9. Compare the four primary methods of construction accounting discussed in this chapter and compute the reported revenue, expenses, and income or profit for each, for a contractor which has only one project for the whole year as reflected in the following. Assume January 1 through December 31 fiscal periods. Ignore any retention or tax considerations for this exercise. The reporting date is 12/31/2019. Contract volume of $1 million. Included in the contract value is a 5% fee. $500,000 was invoiced and received as of 11/30/2019. All invoice values include a proportional share of fee. An additional $100,000 is invoiced as of 12/31/2019, due 1/10/2020. $450,000 has been paid by the GC in labor, material, and subcontractor expenses through 12/15/2019. $90,000 was invoiced by subcontractors and suppliers for month ending 12/31/2019, payable ten days after receipt of payment from the client. That is factored into this month's $100,000 pay request. The balance of the construction costs will be paid in full by 3/31/2020 by the client to the GC and the GC to its subcontractors and suppliers and craftsmen. Theoretically the contractor's expenses will exactly equal its estimated costs, but it never happens this way. 10. Assume the contractor in Exercise 9 did not have any additional business in 2020. What revenues, expenses, and profits would be reported for that fiscal year for each of the four different accounting methods? Construction accounting methods As a member of the jobsite management team you are not necessarily going to be involved with the accounting processes and methods utilized by the home office accounting department and the CFO, but you should know some of the major issues. There are basically four different types of accounting processes available to construction contractors which include cash, accrual percent age of completion, and completed contract. Each of these four methods will be described in this section in turn. They are differentiated in the processing and timing of revenue and expenditure recognition, or when they account for money. The cash and accrual accounting methods are more applicable for short-term construction projects, those lasting less than one year, and percent complete and completed accounting methods are best suited for construction companies with projects lasting longer than one or two years. Accounts receivable includes the steps necessary to invoice a client for work performed and receipt of revenue in the form of payment. Accounts pay able involves commitments made to process expenditures for labor, materials, and subcontracts for construction work performed. Accounting methods 17 Cash The cash accounting method is usually reserved for smaller contractors, such as those with less than $5 million in annual company volume. Approximately 80% of construction companies employ ten or fewer employees and use the cash method. Contractors don't actually work with hard currency in construction, but the term 'cash' generally means a physical exchange of checks or electronic debit transfers from a bank account. The cash method is very simple. Contractors typically use a fiscal year that runs from January 1 to December 31. If a check is received from a client and deposited into the bank, it is reported as revenue. If a check is written to a subcontrac tor, it is reported as expenditure. The checks themselves do not have to dear the bank for either to be reported. This system does not consider work performed and not yet invoiced, nor a pay request invoiced to a client but not yet received, nor invoices received from subcontractors but not yet paid. The cash accounting method reflects very uneven cash flows. This uneven cash flow may cause problems for auditors, CPAs, the Internal Revenue Service (IRS), and equity partners who all look for consistency in financial reporting At the end of the year the contractor has some tax-planning flexibility in either depositing a client's check in December or holding it until January to postpone tax liabilities. The contractor may also process invoices from subcontractors early in December, although they may not be due until January, therefore moving costs or expenditures forward so that they may be deducted from this year's taxes. The cash method is also popular with designers and consultants such as archi- tects, engineers, inspectors, and agency construction managers. Chapter 3 will describe the roles of many of these contributors to the built environment. Cash The cash accounting method is usually reserved for smaller contractors, such as those with less than $5 million in annual company volume. Approximately 80% of construction companies employ ten or fewer employees and use the cash method. Contractors don't actually work with hard currency in construction, but the term 'cash generally means a physical exchange of checks or electronic debit transfers from a bank account. The cash method is very simple. Contractors typically use a fiscal year that runs from January 1 to December 31. If a check is received from a client and deposited into the bank, it is reported as revenue. If a check is written to a subcontrac tor, it is reported as expenditure. The checks themselves do not have to clear the bank for either to be reported. This system does not consider work performed and not yet invoiced, nor a pay request invoiced to a client but not yet received, nor invoices received from subcontractors but not yet paid. The cash accounting method reflects very uneven cash flows. This uneven cash flow may cause problems for auditors, CPAs, the Internal Revenue Service IRS), and equity partners who all look for consistency in financial reporting, At the end of the year the contractor has some tax planning flexibility in either depositing a client's check in December or holding it until January to postpone tax liabilities. The contractor may also process invoices from subcontractors early in December, although they may not be due until January, therefore moving costs or expenditures forward so that they may be deducted from this year's taxes. The cash method is also popular with designers and consultants such as archi tects, engineers, inspectors, and agency construction managers, Chapter 3 will describe the roles of many of these contributors to the built environment. Accrual The accrual accounting method reports revenues when they are billed or earned, and become accounts receivable, but not necessarily received. Retention held by the client is not reflected as income until it is received after project close-out. Expenses are recorded when costs are incurred and subcontractor invoices are invoiced and become accounts payable. The accrual method pro vides a more consistent financial reporting trail than the cash method. The accrual method is generally limited to smaller contractors, similar to the cash method, which have annual volumes of $5 million or less. Percentage of completion The percentage completion method is recommended for commercial contractors which have a volume greater than $10 million and/or have long-term contracts which may last longer than two years and overlap from one fiscal year into another. It is considered a more accurate and consistent indicator for recognizing income. This accounting method simply reports the percentage a con struction company is complete at the end of the fiscal year with all of their construction projects. This is accomplished by reporting the percent of estimated costs incurred, and the proportional share of profit earned. In the case of a construction company with more than one project this is the summary of all of its project percentages completed. This is similar to invoicing against a pre- established schedule of values as will be discussed later. In the percentage of completion accounting 18 Accounting methods method, the retention is also recorded at the completion of the project, similar to accrual. Larger architects and engineers may also utilize percentage completion financial reporting. The percentage of completion method will be the basis for the case study in this book. 18 Accounting methods method, the retention is also recorded at the completion of the project, similar to accrual. Larger architects and engineers may also utilize percentage completion financial reporting. The percentage of completion method will be the basis for the case study in this book. Completed contract The completed contract accounting method is even more irregular than the cash basis. In this case, contractors do not recognize any revenue or expenditures until the project has been com pleted and they are paid. This method may be used for small general contractors, such as those which do remodeling projects and speculative home builders, which are paid in full upon comple- tion. Residential tract builders are contractors which build and sell homes on a (also known as spec home builders). They are essentially real estate developers. In the completed contracting accounting method, jobsite administration expenses and home office overhead are pro portioned to projects and expenses are reported when revenues are received, at project completion, with respect to tax implications. Because a home builder may sell ten houses in one year and only two in another, based on timing of construction starts or changes in the economy, revenues may change dramatically from one year to the next with the completed contract accounting method. Internal accounting controls There are many purposes of construction cost accounting as was briefly introduced in Chapter 1. One major external reason of accounting for revenues and expenditures includes reporting net income and paying taxes. There are also a variety of internal reasons for account assists with management of the financial affairs of the company. Those include measurement of profits and their net effect on investor's equity; known as return on equity (ROE). As discussed, construction products are not repetitive, rather they are variable. Internal financial reports allow to perform self-diagnosis on industry specialization. Are we operating in the proper segment or focus area of the industry? Is one geographical area better for the company and our employees than another? Is our focus on the proper type and size of work? Internal accounting, or audits, also allows contractors to measure the performance of their most important asset, their people. Construction is project based, and each project is staffed with a project manager and superintendent who need to return a fair profit to the company. One addi- tional reason that contractors perform internal accounting management is to ensure that jobsite and home office teams are properly managing the corporation's money. The superintendent has several financial management responsibilities on the jobsite, many of which will be discussed throughout this book. Protection of construction materials from weather and external theft, and jobsite safety and security, are under the superintendent's control. Although not always considered as financial concerns, if not addressed properly these aspects will have a negative effect on project costs. Internal financial theft is unusual, but it can happen. There are several ways a contractor 9. Compare the four primary methods of construction accounting discussed in this chapter and compute the reported revenue, expenses, and income or profit for each, for a contractor which has only one project for the whole year as reflected in the following. Assume January 1 through December 31 fiscal periods. Ignore any retention or tax considerations for this exercise. The reporting date is 12/31/2019. Contract volume of $1 million. Included in the contract value is a 5% fee. $500,000 was invoiced and received as of 11/30/2019. All invoice values include a proportional share of fee. An additional $100,000 is invoiced as of 12/31/2019, due 1/10/2020. $450,000 has been paid by the GC in labor, material, and subcontractor expenses through 12/15/2019. $90,000 was invoiced by subcontractors and suppliers for month ending 12/31/2019, payable ten days after receipt of payment from the client. That is factored into this month's $100,000 pay request. The balance of the construction costs will be paid in full by 3/31/2020 by the client to the GC and the GC to its subcontractors and suppliers and craftsmen. Theoretically the contractor's expenses will exactly equal its estimated costs, but it never happens this way. 10. Assume the contractor in Exercise 9 did not have any additional business in 2020. What revenues, expenses, and profits would be reported for that fiscal year for each of the four different accounting methods? Construction accounting methods As a member of the jobsite management team you are not necessarily going to be involved with the accounting processes and methods utilized by the home office accounting department and the CFO, but you should know some of the major issues. There are basically four different types of accounting processes available to construction contractors which include cash, accrual percent age of completion, and completed contract. Each of these four methods will be described in this section in turn. They are differentiated in the processing and timing of revenue and expenditure recognition, or when they account for money. The cash and accrual accounting methods are more applicable for short-term construction projects, those lasting less than one year, and percent complete and completed accounting methods are best suited for construction companies with projects lasting longer than one or two years. Accounts receivable includes the steps necessary to invoice a client for work performed and receipt of revenue in the form of payment. Accounts pay able involves commitments made to process expenditures for labor, materials, and subcontracts for construction work performed. Accounting methods 17 Cash The cash accounting method is usually reserved for smaller contractors, such as those with less than $5 million in annual company volume. Approximately 80% of construction companies employ ten or fewer employees and use the cash method. Contractors don't actually work with hard currency in construction, but the term 'cash' generally means a physical exchange of checks or electronic debit transfers from a bank account. The cash method is very simple. Contractors typically use a fiscal year that runs from January 1 to December 31. If a check is received from a client and deposited into the bank, it is reported as revenue. If a check is written to a subcontrac tor, it is reported as expenditure. The checks themselves do not have to dear the bank for either to be reported. This system does not consider work performed and not yet invoiced, nor a pay request invoiced to a client but not yet received, nor invoices received from subcontractors but not yet paid. The cash accounting method reflects very uneven cash flows. This uneven cash flow may cause problems for auditors, CPAs, the Internal Revenue Service (IRS), and equity partners who all look for consistency in financial reporting At the end of the year the contractor has some tax-planning flexibility in either depositing a client's check in December or holding it until January to postpone tax liabilities. The contractor may also process invoices from subcontractors early in December, although they may not be due until January, therefore moving costs or expenditures forward so that they may be deducted from this year's taxes. The cash method is also popular with designers and consultants such as archi- tects, engineers, inspectors, and agency construction managers. Chapter 3 will describe the roles of many of these contributors to the built environment. Cash The cash accounting method is usually reserved for smaller contractors, such as those with less than $5 million in annual company volume. Approximately 80% of construction companies employ ten or fewer employees and use the cash method. Contractors don't actually work with hard currency in construction, but the term 'cash generally means a physical exchange of checks or electronic debit transfers from a bank account. The cash method is very simple. Contractors typically use a fiscal year that runs from January 1 to December 31. If a check is received from a client and deposited into the bank, it is reported as revenue. If a check is written to a subcontrac tor, it is reported as expenditure. The checks themselves do not have to clear the bank for either to be reported. This system does not consider work performed and not yet invoiced, nor a pay request invoiced to a client but not yet received, nor invoices received from subcontractors but not yet paid. The cash accounting method reflects very uneven cash flows. This uneven cash flow may cause problems for auditors, CPAs, the Internal Revenue Service IRS), and equity partners who all look for consistency in financial reporting, At the end of the year the contractor has some tax planning flexibility in either depositing a client's check in December or holding it until January to postpone tax liabilities. The contractor may also process invoices from subcontractors early in December, although they may not be due until January, therefore moving costs or expenditures forward so that they may be deducted from this year's taxes. The cash method is also popular with designers and consultants such as archi tects, engineers, inspectors, and agency construction managers, Chapter 3 will describe the roles of many of these contributors to the built environment. Accrual The accrual accounting method reports revenues when they are billed or earned, and become accounts receivable, but not necessarily received. Retention held by the client is not reflected as income until it is received after project close-out. Expenses are recorded when costs are incurred and subcontractor invoices are invoiced and become accounts payable. The accrual method pro vides a more consistent financial reporting trail than the cash method. The accrual method is generally limited to smaller contractors, similar to the cash method, which have annual volumes of $5 million or less. Percentage of completion The percentage completion method is recommended for commercial contractors which have a volume greater than $10 million and/or have long-term contracts which may last longer than two years and overlap from one fiscal year into another. It is considered a more accurate and consistent indicator for recognizing income. This accounting method simply reports the percentage a con struction company is complete at the end of the fiscal year with all of their construction projects. This is accomplished by reporting the percent of estimated costs incurred, and the proportional share of profit earned. In the case of a construction company with more than one project this is the summary of all of its project percentages completed. This is similar to invoicing against a pre- established schedule of values as will be discussed later. In the percentage of completion accounting 18 Accounting methods method, the retention is also recorded at the completion of the project, similar to accrual. Larger architects and engineers may also utilize percentage completion financial reporting. The percentage of completion method will be the basis for the case study in this book. 18 Accounting methods method, the retention is also recorded at the completion of the project, similar to accrual. Larger architects and engineers may also utilize percentage completion financial reporting. The percentage of completion method will be the basis for the case study in this book. Completed contract The completed contract accounting method is even more irregular than the cash basis. In this case, contractors do not recognize any revenue or expenditures until the project has been com pleted and they are paid. This method may be used for small general contractors, such as those which do remodeling projects and speculative home builders, which are paid in full upon comple- tion. Residential tract builders are contractors which build and sell homes on a (also known as spec home builders). They are essentially real estate developers. In the completed contracting accounting method, jobsite administration expenses and home office overhead are pro portioned to projects and expenses are reported when revenues are received, at project completion, with respect to tax implications. Because a home builder may sell ten houses in one year and only two in another, based on timing of construction starts or changes in the economy, revenues may change dramatically from one year to the next with the completed contract accounting method. Internal accounting controls There are many purposes of construction cost accounting as was briefly introduced in Chapter 1. One major external reason of accounting for revenues and expenditures includes reporting net income and paying taxes. There are also a variety of internal reasons for account assists with management of the financial affairs of the company. Those include measurement of profits and their net effect on investor's equity; known as return on equity (ROE). As discussed, construction products are not repetitive, rather they are variable. Internal financial reports allow to perform self-diagnosis on industry specialization. Are we operating in the proper segment or focus area of the industry? Is one geographical area better for the company and our employees than another? Is our focus on the proper type and size of work? Internal accounting, or audits, also allows contractors to measure the performance of their most important asset, their people. Construction is project based, and each project is staffed with a project manager and superintendent who need to return a fair profit to the company. One addi- tional reason that contractors perform internal accounting management is to ensure that jobsite and home office teams are properly managing the corporation's money. The superintendent has several financial management responsibilities on the jobsite, many of which will be discussed throughout this book. Protection of construction materials from weather and external theft, and jobsite safety and security, are under the superintendent's control. Although not always considered as financial concerns, if not addressed properly these aspects will have a negative effect on project costs. Internal financial theft is unusual, but it can happen. There are several ways a contractor