Construction Accounting – Balance Sheet Construction in Process Accounts

Construction accounting consists of three major groups of accounts. The first and most understood set are the accounts found on the profit and loss statement. Customarily referred to as Cost of Goods Sold or Costs of Construction, these accounts convey the total costs of construction against the revenue earned for those contracts. The second major group is located on the balance sheet in the current assets section. This group is called the ‘Construction in Process’ (CIP) accounts. The third major group is also located on the balance sheet down in the current liabilities section and is called ‘Construction Billings’ or ‘Construction Deposits and Draws’.

This article explains the balance sheet accounts related to construction accounting. I will explain how they are designed, formatted and presented. In addition, I’ll explain the impact either the completed contract or percentage of completion method has on the corresponding project’s account balance. Finally, I’m going to explain to you how to interpret the information presented.

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In another article I will go into detail related to Construction Billings and the corresponding deposits and draws. This article will focus on the Construction in Process/Progress or what is commonly shortened to CIP.

To fully appreciate and understand this form of construction accounting it is best that you have some background knowledge before your read this balance of this article. Also, the information I present here is detailed and lengthy; so please bear with me as you read this. The benefits will be well worth the time invested. Before we begin, please read the following articles so you have some background related to this article. I include a short description of each just in case you already understand the subject so you may skip the matter and keep moving along.

How to Read the Balance Sheet – Simple Format – a basic introduction to the balance sheet and how it is laid out and read. This is for the novice business owner to begin the process. If you are already familiar with the meaning of current assets than you will not need to read this article.
How to Use Class Accounting in Construction – class accounting should be used for residential contractors involved in more than just one area of residential construction. So if you perform two or more of the following: new home, remodeling, renovation, additions or restoration; then consider using class accounting for your construction company.
Project Accounting Principles for Contractors – an extremely in depth explanation of project accounting for residential construction. A lot of attention is given to terminology and understanding the financial position related to the project as it progresses. A detail example is illustrated for phase accounting using insulation. This article goes into the details for Construction in Process (CIP).
Percentage of Completion Method for Construction – a method of accounting whereby the costs associated with the percentage of completion achieved to date for a project are transferred to the profit and loss statement at the end of each cycle. In addition, the revenue generated to date is also transferred to the profit and loss statement.
Completed Contract Method of Accounting for Construction – a method of accounting used by most small construction companies or used for lower value projects or projects of a short duration. In a nutshell, all costs are accumulated on the balance sheet until the project is completed and the final invoice is generated to the customer. At this moment, all the costs are then transferred to the profit and loss statement’s costs of construction accounts.

For the sake of ease and understanding, Construction in Process or Construction in Progress will be referred to as CIP. On the flip side of this are deposits and draws received for the projects. These are sometimes referred to as billings and are handled in several different ways for the purpose of properly recording this information to the profit and loss statement. Again, I cover the deposits and draws for projects in a related article that I will post to this site prior to the end of May 2016.

Now that we all are in agreement to the terminology and the basic principles involved, let’s begin to get into the details. First up, a basic understanding of the balance sheet related to CIP and Billings.

Construction Accounting – Introduction to Balance Sheet Format

In most industries, the balance sheet’s upper half has three distinct groupings of accounts. They are current assets (cash, receivables and inventory), fixed assets (vehicles, equipment and office technology) and other assets (intangibles, long-term receivables and deposits made). In general it looks like this:

XYZ, Inc.
Balance Sheet
December 31, 201X

ASSETS
Current Assets:
    Cash $ZZ,ZZZ
    Account Receivables ZZ,ZZZ
    Inventory ZZ,ZZZ
    Sub-Total Current Assets $ZZZ,ZZZ
Fixed Assets:
    Vehicles ZZ,ZZZ
    Equipment ZZZ,ZZZ
    Office Technology/Fixtures ZZ,ZZZ
    Accumulated Depreciation   (ZZ,ZZZ)
    Sub-Total Fixed Assets (Net) ZZ,ZZZ
Other Assets:
    Financing Agreements (Net) Z,ZZZ
    Undeveloped Lots   ZZZ,ZZZ
    Sub-Total Other Assets ZZZ,ZZZ
Total Assets $ZZZ,ZZZ

In construction, project accounting values are a function of inventory. Think of it like a retail store, your product is in the process of getting ready to be purchased by a customer. Therefore, CIP is a subset of inventory. Now most contractors have no other form of inventory other than the various projects in stages of construction. So the current assets section will look like this for a contractor:

Current Assets:
Cash $ZZ,ZZZ
Account Receivables ZZ,ZZZ
Construction in Process ZZZ,ZZZ
Total Current Assets $ZZZ,ZZZ

Notice the word inventory is not used. Therefore the dollar value associated with CIP reflects the total amount of money expended for all the projects under construction combined. The next section will elaborate on this in more detail.

Construction in Process Presentation Format

Now we get into the nitty-gritty stuff. The CIP account in the current assets section reflects the combined total of all expenditures related to existing projects. So let’s assume you have six different projects in progress. For now, it doesn’t matter whether the project is a new home contract, a spec house or an addition; you simply have six different projects. The value on that line of current assets reflects the combined total of all six projects. In detail it will look like this:

Current Assets:
Cash $ZZ,ZZZ
Account Receivables ZZ,ZZZ
Construction in Process:
#140819                            $ZZZ,ZZZ
#141021 ZZZ,ZZZ
#141108 ZZ,ZZZ
#150113 ZZ,ZZZ
#150327                            ZZZ,ZZZ
#150416           Z,ZZZ
Sub-Total CIP ZZZ,ZZZ
Total Current Assets $ZZZ,ZZZ

Now I’m a big advocate of class accounting in construction. So if you have several divisions of construction such as:

New Home
Spec
Additions
Remodeling
Renovations
Restoration
Mitigation

Then you would really gain advantage by rearranging the projects into their respective classes of construction. Now I’m going expand the above CIP account and illustrate CIP by classifying the data into groups. So for this presentation format, this particular contractor builds new homes via a design/build contract, builds spec houses and he does additions. He doesn’t get involved in the remodeling industry but that is where he started out. So let’s take a look at the CIP account laid out in a ‘Class Presentation Format’ summation based:

Current Assets:
Cash $ZZ,ZZZ
Account Receivables ZZ,ZZZ
Construction in Process:
Design/Build                     $ZZZ,ZZZ
Spec ZZZ,ZZZ
Additions                          ZZZ,ZZZ
Sub-Total CIP   ZZZ,ZZZ
Total Current Assets $ZZZ,ZZZ

‘Class Presentation Format’ detail arrangement:

Current Assets:
Cash $ZZ,ZZZ
Account Receivables ZZ,ZZZ
Construction in Process:
Design/Build
#141021 $ZZZ,ZZZ
#150327 ZZZ,ZZZ
Sub-Total $ZZZ,ZZZ
Spec
#140819 ZZZ,ZZZ
#150113 ZZ,ZZZ
Sub-Total ZZZ,ZZZ
Additions
#141108 ZZ,ZZZ
#150416 Z,ZZZ
Sub-Total ZZ,ZZZ
Sub-Total CIP ZZZ,ZZZ
Total Current Assets $ZZZ,ZZZ

All three presentation formats are acceptable. I prefer the more detailed format especially if you run three or more classes of construction. If you only have only one class of construction, then use the first presentation format I illustrate above. But let me ask you, doesn’t this look informative? You can clearly ascertain the amounts invested into each one of the projects that are ongoing. This is essential in understanding where your funds are utilized.

But this raises a question. Does the completed contract method or the percentage of completion method affect this dollar value?

The answer is yes sir it does. Now, let’s explore this issue related to the presentation format of CIP.

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Completed Contract or Percentage of Completion Method – Impact on the CIP Accounts

If a contractor uses the completed contract method of accounting; the accountant customarily transfers all of the costs accumulated for the project to the profit and loss statement’s costs of construction section at the completion of the project. So when you are looking at the CIP accounts on the balance sheet in a detailed format, each project’s costs reflect NO transfer of costs to the P&L. Therefore, the completed contract method reflects the total accumulated costs for all projects that are currently under construction.

However, with the percentage of completion method the results are different. This method generally transfers the accumulated costs each accounting cycle (most common cycle period is monthly) to the profit and loss statement’s costs of construction accounts. When you transfer the dollar value associated with the respective project, the value in the project’s account under CIP remains relatively low and at times zero. The zero usually occurs at the end of the accounting cycle and definitely at the end of the project.

Remember, the balance sheet reflects a snapshot of a moment in time. If the balance sheet is dated for the last day of the accounting period and the accountant has transferred all the costs associated with the project to the profit and loss statement, then the value for the respective project will be zero on that day. The day before, the balance will be high for that project and reflects all the costs incurred through that moment in time that HAVE NOT been transferred to the profit and loss statement.

With a traditional spreadsheet presentation it would look something like this:

Project ID # Period #1 Period #2 Period #3
Beginning Balance New Period -0- $800 $1,127
Costs Accumulated During Period $9,714 23,942 5,847
Total Non-Transferred Costs 9,714 24,742 6,974
Costs Transferred to P&L (8,914) (23,615) (6,974)
Ending Balance in Project’s CIP $800 $1,127 -0-

In percentage of completion method, some elements of the project have little to no progress made but have incurred costs such as materials are on the job site. In these situations, the evaluator keeps the percentage for that function at zero and at the same time does not transfer the costs to the profit and loss statement. So it is possible to have some costs remain on the balance sheet associated with a project that is managed for accounting purposes under the percentage of completion method. I illustrated this above with the ending balances at the end of periods one and two with some balances.

As an example:

Using the costs illustrated above, assume this is a bathroom remodeling job. Around the 20^th of the month, the tile for the tub is delivered and is set in the garage because there is no room for it in the bathroom. Because the contractor is a couple weeks away from setting the tub tile, he decides at month’s end to not include this element of construction as completed or even assigned any percentage. However, the contractor has paid for the tile and its cost is accumulated onto the balance sheet.

In period two, the contractor did set the tile but at month’s end has not mounted the base for the vanity as it now has been purchased and is in the garage to prevent damage while awaiting installation. Again, the contractor does not assign any percentage of completion to this step in the contract and therefore does not transfer any costs of installing the vanity to the profit and loss statement. Therefore the balance sheet CIP account has this accumulated value sitting in this project’s account.

Therefore, when looking at the CIP accounts on the balance sheet in detailed format, the project may have a balance in its account. Most often they do not; but this is strictly a determination made by management in evaluating their monthly progress for projects.

Construction Accounting – How to Review and Interpret Information

As of now, you should have a clear understanding of how Construction in Process accounts are presented and formatted on the balance sheet. In addition, based on the accounting method used (completed or percentage of completion) you can understand why the associated balance exists. Now I need to explain to you how to review and interpret the information.

For any contractor, it is critical to understand where you are in the overall scheme of progress related to your respective projects. Conceptualize each project as two primary financial components. Every project will have the core costs associated with construction (materials, labor, subcontractors and other direct costs) and margin. The margin includes money to cover indirect costs of construction such as management salaries, transportation, insurance, and other payroll costs such as benefits and retirement contributions. In addition, the margin will also include money to cover the overhead costs (front office operations) and finally the best part, PROFIT for the contractor.

When looking at CIP value in a project’s account, I usually envision the overall progress the company has made on the project. If the total contractual amount for project is $200,000 and the costs in the account have accumulated to $42,000 I would wonder how much have we earned as margin. Well to evaluate this, we would need to estimate the percentage of completion to date. Based on the project manager’s description he tells me the foundation is complete, the framing is done and the roof is on. However, none of the trades have started nor are there windows or exterior doors etc. Therefore, he estimates the project is 30% complete.

OK, now we have something to work with. If we are 30% complete then basically we have earned about $60,000 of our $200,000 contract. If this is true, then I simply deduct my direct costs of $42,000 from the $60,000 we have essentially earned and I have a margin earned of $18,000. I can live with that and feel comfortable the project is earning money for the company.

But this is the more common outcome. I most often would get that the project is 20% complete and thus we have only earned about $40,000 of the $200,000 contract and have spent $42,000 to date. That’s when the cussing starts. I need to investigate and usually it’s a simple matter of looking at the details in the CIP account of all the bills we have received and their corresponding function.

Frequently, the bills received reflect materials delivered to the job site. Often materials show up well before they are needed. In the case presented in the prior paragraph the project manager explains that the house is still being framed, but my materials reflect all of the framing materials delivered and a couple of pallets of shingles too. In my head, I adjust the costs downward to reflect the costs for shingles, plywood and the trusses. In addition I subtract costs for the two pallets of shingles, felt paper, vents, roofing nails, etc. and now my costs are closer to $29,000. So now I can tell that we indeed are generating margin from this project as the actual costs in my calculation correspond to the actual progress made.

By the way, this mirrors the percentage of completion method of accounting in construction.

You should do this for each project in the detail format of CIP. This will provide a lot of comfort in understanding where you are in the overall scheme of earning money for the company.

Now that you understand how to review the information, let’s progress a little more and interpret the information too.

To start, let’s review the process associated with a bill from a supplier. When a bill is received, it should be stamped with a progress stamp identifying the project id number, the phase of construction, dates and initials of the project manager that indeed he ordered this material and approves of the corresponding costs. From here the accountant books the entry to the accounting records. The accountant debits the corresponding CIP account assigned to this project and credits the Supplier Payables account down in current liabilities. If you are not familiar with the presentation format of current liabilities, please read Current Liabilities Section of the Balance Sheet for a comprehensive understanding.

What this means is that materials are on the job site, but we have not paid for them yet! This is important to understand, you must have the cash to pay for the materials which is explained in a different article but for now, you have not physically paid for the materials.

I advocate to contractors to divide their account payables into two distinct groups. The first account corresponds to your traditional understanding of account payables and it reflects the indirect and overhead costs of operations. When the fuel for the trucks bill arrives, it goes into this account. Same for office supplies and the electric bill for the office and so on.

However, for those bills that are directly assignable to the projects, I advocate entering these bills as payables to suppliers. This includes bills from subcontractors, the bank for interest related to the financing of the respective project, even the port a potty for the respective project. Any bill that has a direct connection to a particular project is coded to this account. You can name the account any of the following:

Supplier Payables
Project Payables
Direct Payables – reflects that these costs have a correlation to direct costs of construction
Vendor Payable

I prefer Project or Supplier Payables as the name of the account.

Now when you look at the balance of this account, it reflects the unpaid direct costs of construction. This is important as it does have a relationship to the CIP. How so? Well the difference between the two amounts should always be that CIP is greater than Project Payables. Below is an example of a presentation format related to these two accounts on the balance sheet:

Construction in Process:
      Design/Build
#141021             $ZZZ,ZZZ
#150327             ZZZ,ZZZ
Sub-Total $ZZZ,ZZZ
Spec
#140819             ZZZ,ZZZ
#150113                 ZZ,ZZZ
Sub-Total ZZZ,ZZZ
Additions
#141108                 ZZ,ZZZ
#150416                  Z,ZZZ
Sub-Total ZZ,ZZZ
Sub-Total CIP $ZZZ,ZZZ

Project Payables $ZZ,ZZZ
Difference B/T CIP & Payables should be > value w/CIP.

Think about this for a few minutes. In a typical relationship, most projects have a deposit fronted by the customer or homeowner. This cash is used to pay the corresponding bills associated with their respective project. Therefore, your project payables should always be less than the CIP. In addition, as you transfer costs associated with a project to the profit and loss statement’s costs of construction accounts, you also transfer the corresponding revenue. This means that the customer owes you money or should pay you the money in very short period of time via a draw on the contract. It is rare for project payables to exceed the balance of construction in process. It doesn’t mean it can’t happen, it means that it should be rare!

If it does happen then you may have some serious issues in the company. These include in order of seriousness:

Insolvency – this is easily evaluated by determining if there is cash available to pay the project payables. If cash is available, then insolvency is not an issue.
Unpaid receivables – this is the most common reason for unpaid project payables. In effect the customer has not paid their bill from you related to their project’s costs. Most often it is a timing issue related to a draw on a project or the customer is holding on to payment for some disagreement related to the contract, such as the wrong materials.
Deferral of paying project payables – this is also another common reason to not pay the bills. Contractors frequently go through high production periods (good weather, significant dollar related phases) without the corresponding receipt of cash related to progress billings or not billing related to the significant percentage of completion. The best example relates to having a project go from foundation to completely framed and dried in (windows, exterior doors, roof on and siding up) and the contractor is in the process of requesting a draw on the project and the project has not been inspected by the bank to confirm the value associated with the percentage completed.
Accountant is on vacation – yes they do take vacations and when they do, they don’t pay the bills.

Again, it is important for you as the owner to interpret the information provided, compare the total CIP value against the project payables and if you owe more than what has accumulated in the CIP account; you need to investigate. You need to feel comfortable that there is a justifiable reason for this discrepancy.

Summary – Construction in Process Accounts

Like I stated at the beginning, this is a long article. But now you have a real appreciation associated with how project accounts are presented on the balance sheet. There are several different formats and I advocate the detail by class arrangement and summation by class and then summation to the total Construction in Process. Now that you understand how to present the information, you should now have an understanding of the impact either method (completed contract or percentage of completion) has on the values in the CIP.

Finally, I explain to you why this is important. You can’t evaluate each of the projects based on their respective percentage of progress against the corresponding direct costs and determine overall production for the company. Furthermore, by comparing the aggregated dollar value of all projects and comparing this amount to the unpaid direct costs you can evaluate your overall cash flow needed to facilitate further production. With this information and understanding of the auxiliary information I provide you should begin to appreciate the relationships CIP provides to the other areas of the financial reports. Act on Knowledge.

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