What is Construction Accounting?
Construction accounting refers to a branch of accounting wherein costs are allocated to a specific construction project. The project is allocated a job number and the same is set up into the accounting software and the costs are allocated by assigning the same to the unique job number as when the same is incurred.
Explanation
In this type of accounting, the costs are allocated to the specific project to which it relates. The costs that are allocated include various costs such as material, labor, architectural fees, consultancy fees, and so on. Apart from these costs, indirect expenses are also allocated to the projects. Indirect expenses may include supervision and inspection costs, equipment rental, insurance, etc.
Characteristics
- It is project-based, and as such, considers each project as a separate profit center.
- The contracts that account for in construction accounting are long-term contracts. The contracts can last for years.
- The activities are decentralized. In other words, activities are done at various construction sites and are not limited to one location.
Methods of Construction Accounting
The methods used in construction accounting include cash accounting, accrual method, percentage of completion method, and completed contract method.
#1 – Cash Method
In the cash method, expenses and revenues are accounted for as and when they are paid and received respectively. It does not follow the matching concept, and thus, no efforts are made to match the expenses against the incomes which incurs it.
#2 – Accrual Method
In the accrual method, expenses are recognized when they are “incurred,” and incomes are recognized when they are “earned.” It gives better clarity of the project’s financial status as compared to the cash method.
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#3 – Percentage of Completion Method
Under this method, the revenues and expenses are recognized only to the extent the project completes. To ascertain the percentage of completed work, one may have to rely on certifications by external competent parties such as architects, valuers, or other qualified persons. On ascertaining the percentage of the total project cost incurred, the same percentage is applied to contract revenue to recognize the income.
#4 – Completed Contract Method
The Completed Contract method recognizes neither income nor expenses until the entire project ends. As a result, income, as well as resultant taxes, are deferred.
Examples
An example concerning the percentage of completion method of construction accounting is presented below.
A construction project of the commercial complex is under process. For the year ended 31st December 2019, the status of the project is as follows:
- Total contract revenue: $100 million
- Total estimated contract cost: $80 million
The percentage of estimated contract cost that has been completed till 31st December is 70% as per independent certifying authority. Now, as per the percentage of completion method, the revenue and expenses that shall be recognized are as follows:
- Contract revenue = $100 Crores *70% = $70 Million.
- Contract cost = $80 Crores * 70% = $56 Million.
Importance
Construction accounting advocates separate accounting for each construction project. By following such an accounting process, a contractor can evaluate the total cost incurred in the case of each project and, as a result, can also ascertain the profits available from each such project by comparing the costs with the associated revenue. The contractor can exercise control over the entire project and check for cost control procedures if required.
Difference Between Construction and Regular Accounting
- Regular accounting aims to generate financial statements and basic related reports to provide the basis for management decisions and also generate tax returns. General businesses use Regular accounting ; i.e., it is used in a fixed environment.
- On the other hand, construction accounting is not just regular accounting, but it is an extension of regular accounting. Although it follows the same basic principles of regular accounting, however, more detailed reporting analysis is added. It is because construction accounting is project-based and accounting is done for each project separately, by treating each project as a separate profit center.
Conclusion
Both small as well as large contractors who run multiple projects simultaneously use Construction Accounting. It helps them to keep control of each project by having an independent analysis of each project. As a result, they get clarity concerning the performance of each project, and it helps them to make decisions accordingly.
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