As the owner of a construction company, it can sometimes be difficult for you to get an accurate understanding of the financial position of your company; at the same time, it is so important because it is the key to operating a successful business.
One issue accountants see with construction companies is that the actual net income the company derives for each project does not always comply with accounting standards. We provide the assurance that the financials are in line with the standards, bringing the revenue amount to where it should be. But, the solution is not always what the company wants to hear, because often the income is decreased as a result, and the company is less profitable than expected.
The actual costs of a project at a certain period are normally pretty easy to see. True revenue is a different story. There is a lot more to take into consideration. But, there is a formula for deriving accurate revenue, and if used consistently, companies can find themselves with a much more accurate picture.
Revenue recognition is based on the estimated costs incurred and can be explained with the following formulas:
Percent complete = Total costs to date/Total estimated (budgeted) costs
Revenue to date = Percent complete * Contract Value
The gross profit amount depends on revenue, and the formula for deriving revenue is:
GP = Revenue – Cost
Adjusting to account for true construction revenue
Sometimes, events occur that do not go along with the plans of the cost estimators and project managers. Unexpected costs may come about that cause a job to go over budget, or even the weather may suspend the project for a time. These cannot be avoided, and as a result, the estimator or project manager may need to adjust the total estimated cost amounts. Herein lies one of the problems. That new total estimate may not be adjusted subsequently by the accounting department, leaving an inaccurate project completion amount that needs to be reconciled after the fact.
Let’s say that ACME Construction estimates that a job with $2M contract value will cost $1M to complete. Essentially, the contract value is the total amount the customer will pay, and the cost is the total expenses expected to be incurred while the job progresses. The accounting department is aware of $900K in costs that have already been incurred for the project.
The first question to ask the project manager, for a clearer understanding of how much the project will cost overall, is “can the remainder of this job be completed for less than $100K?” This is an important question to ask, because with $900K already incurred, there is only room for $100K in additional costs to stay within the $1M budget.
If the answer is “no, it will take another $500K, because we need to clean up and rebuild a section after the thunderstorm,” the cost estimate for this job is now $1.4M and not the budgeted $1M. This $1.4M is derived from the $900K already incurred, plus the additional $500K needed to clean up and continue construction. This is where the accountants see discrepancies. Many times, this type of adjustment is not added to the numbers they’ve seen, and therefore the company has an incorrect estimated cost amount.
Without a cost estimate change, the revenue would be derived from a $1M cost estimate and not the needed $1.4M, which would lead to a lower gross profit. Take a look at the comparisons below, using the formulas we just discussed.
$900K/$1,000K = 90% completion
90% * $2M = $1.8M revenue
$1.8M – $900K = $900K Gross Profit
Updated to account for changes:
$900K/$1,400K = 64% completion
64% * $2M = $1.28M revenue
$1.28M – 900K = $380K Gross Profit
The change leads to a $520K profit swing, explained as the $900K estimated minus the $380K actual. As accountants, we see this frequently and are able to adjust these numbers at the end of the year during our financial statement and tax work. However, this is not a good habit for contractors to take on with their construction accounting, because it gives a false sense of the project’s progress and thus an inaccurate financial position from that project. Communication and periodic updates between the controller and project manager are key to having an accurate financial position.
Understanding relationships by understanding your cash position
It is also crucial to have an understanding of relationships between accounts in the general ledger.
An example of this would be understanding the construction company’s cash position. If the company appears to be profiting rapidly, the cash must be flowing in just as quickly. If the cash is not flowing, the projects must have large underbillings, to explain the lack of cash coming in. Underbillings is short for costs and revenues in excess of billings. When revenue is recognized, but not billed, the amount goes to this underbillings account and not accounts receivable. With a low underbillings number, as well as a low cash balance, how is the company possibly making that much profit?
This also goes the other way. If the company is not making a lot of profit, or even manufacturing a net loss, the cash is not expected to be brought in rapidly. This is where the overbillings come in to play. An overbilling is billings in excess of costs and revenues. If the company sends out a bill before appropriately recognizing the revenue, the amount goes to this overbilling, which is more-or-less a deferred revenue account, where the revenue is not yet recognized, but will be at a later point
For a true financial picture…
At its simplest: always have up-to-date records and know the uses and relationships of the accounts on your general ledger. The construction industry is a complex arena when it comes to financials and having help with your construction accounting can keep everything on track and keep your company’s financials in compliance. If you would like help understanding the true financial position of your construction company, contact the MKS&H construction accounting experts.