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 expensesIndirect ExpensesIndirect expenses are the general costs incurred for running business operations and management in any enterprise. In simple terms, when you want to buy grocery from a supermarket, the transportation cost to get you to the supermarket and back is the indirect expenses.read more may include supervision and inspection costs, equipment rental, insurance, etc.
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For eg:
Source: Construction Accounting (wallstreetmojo.com)
Characteristics
- It is project-based, and as such, considers each project as a separate profit centerProfit CenterProfit Center is the segment or division of a business responsible for generating revenue & contributing towards its overall profit. Here, the objective is to increase sales & reducing the cost incurred. read more.
- 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 accountingCash AccountingCash Accounting is an accounting methodology that registers revenues when they are received & expenditures when they are paid in the given period, thereby aiming at cash inflows & outflows. read more, accrual methodAccrual MethodAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. read more, percentage of completion methodPercentage Of Completion MethodThe percentage of completion method is an accounting method for recognizing revenue and expenses for long-term projects that span over more than one accounting year. The revenue is recognized yearly as a percentage of work completed during that year. Revenue to be recognized = (Percentage of Work Completed in the given period) * (Total Contract Value) read more, and completed contract methodCompleted Contract MethodThe Completed Contract Method is when the company officials decide to postpone its profit recognition and revenue until they deliver every project. Usually, business organizations adopt such practices when they are doubtful about the recovery of their debts.read more.
#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.
#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 controlCost ControlCost control is a tool used by an organization in regulating and controlling the functioning of a manufacturing concern by limiting the costs within a planned level. It begins with preparing a budget, evaluating the actual performance, and implementing the necessary actions required to rectify any discrepancies.read more procedures if required.
Difference Between Construction and Regular Accounting
- Regular accounting aims to generate financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more 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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