Construction Accounting (Definition, Example)

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

This is project-based and as such, each project is considered as a separate profit center.
The contracts that are accounted for in the 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 that are used in construction accounting include cash method, 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 done to match the expenses against the incomes for which they are incurred.

#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.

#3 – Percentage of Completion Method

Under this method, the revenues and expenses are recognized only to the extent the project is completed. In order to ascertain the percentage of completed work, one may have to rely on certifications by external competent parties such as architects, valuers or other competent persons. It is ascertained as to how much percentage of the total project cost has been incurred and the same percentage is applied to contract revenue so as to recognize the income.

#4 – Completed Contract Method

In the case of the completed contract method, neither income nor expenses are recognized until the entire project has been completed. As a result, income, as well as resultant taxes, are deferred.

Examples

An example with respect to 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 31^st 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 31^st 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 relevant 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 in order to provide the basis for management decisions and also generate tax returns. Regular accounting is used for general businesses 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. It although follows the same basic principles of regular accounting, however, more detailed reporting analysis is added. This is because of the fact that construction accounting is project-based and accounting is done for each project separately, by treating each project as a separate profit center.

Conclusion

This is being used by both small as well as large contractors who run multiple projects simultaneously. It helps them to keep control of each project by having an independent analysis of each project. As a result, they get clarity with respect to the performance of each project and it helps them to take decisions accordingly.