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A common problem for contractors is setting up item codes in their accounting software. Most accountants and bookkeepers fail to fully understand the concepts behind item codes and how it works with the construction industry. This article is designed to explain to you the underlying concepts and how to set up item codes for contractors.
To understand the concepts of item codes, first the reader must understand the three methods of construction accounting. With this knowledge of the three forms, the creation of item codes becomes clear with how to set them up. I’ll finish with a few examples and how the accounting unfolds tying the codes to the financial reports.
Three Methods of Construction Accounting
Accounting textbooks will tell you there are only two methods of construction accounting. The reality is that there are three. I’ll explain the two textbook methods first then tell you about the third.
The first and most commonly used method is referred to as the ‘Completed Contract Method’. Simply stated, the project’s costs and associated customer payments or draws are recorded to the balance sheet and upon completion, the project’s costs and receipts are transferred to the profit and loss statement. It is sometimes referred to as the balance sheet method for construction accounting.
The second method, used mostly with large contractors or projects is called the ‘Percentage of Completion Method’. This method transfers costs to the profit and loss statement at the end of each accounting period. Similar to the completed contract method, the costs and earnings are accumulated on the balance sheet and then based on the percentage of work completed during that accounting period, those costs and earnings are recorded to the income statement (profit and loss statement).
There are variations of the two textbook methods. If you need to read up on those variations, please refer to Contractor’s Audit Guide.
However, there is a third method and it is used mostly with smaller contractors, remodelers, restoration contractors, and construction trades. Unlike the textbooks methods whereby the costs and associated receipts/earnings are first recorded to the balance sheet, this method takes all costs and earnings straight to the income statement (profit and loss statement). This method is called the direct method. It makes sense, most smaller contractors, remodelers, restoration companies and trades complete their work related to projects in less than 90 days. It is rare to have a project take longer than 90 days from start to finish to get done. This method is less complicated and reduces the accounting time to record economic activity.
In reality, the direct method is the most common if you measure it by the volume of economic activity recorded in accounting.
This creates a problem when setting up item codes (cost codes, phase codes etc.) with accounting.
Setting Up Item Codes
Item codes are used with cost accounting or ‘Project Accounting’ as it is known in the construction industry. The item code is given a name and it is assigned an account identification to record the debit side of the transaction. As an example:
Plumbing – Record the debit in the construction in process account.
In the above, the item code for plumbing assigns the debt to a current asset, like inventory, called construction in process. The credit side of this entry is based on how the work is paid. It can be entered as a bill from the plumber which means the credit is recorded to accounts payable. Sometimes, it is paid with a check or via a debit card which means the credit is straight to the operating bank account. But the key to this is how the debit is recorded. It goes automatically to the construction in process account which is traditional set up as a control account.
When setting up this item code in the accounting software, the software wants to know where you want to record the debit side, the credit side is based on the entry source (bill from a vendor, credit card transaction, check or debit card).
With either the completed contract or percentage of completion method, assigning the debit to construction in process (work in process or construction in progress) is correct. Again, the construction in process account is a balance sheet account. However, if you are using the direct method of accounting, this isn’t going to work. Remember, with the direct method, the debit needs to go straight to the income statement (profit and loss statement) for accounting purposes. Therefore, if you are using the direct method of accounting, when setting up the item code, set the account straight to the cost of sales section (a.k.a. costs of construction), and the appropriate sub account (land, materials, labor, subcontractors, equipment and other). Thus, for plumbing, the appropriate debit account to record the entry when using the direct method is costs of construction/subcontractors.
The same is true related to setting up the item codes for the revenue side of the project. Here, the accounting method determines where the credit side of the entry is recorded. If using the completed contracted or percentage of completion (or one of the variations of these two methods) the credit is recorded to the current liabilities section of the balance sheet. If the company is using the direct method of accounting, set the credit account to one of the revenue accounts on the income statement (profit and loss statement).
Setting up item codes is easy once you understand the relationship between the method of accounting used and where the debit side of the entry is recorded. If using the completed contract or percentage of completion method, set the debit side up to record the value to the construction in process account. If using the direct method (normal for subcontractors and remodelers), set the debit side of the entry to go directly to the costs of construction section of the income statement (profit and loss statement).
As a side note, some contractors use both direct and completed contract method. This is quite normal with contractors that build homes and provide remodeling services too. In effect, they have several classes (divisions of income) related to their organization. If this is the case, the accountant needs to set up two sets of item codes, one set for the completed contract method and another set for directly assigning the debit/credits to the income statement. When entering the bills or charges, the bookkeeper must select the proper item code from the correct set. ACT ON KNOWLEDGE.