Minimum Bottom Line Profit Should Average 9.4%!
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After Income Taxes Are Paid!
The contractor’s chart of accounts is significantly different than the traditional chart of accounts. First off, the layout is more dependent on the balance sheet than the income statement (profit and loss) accounts. Furthermore, the income statement accounts are laid out to present a resource based costing presentation than a job costing format. To add another layer of complexity, the chart of accounts is somewhat oriented towards the method of accounting selected by the contractor.
This article will explain all these variances and how to choose the proper chart of accounts for your contracting company.
To understand the appropriate selection for your entity, this article first explains the slight difference with the chart of accounts related to the completed contract or percentage of completion method that contractors utilize for accounting purposes. The second section below will cover the income statement and I’ll finish up with a few helpful hints.
Throughout, I’ll sprinkle in some of chart of accounts layout to reflect the subject matter at that point.
Completed Contract or Percentage of Completion Method
The accounting method selected has a significant bearing on the chart of accounts for a contractor. The two methods are:
This method accumulates all costs to a current asset account called construction in process (CIP). Other names for this account include work in process or construction in progress. All three names are acceptable. The key is that the account is similar to inventory. Think of a retail outlet for lawn equipment. The store buys the main product from the wholesaler and then assemblies the item and may add some accessories. Once this item makes it to the retail floor, it has materials, labor and other types of costs accumulated as the total cost for this one particular item. It sits on the balance sheet as inventory for retail. With construction, the concept is similar. The contractor buys materials, adds labor and ends up with a product for sales; in this case a house. Therefore, the CIP account mirrors the inventory account for a retailer.
The difference is on the liabilities side of the equation. A retailer generally pays for the materials via its vendor accounts. Since retailing has a shorter working capital cycle, the cash to pay the end bills is customarily fronted by the retailer’s retained earnings or some kind of line of credit. With contractors, it is different. Here projects are customarily longer term in the working capital cycle. Custom homes take nine to twelve months start to finish to complete the working capital cycle. Furthermore, it gets a little more complicated because the homeowner or end buyer will make deposits on the contract. Banks may front money for the work. Therefore, the balance sheet has a separated section within current liabilities to identify all these monetary resources. Look at this standard presentation for the contractor related to the completed contract method:
Chart of Accounts (Completed Contract Method)
Construction in Process
Take note, the completed contract method utilizes three distinct accounts on the balance sheet for the contractor.
- Construction in Process (CIP) – current asset
- Customer Deposits/Payments – current liability
- Project Notes – current liability
These three accounts accumulate the dollars for the actual costs of construction via the CIP account and the sourcing of funds whether from the customer or as draws from a bank note. When the project is completed the accounts are cleared of the actual costs and sources of money to the income statement. This method focuses on when the project is completed. The other method is slightly similar, but more complicated. Percentage of completion is designed for larger contractors, i.e. contractors doing more than $20 Million per year in work.
Percentage of Completion Method
This method is somewhat similar to the completed contract method except it posts the costs and the revenue associated with those costs to the income statement every accounting cycle (monthly or quarterly). Any activity in the interim is accumulated in the construction in process account for costs. But because these contracts are typically longer in duration, the contracts are more intensive and thus, more accounts are required. The following are the traditional accounts associated with the percentage of completion method:
Construction in Process
These accounts follow the flow of how a percentage of completion method works. The key is that the percentage of completion method accumulates all items to the balance sheet during the interim accounting period and then using a process, transfers the costs and revenues earned to the income statement at the end of the cycle. Notice a few differences with this method over the completed contract method.
First off, there is an accounts receivable account. This is because, unlike the completed contract method whereby the customer or the bank simply fronts money during the construction process; with the percentage of completion method, the customer/buyer is legally obligated to pay as the project goes through stages of construction. With the completed contract method, the contract states that the legal obligation is fulfilled once the project is done. The percentage of completion method is different because it often takes more than a year to complete the work, therefore the contractor wants to recognize his earnings as he progresses. The contract and the corresponding accounting is designed with this in mind. Therefore, as the contractor invoices the customer for services and costs rendered, the customer then owes the contractor this amount. So one key difference between the two methods is that invoicing occurs with the percentage of completion method, whereas with the completed contract method, invoicing does not exist. The customer merely fronts money in accordance with the contract.
Another difference between the two methods relates to the end result. With the completed contract method, the project is accepted by the customer at the end of the project. With the percentage of completion method, the customer often accepts the project in incremental steps. However, the customer wants some financial incentive to get the contractor to get the project done. This form of insurance is achieved by the utilization of a retainage clause in the contract. Here the contractor reserves out a long-term receivable called retainage (customarily 8 to 10% of the contract) and the customer holds this amount in reserve and pays once the project is complete. As each step is invoiced to the customer, a part of the invoice is accumulated in the retainage account which is paid once the project is approved and completed.
A third difference relates with the customer deposits account. Under the completed contract method, the account also includes customer payments. Under that method, in addition to the initial deposit the customer often has to prepay for any change orders or upgrades requested. Under the percentage of completion method, any change orders or upgrades are simply invoiced to the customer as that work is done. Thus, no need to have the payments extension on that account’s name. It isn’t customary for a customer to make a deposit for the project with the percentage of completion method. However, there may exist a customer deposit with the percentage of completion method. Many contractors refer to this as the mobilization aspect in the contract, thus the requirement for a deposit. Others require it if there is a need for initial outside work that must be done to get ready to get the project underway including engineering work, bonding requirements etc.
The most interesting account with the percentage of completion method relates to progress billings. Notice with the completed contract method, there are no progress billings? Why? Often a bank finances a project, but this financing is most commonly tied to the customer’s credit and not the contractor’s credit. However, many contractors will build spec houses or build customized homes for customers and the land is owned by the contractor. Thus, the contractor is financing the project, therefore you customarily see a project notes account under the completed contract method. With the percentage of completion method, the customer gets the financing and pays off an invoice, i.e. a progress billing. This account is used during the incremental time period by the contractor. Once the accounting cycle closes, the contractor will transfer the entire dollar amount to the income statement that is in this account. Therefore, it is rare for this account to have a value in it at the end of an accounting cycle. It may have value due in it related to timing issues (progress invoices allowed based on completion milestones as stipulated in the contract), but most often it has a zero balance in it at the end of each accounting cycle.
Both methods require the transfer of the accumulated costs to the income statement at some point.
Income Statement Accounts
With a contractor, he/she is really interested in knowing four distinct sets of information.
- Contract Work, (Sales)
- Direct Cost of Construction (Cost of Sales)
- Indirect Costs
I’m sure you are reading this and saying to yourself, what the heck are indirect costs? To understand this, let me explain the first two groups and then you’ll have a better understanding and hopefully, an appreciation of the third group.
The income statement isn’t really designed around the particular accounting method. It is designed to illustrate to the reader the four major groups associated with construction.
This is merely the sales related to the work done. Under the completed contract method, the value increases when a project is done. Both the revenue and the corresponding costs are transferred from the balance sheet to the income statement. This method customarily sees large values in change related to the completed contract method for both the contract work account. As with the construction in process account, this particular account can have several different names, but they all mean the same thing, the amount legally earned by the business for work done. Other names include:
- Contractual Progress
- Construction Completed
There is no legal requirement to use a particular name, use what you are comfortable with. Just remember, this account refers to sales made as it relates to a contract.
In addition to the primary sales account above, many contractors will separate out customer change orders and upgrades to the sales function. Thus, gross sales may have an account structure such as this:
Sub-Total Gross Sales
By the way, the difference between upgrades and change orders relates to the contract. Customarily, upgrades is an addendum to the contract, whereas a change order is a separate agreement done on the side and the customer prepays for this work. Basically, upgrades are more comprehensive than change orders.
We’re not done yet.
As with any company, especially retail, customers often dispute the purchase or the retailer uses some kind of advertising campaign to initiate the sale. Construction is no different. Often, contractors use outside services to get a contract. You see this most often with home builders. They will use a broker to sell a house. This is an adjustment to the total sales price and includes some closing costs, especially under the completed contract method. Offsets (contra-accounts) to gross sales include:
- Commissions Paid
- Contract Allowances – Incentives to get the customer to finish the deal
- Closing Costs
Therefore the sales area of a contractor’s chart of accounts will look like this:
Completed Contract Percentage of Completion
Contracted Work Yes Yes
Upgrades Yes Yes
Change Orders Yes Yes
Miscellaneous Yes Yes
Commissions Yes Yes
Contract Allowances Yes Yes
Closing Costs Yes No
There are several articles on this site addressing allowances, contract allowances are different. Here, this account has nothing to do with typical allowances granted to the customer for their selections related to the kitchen or bathroom. This account refers to granting the customer allowances because the contractor FAILED to get something done in accordance with the contract. It could be the quality of the materials or failures to get the project done by a certain deadline etc. It has nothing to do with selections.
The end result from above is NET CONTRACTED SALES.
Direct Costs of Construction
The direct costs of construction refers the actual costs that can be directly associated to a particular project. Materials bought are customarily assigned to a respective project. The same goes for labor, subcontracting, equipment usage and other costs. This section identifies those costs based on the typical third party understanding of what goes into a project. Direct costs include:
Those costs accumulated in the construction in process account over on the balance sheet are transferred to the income statement and grouped by their respective resource used to build the project. Some contractors will include an account for warranty work for work already completed. Notice these costs are directly related to the CIP account.
Indirect Costs of Construction
Unlike direct costs which can be directly tied to a project, indirect costs of construction cannot be tied to a project. Why? Because they are customarily shared among several, at least two, projects. The perfect example is transportation. The project manager’s truck is driven to several different projects each week. How do you assigned the gasoline purchased? You can, but it requires tracking miles exactly and multiple source inputs to a spreadsheet and the cost to calculate this isn’t worth the benefit.
Therefore, you accumulate these indirect costs into one section so the reader of financial reports can understand that there are costs to do construction work, but have nothing to do with the office nor can they be directly assigned to a project. Customary accounts for indirect costs include:
- Project Management – most project managers work more than one job at a time. Thus it is very difficult to allocate or assign their time to a particular project.
- Transportation – all the costs related to field vehicles are recorded here and often these vehicles are used in more than one project.
- Insurance – general liability, worker’s compensation, errors and omissions etc. are accumulated in this account. However, builder’s risk and bonds are always assigned to a project since they are customarily received by project. Those directly assignable end up in the ‘Other’ direct cost account as noted above.
- Communications – cell phones, radios for field operations
- Supplies – safety equipment, small tools and documentation are assigned to this account.
- Management and Administrative Payroll
- Office Operations
- Taxes and Compliance
You can add a miscellaneous account as a catch all, but most accountants include the miscellaneous account as one of the accounts under office operations.
Summary – Chart of Accounts
A few helpful hints are appropriate at this point:
- Design your chart of accounts around the particular accounting method you will use. Job costing is different and is a function of item codes or job costs including phase codes. In general, the chart of accounts is rarely affected by job/item codes.
- The information provided is designed for contractors generating less than $50 Million in sales per year.
- Spreadsheets are often used when transferring balance sheet account information to the income statement; basically the spreadsheet groups the respective entries in the CIP account into their income statement account groups. There are a couple of articles on this website that explains this in detail.
- Very few CPA’s truly understand this, so seek out one with construction experience when asking for advice.
- Your system DOES NOT have to conform to any preexisting standard; there is no such thing. Design it to fit your company and the outcomes you seek.
Although the above looks complicated, developing a chart of accounts is merely a process of acknowledging your accounting method and the processes you currently utilize or will work with in the future. If you need advice, I’m here to help, email@example.com. ACT ON KNOWLEDGE.