Construction Accounting

Article byNiti Gupta
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Construction Accounting?

Construction accounting is 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 in the accounting software, and the costs are allocated by assigning the same to the unique job number as when the same is incurred.

Construction Accounting

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Both small and large contractors who run multiple projects simultaneously use Construction Accounting. It helps them 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 make decisions accordingly.

Construction Accounting Explained

The concept of construction accounting refers to that branch of accounting which meets the financial requirements of the construction sector. Construction projects often face a lot of limitations like delayed timeline, compex structure designs, various contractual terms and obligations,  fluctuating cost, etc.

This part of accounting caters to the principles and practices that focus on such criterias and practices of construction projects.

In this type of accounting, the costs are allocated to the specific project-related. The allocated costs 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.

There are innumerable complexities that are involved in such projects, which demand detailed attention while entering them in construction accounting software. Along with a clear and detailed understanding of each step along with their rulws and regulations so as to promote an efficient management of such projects along with optimum utilization of resources.

Construction Accounting

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Characteristics

Some important characteristics of the concept using construction accounting software are as follows:

  • 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.
  • They involve many contracts or jobs which needs to be tracked for expenses and revenues related to each project.
  • The billing process in the construction accounting programs is dependent on the level or completion of stages. A percentage of the total cost of project is billed to clients.
  • There is the concept of retainage in which a part of the contract price is kept back by the owner until the project is complete.
  • The work in progress is the cost of the past that is not yet complete.
  • They need to comply with various rules and regulations as per the industry standards and tax rules of the jurisdiction where project is taking place. It also has to follow th specific accounting standards.

Thus, the above are some important characteristics of construction accounting.

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Journal Entries

Let us try to understand the journals for construction accounting programs required for the accounting process of the same.

A very important part of accounting for construction projects are progress billing.  This keeps a record or tracks the revenue generated for individual projects. The construction company has to submit all bills related to completed work for accounting. The entry for the same are as follows:

Accounts Receivable A/c Dr

To Progress Billing A/c.

When the cash is actually received, the entry will be:

Cash A/c Dr

To Accounts Receivable A/c

Again there is a temporary account which is an asset account which records all construction in progress. Th eentry for the same is as follows:

Construction in progress A/c Dr

To Cash/ Accounts Payable A/c

In the construction accounting format, it is to be noted that any  kind of penalty paid will be netted against revenue. They cannot be added to the expenses of the project.

Methods

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 incur them.

#2 – Accrual Method

In the accrual method, expenses are recognized when “incurred,” and incomes are recognized when they are “earned.” It gives better clarity of the project’s financial status than the cash method.

#3 – Percentage of Completion Method

On ascertaining the percentage of the total project cost incurred, the same percentage is applied to contract revenue to recognize the income. 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.

#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:

  1. Total contract revenue: $100 million
  2. Total estimated contract cost: $80 million

The percentage of estimated contract cost completed until 31st December is 70% as per the 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 in a construction accounting format can exercise control over the entire project and check for cost control procedures if required.

Construction Accounting Vs Regular Accounting

Both the above are two different types of accounting concepts with some differences. Let us identify the differences.

  1. 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.
  2. Construction accounting is project-based, and accounting is done for each project separately by treating each project as a separate profit center. On the other hand, construction accounting is not just regular accounting but also an extension of regular accounting. Although it follows the same basic principles as regular accounting, a more detailed reporting analysis is added.
  3. The building construction accounting is typically project based, meaning the method focus on special custom projects, each with profitability objective. But the latter focus on regular activities and transactions.
  4. The former is difficult because of many intricacies and complexities as compared to the latter because the former involves cost of resources and often there are multiple projects being handled at the same time.
  5. For the former, the sites of the projects are located in multiple places and transactions and resource details are to be accounted for related to each site. This is not the case with regular accounting, because the accounting department are centralised in offices.
  6. The contracts for the building construction accounting are normally for long term and depend in the type of projects. This involves complex revenue recognition and payment schedules unlike the latter where the payment and revenues are for a point of time.

Recommended Articles

This article is a guide to what is Construction Accounting. We explain the method, journal entries, differences with regular accounting & examples. You can learn more about it from the following articles –