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.
Completed Contract Method of Accounting
The completed contract method of accounting recognizes revenue and the associated costs once the project is completed. This is one of the two popular accounting methods used in the construction industry. For residential contractors, the completed contract method of accounting has a tax advantage by deferring revenue recognition but is generally not considered the best method of accounting in the construction industry.
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 to the method of accounting selected by the contractor.
In project accounting there are two different methods of accounting used. The first is the completed contract method which is explained in more detail in Lesson 75. The second and the focus of this lesson is the percentage of completion method of accounting. This method is an advanced skill for accountants and requires knowledge of its proper application along with a new type of control account called work in process or work in progress.
Just like a tip of an iceberg, a progress billing for a construction project is an invoice for a small part of the overall contract value. It needs to be recorded correctly and presented to management in a way that is understandable and beneficial for making decisions. This article will introduce the concept and cover how progress billings are presented on the balance sheet.
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 in Process. 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.
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.
The completed contract method of accounting recognizes revenue and the associated costs once the project is complete. This is one of the two popular accounting methods used in the construction industry. For residential contractors, the completed contract method may have a slight tax advantage by deferring revenue recognition but is generally not considered the best method of accounting in the construction industry.