWLEDGE.

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