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Leading Luxury Builders To Great ness

FREE GUIDE W HY IS CONSTRUCTION ACCOUNTING DIFFERENT? Learn everything you need to know to run a highly profitable construction business


In thismodule we will take real life examples, simple processes, and help you find timely results by diving into each of the building blocksof accounting for contractors to help you understand what CLB believesis necessary to run a highly profitable and successful construction business. But first , let ?s look at what makes const ruct ion different from so many ot her indust ries. In comparison t o ot her indust ries, like ret ail or manufact uring, const ruct ion cont ract ing has several dist inct t rait s from an account ing perspect ive. On t he following pages, we will walk you t hrough t he charact erist ics of const ruct ion account ing: 1. PROJECT-BASED 2. DECENTRALIZED PRODUCTION 3. LONG-TERM CONTRACTS W ITH EXTENDED PAYMENTS

PROJECT-BASED Whether talking about billing, production or labor, contractors operate their business primarily around projects. The financial focus revolves around each job. In other business, such as a chain of designer cupcake shops or a pneumatic-valve manufacturer, managers might treat each store, plant, product line, or the entire business as a ?profit center.?For most industries, these are stable and predictable. Contractors, however, need to treat each and every construction project as a unique, short-term profit center. What really makes this special is that each construction job tends to have unique inputs and requirements. Even when projects have similar production requirements, they?re often subject to different site conditions or local variables like labor availability, cost of materials, and legislation. Plus, projects are continually opening and closing during the year with each contract. In the end, luxury builders and remodelers have one way to control costs and to bid intelligently. That?s to track accurate costs for each project and to account for the expenses and production activities that make up job costs.

DECENTRALIZED PRODUCTION Similarly, in contrast to retail and manufacturing, production primarily happens on different job sites rather than fixed locations like plants. As such, equipment use and labor frequently move from site to site. This results in mobilization costs. It also means that equipment and labor costs must be tracked to each job site with the correct wage rate. On top of distinct project requirements, construction also features long and often seasonal production cycles. Because production can be less predictable, contractors often aren?t able to retain large amounts of inventory. As a result, the cost and availability of production inputs can fluctuate and require special, careful tracking and planning.

LONG-TERM CONTRACTS Tied to the idea of long production cycles is the idea that construction contracts are longer than those in many other businesses. Imagine selling a truck. If you?re a dealer, the contract is complete as soon as the transaction is. The customer pays, and you hand them the keys. If you?re a truck manufacturer, it might be a longer term between the sale and delivery, or you may just deliver from a stock of inventory. In construction, production contracts can last years and have multiple, extended payments over that time. Contract terms commonly allow 30, 60, even 90 days, or more, to pay invoices. Retainage withholding or disputes can delay payment even longer. As a result, revenue recognition and cash management in construction carry special considerations. Contractors need precise tracking and reporting, as well as collection and cash-flow strategies.


Factoring in some of the essential differences from general accounting, construction accounting relies on a number of important concepts: 1. 2. 3. 4. 5.


W HAT IS JOB COSTING? For most businesses, the accounting general ledger (G/L) is all they need. This lets them track transactions that impact the whole company?s financial picture. However, because construction accounting is project-centered and production is decentralized, contractors also need a way to track and report transactions specific to each job. That?s job costing: the practice in construction accounting of tracking costs to particular projects and production activities.

W HAT JOB COSTING DOES In construction accounting, job costing and the G/L work together like a left and right hand. The G/L looks across at the whole company, and job costing looks at the project level. And where the G/L is made up of accounts (like materials expenses or accounts payable), job costing is made up of: 1. INDIVIDUAL PROJECTS 2. COST ACTIVITIES (LIKE FOUNDATION OR FRAMING) 3. COST TYPES (LIKE LABOR OR MATERIALS) GENERAL LEDGER


Tracks company finances

Tracks project data

Produces financial statements, aging reports, over/under billing

Produces estimated vs. actual, production reports, WIP reports

Organized by chart of accounts

Organized by job cost structure

When all of that job data is recorded and organized, the result is actionable reporting that project managers and foremen can really use. Contractors are able to coach their project managers and superintendents in how to supervise costs and production successfully. Estimators are able to know the true break-even cost, even in tight bids. PMs and supers have a ?scorecard? to see how their crews are performing, to learn and to make adjustments. With better estimating, bidding, and cost controlling, contractors should be able to protect narrow profit margins and keep taking on the right projects.

HOW JOB COSTING DOES IT Job costing can measure several different aspects of a project in order to improve estimates and budgeting. While financial reporting from the G/L just looks at dollars, contractors can use job costing to track: Physical completion

(in units)

Costs faced

(in dollars)

Labor used

(in hours)

HOW JOB COSTING DOES IT, continued It tracks these not only to each job but also within each group of job activities and each type of cost. For example, a contractor might ?code?an invoice to Job 140 (Lake Ave. Remodel), Cost Code 100 (Foundation), Cost Class ?MAT?(Materials). Some might also categorize costs by project phases or sub-jobs, like floors of a structure or buildings in a development. The system of categories the contractor uses across all of their jobs is called the job cost structure. By tagging every transaction with information from the job cost structure, contractors are able to see a whole new dimension to their costs. They can look at how much each aspect of operations costs on a particular job and across the company as a whole. Along with expenses, they can track progress according to specific budget items, detect patterns, and report profitability or overruns for different production activities as they?re underway. Importantly, they can also identify costs shared between multiple jobs, like equipment, and calculate a fair way to distribute those costs, which is called overhead allocation. In the end, the goal of job costing is to help contractors identify their true costs and profitability.

W HAT IS CONTRACT REVENUE RECOGNITION Revenue recognition or income recognition is how a contractor determines when they?ve officially made money on a project. It also helps determine when they should officially record an expense. Remember, this comes into play because construction contracts are usually long-term and often have delayed payments. Contractors aren?t necessarily able to complete, bill, and collect on a contract in the same month. In fact, for many contractors, this never happens. That leaves contractors and accountants with a choice of revenue recognition method. The method they choose will determine when income and expenses ?count.?In some cases, they might use one method for their own bookkeeping and one for tax reporting, as long as they remain consistent over time. In construction accounting, the main options have traditionally included cash-basis, completed contract and percentage of completion. However, contractors now have to consider guidance from the new ASC 606 revenue recognition standards with their construction CPA.

THE CASH M ETHOD The simplest method for recognizing revenue is the cash method. Everything is based on its real-time impact on the company?s cash. Contractors record revenue when and only when they receive payment ? and report expenses when and only when they actually pay. Therefore, there are no accounts payable (A/P) or accounts receivable (A/R). Under cash accounting, if money didn?t change hands yet, there?s no transaction to account for. While cash-basis accounting has several advantages, it?s not for every construction business. In fact, while many U.S. small businesses prefer cash accounting for its simplicity and flexibility, only some contractors qualify. According to the IRS, only construction businesses with less than a set average annual revenue can use the cash method for tax purposes. If a business?sales exceed that amount, they?ll have to use another method for tax purposes. In that case, they may decide simply to use another method for their own books as well. Each of these other methods will be known as an accrual method. An accrual method will recognize an expense when it?s incurred and revenue when it?s earned, even if cash hasn?t come in or out yet. In other words, it tracks how money ?accrues,?or accumulates, in holding before it moves as cash.

THE COM PLETED CONTRACT M ETHOD Under the completed contract method (CCM), contract income isn?t reported until the project finishes. Neither are expenses. Of course, that doesn?t mean there aren?t expenses during construction or that contractors can?t bill in the meantime. It just means that any profit isn?t official until the end. Everything hits the income statement at one time. This sometimes means contractors are able to defer taxable revenue if the contract won?t be completed until the following tax year. CCM also has particular restrictions from the IRS. To be eligible, contractors can?t exceed a certain average annual revenue and their contracts must be able to be completed within a set timeframe.

THE PERCENTAGE OF COM PLETION M ETHOD The percentage of completion method (PCM) allows a contractor to recognize revenue as they earn it over time. As a project progresses toward completion, the contractor can bill for the work they?ve performed. Each time they issue an invoice, they can record the earned revenue. This continues until they finish the contract. In order to calculate how much of the contract they?ve earned for a billing period, they might choose among a number of methods, including cost-to-cost and estimated percent complete.

ASC 606 NEW REVENUE RECOGNITION STANDARDS That said, there?s a new rule in town. The Financial Accounting Standards Board, which oversees U.S. generally accepted accounting principles (GAAP), issued ?ASC 606: Revenue from Contracts with Customers?as a new set of standards for recognizing revenue. GAAP provides best-practice accounting standards across all U.S. industries. As of December 2018, all companies reporting under GAAP need to follow ASC 606. And while private companies don?t have a formal obligation to use GAAP, many choose to follow its best practices. Among other areas of guidance, these standards help contractors identify whether they should recognize revenue on their books at a single point in time (as with CCM) or over time (as with PCM). With ASC 606, the question hangs on the idea of transferring control. Control is transferred when the constructed asset becomes the customer's to own. If it?s on the customer?s land, the foundation of a building might come under the customer?s control as soon as it?s poured, the frame as soon as it?s put up, etc. With a total development project, transfer of control might not be until the contractor hands over the keys. But because it?s part of a contract obligation, the parties must settle ahead of time when control is transferred ? at a point in time or over time ? in order to account for income appropriately. POINT IN TIME


Contractor has no right to payment until the end

Contractor has a right to payment at various stages

Contractor has legal title until transfer

Customer has legal title of the asset

Contractor has physical possession until transfer

Customer has physical possession of the asset

Contractor has use and benefits until transfer

Customer has ongoing use and benefits of the asset

ASC 606 NEW REVENUE RECOGNITION STANDARDS, continued Of course, the ASC 606 rule provides many other important standards for contractors to follow. That includes identifying whether they need to count a project as one contract or multiple contracts, how to determine the contract price, and how to allocate the sales. It also entails changes to accounting for contract losses, stored materials and cost-to-cost calculations. As with using cash accounting or methods like PCM and CCM, contractors need to consult with their construction CPA to make sure they?re on track.

W HAT IS CONTRACT RETAINAGE? Another peculiarity to be accounted for in construction is the practice of withholding retainage, or, retention. Retainage is the predetermined amount of money an owner may hold back from payment until they?re satisfied with contract completion. A common retention amount might be 5-10% of the contract value or invoiced amount, but it can be less or more. The idea of retention is to provide the customer with some security against any deficiencies or defects on the project.

HOW RETAINAGE W ORKS For most contractors, retainage is simple enough on paper, even though by nature it?s an exception to the rule. In practice, when a contractor earns revenue under an accrual method like CCM or PCM, they have the right to issue an invoice and record the amount as an account receivable (A/R) until it?s collected. That is, except for retainage. According to revenue standards, the contractor doesn?t have a current, unconditional right to the retainage portion of an invoice. Therefore, it?s not treated as a receivable (A/R) amount. Contractors record it instead in a separate asset account. Once a contractor does have a right to it, after satisfactory contract completion, the contractor issues an invoice for it and moves it from the asset account to the A/R account for collection. However it looks on paper, however, retainage has a bigger impact in reality. Retainage laws vary from state to state, but in some cases, owners can withhold it for over a year. Additionally, retention between 5-10% can actually take a 20-50% bite out of a contractor?s profit. * Given construction?s narrow profit margins, smart retainage management is at least as important as proper retainage tracking.

SPECIALIZED CONSTRUCTION BILLING Many industries operate around fixed-price, point-of-sale billing, but that?s not always the case with construction. Because construction production is project-based, decentralized, and long-term, contractors may use a number of billing styles and methods. Specialized software is often required to create and track these styles or methods. Let?s look at just a few contract types and billing formats.

FIXED PRICE Also known as a lump-sum contract, fixed price billing is based on a detailed estimate that gives a total cost for the entire project. It can also be considered as one of two types: fixed-price hard bid and fixed-price negotiated. A hard bid essentially says, ?No matter what, we?re building it for this amount of money.?As a result, the risk is heavily on the contractor rather than the owner. If there are any overruns because of changed site conditions or input costs, that falls on the contractor. A negotiated lump sum, on the other hand, might allow for some contingencies and unforeseen events. Billing a fixed-price contract often happens on a percentage-of-completion basis with retainage withheld.

TIM E & M ATERIAL Time-and-material billing bases the contract price on a per-hour labor rate plus the cost of materials used. For both the labor and materials components, the contractor may apply a standard markup. This builds their profit percentage into the amount and accounts for the cost of overhead. For example, an HVAC technician paid at $20 an hour might be billed at a fixed $50 per hour. Additionally, the equipment they install might follow a standard markup table by item or price, such as ?2x?for a disposable air filter. If the technician spent two hours on the dispatch and additionally replaced a $20 air filter, the contractor would bill the customer $100 for labor plus $40 for materials.

UNIT PRICE Under a unit-price contract, the contractor bills a customer at a fixed price-per-unit rate. Typically, this will be useful if they aren?t able to estimate the unit production for the project with a lot of certainty. Unit-price billing is especially common among heavy-highway and utility construction companies.With unit price, risk tends to be shared between the contractor and customer, since production quantities can end up higher than estimated. As long as they?ve estimated the unit pricing correctly, the contractor may increase their revenue in this case. Otherwise, if unit pricing is off, they stand to lose money.

AIA PROGRESSIVE BILLING One common construction billing format is known as AIA progress billing, named after the American Institute of Architects that produces its official forms. As a type of progress billing, AIA billing invoices the customer based on the percentage of work completed for that billing period. This invoice generally consists of a signed summary sheet, followed by a schedule of values that details what?s been completed and billed to date. Together, these documents are considered an ?application?for payment, because the recipient will have a chance to review the schedule of values and either accept or dispute the billed amount. If they disagree, they?ll send back ?redlines?so that the contractor can revise and resubmit the AIA billing application.

CONSTRUCTION BILLING Finally, with multiple profit centers and decentralized production, plus rigorous compliance requirements, construction also sees some of the more unique and complex payrolls. This is most true where there are: 1. PREVAILING WAGE REQUIREMENTS AND CERTIFIED PAYROLL REPORTING 2. MULTIPLE PAY RATES, MULTIPLE STATES AND MULTIPLE LOCALITIES 3. OTHER COMPLIANCE REPORTING

CERTIFIED PAYROLL & PREVAILING WAGE Contractors who work on public projects commonly have to navigate prevailing wage payroll, often called ?Davis-Bacon payroll?after the landmark Davis-Bacon Act. Prevailing wage legislation requires contractors to pay the rate of compensation that?s standard, or ?prevails,?for each worker classification on similar jobs in the area. Contractors must then certify their compliance on each project using certified payroll reports that may vary between different states or agencies. In some sense, prevailing wage payroll is like a minimum wage but more complex. First, prevailing wage payroll may include and sometimes requires non-cash compensation called ?fringe benefits,?such as health care or continuing education. Second, the prevailing wage rate will vary not just by area but also specific worker classification. Each jurisdiction may have particular determinations for which job functions qualify under which classification ? and which level within that class. So, a single employee might have multiple prevailing wage rates and fringe requirements on a single job, depending on what they?re doing each hour. These rates can also change every six months to a year.

UNION PAYROLL & REPORTING Union contractors face a similar situation as prevailing-wage contractors. Where certified payroll typically tracks wage and fringe obligations for government agencies, union payroll needs to track and report wage and fringe obligations to the union local. This becomes even more complicated with multi-union payroll. For example, a crew might have a home union but work on a project within another union local?s jurisdiction. In that case, the home local might have a claim on health care contributions and pension deductions while the job local wants dues and political action contributions. Each appropriate fringe and deduction would need to be split out to the right local and reported appropriately Reporting requirements for a particular union may exist on a national or a local level. Contractors can typically determine their requirements, especially when entering another jurisdiction, by checking with their local union business manager.

M ULTIPLE RATES, STATES & LOCALITIES Apart from multiple prevailing wage and union rates, contractors commonly deal with multiple rates for numerous other reasons. Working on job sites in multiple cities and states, employees may have multiple tax withholdings all within a single payroll. As a result, contractors in multiple jurisdictions have to watch out for double taxation. Chiefly, this can be a problem where an employee resides in one state and works in another. When states have a reciprocal relationship, however, the worker?s state of residence may issue credit for taxes paid on income earned out of state. This way, they don?t pay twice; however, this approach requires careful attention to timecards and pay stubs. Contractors and builders also have to watch that they don?t overpay on unemployment tax when an employee works in multiple states. Unemployment is often owed only to one state per employee. If it?s mistakenly paid to each state they worked in, contractors shouldn?t expect to be contacted for a refund. Because it?s not always clear where unemployment should be paid, the Department of Labor suggests considering four factors in sequence: 1. 2. 3. 4.


COM PLIANCE REPORTING Finally, contractors can face numerous payroll reporting requirements, even if they don?t have to file certified payroll. These can include union reports, workers? compensation, new hire reporting and equal employment opportunity (EEO) minority compliance. Contractors need to have a keen awareness of these requirements for each jurisdiction they bid and work in, from the federal down to the local level.


For contractors, the amount of metricsto gauge the effectiveness of your construction businesscan be overwhelming. Between balance sheetsand profit-and-loss (P&L) statements, it?snot alwaysclear what all of these numbersare supposed to mean for the health of your company. That?swhere financial ratioscome in. Financial rat ios are key equat ions you can use t o sort t hrough your numbers and get a clearer look at how well your const ruct ion business is performing. Underst anding how t o calculat e and read financial rat ios can also help you predict fut ure out comes for your business ? like whet her you might get approved for a loan or whet her you could be heading t oward cash problems! In t his art icle, we?ll explore some of t he more common set s of financial rat ios and how you can use t hem t o measure t he performance of your business wit hin t he const ruct ion indust ry: 1. CURRENT RATIO 2. QUICK RATIO 3. DEBT-TO-EQUITY RATIO 4. W ORKING CAPITAL TURNOVER RATIO 5. EQUITY TURNOVER RATIO

LIQUIDITY RATIOS Liquidity ratiosdetermine a company?sability to pay off short-term debtsusingavailable assets. In the event that all short-term liabilitiessuddenly became due, liquidity ratiosprovide a glimpse asto whether your company would be able to cover those debts.

1. CURRENT RATIO The current ratio, sometimescalled the workingcapital ratio, isthe result of dividingall current assets by all current liabilities.

CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES Generally, a current ratio of greater than or equal to 1.0 is considered good. This means that there are enough current assets in the business to cover the cost of current liabilities. Some construction experts might encourage a current ratio of 1.3 or greater. A ratio of less than 1.0 could indicate potential financial trouble. So, is bigger always better?Not necessarily. Too high a ratio could indicate inefficient use of working capital. In other words, an excess of short-term assets (like cash) might be sitting idle instead of gaining interest as long-term investments. Let?s take a look at an example of a current ratio. John owns a small construction firm and finds the following figures from his balance sheet: CURRENT ASSETS




Based on these numbers, John has a current ratio of 2.0. This means that, right now, John has more current assets than his current liabilities and might be considered a lower risk to a lender.

LIQUIDITY RATIOS Liquidity ratiosdetermine a company?sability to pay off short-term debtsusingavailable assets. In the event that all short-term liabilitiessuddenly became due, liquidity ratiosprovide a glimpse asto whether your company would be able to cover those debts.

2. QUICK RATIO Buildingfrom the current ratio isthe quick ratio, also referred to asthe acid-test ratio. While the current ratio takesinto account all current assets, the quick ratio looksonly at cash, cash equivalents, short-term investmentsand accountsreceivables? all divided by current liabilities. It measuresthe ability to pay for current liabilitieswithout havingto convert assetsto cash. A simple quick ratio for the construction industry can be expressed:

QUICK RATIO = CASH + ACCOUNTS RECEIVABLE / CURRENT LIABILITIES As the name suggests, the quick ratio focuses on specific assets which are easiest and quickest to sell in order to pay off current liabilities. Because of this, it excludes assets such as inventory, which takes time to liquidate, and under-billings, which take time to collect. Many financial analysts look for a ratio between 1.1 and 1.5. Let?s say another construction firm owner, Matt, has the following on his balance sheet:







To find the quick ratio for his company, we?d add his most-liquid assets ($80,000 + $20,000) and divide them by his current liabilities to find his quick ratio of 0.5. Since this is less than 1.0, Matt doesn?t have enough assets he can quickly convert to cash to cover his current liabilities. As a result, lenders might see him as a higher risk.

LEVERAGE RATIOS Leverage ratioslook at how a company financesitsassetsand operations? whether through debtsor investments. Since businessesrely on a mixture to operate, leverage ratiosallow ownersto see if their company isrelyingtoo much on debt.

3. DEBT-TO-EQUITY RATIO The debt-to-equity ratio isa leverage ratio that measureshow much growth a company hasfinanced through debt. To find thisratio, divide your total liabilitiesby the equity on your balance sheet:

DEBT-TO-EQUITY RATIO = DEBT / EQUITY Typically, a debt-to-equity ratio of less than 2.0 is considered good. A higher ratio could mean that the company has used too much debt to stimulate growth. As the owner of his roofing company, John finds the following from his balance sheet: DEBT




Based on his current standing, John has a debt-to-equity ratio of 3.0. This means that his creditors have three times as much invested in the company as he does. And if that doesn?t concern him, it might concern banks.

EFFICIENCY RATIOS Efficiency ratiosassesshow well a company managesitsassetsand liabilities, focusingon how these assetsgenerate revenue. For all of the valuesused in an efficiency ratio, it?simportant to look at the same range of time.

4. W ORKING CAPITAL TURNOVER RATIO Also, a liquidity ratio, the workingcapital turnover ratio isfound by dividingconstruction salesby your workingcapital. Because workingcapital iscurrent assetsminuscurrent liabilities, thisratio reflects how much company value isfreed up for operations.

W ORKING CAPITAL TURNOVER RATIO = NET ANNUAL SALES / W ORKING CAPITAL Having a higher ratio indicates how you?re using capital to produce sales. Too high of a ratio could signal that there isn?t enough available working capital to support sales growth. A working capital turnover ratio exceeding 30.0 generally highlights needing more working capital for the future. Conversely, too low of a ratio could suggest ineffectively employed working capital. Let?s assume Matt calculates the following from his financial statements: NET ANNUAL SALES




Matt has a working capital ratio of 5.0, meaning every dollar of working capital is only supporting $5 worth of sales growth.

EFFICIENCY RATIOS Efficiency ratiosassesshow well a company managesitsassetsand liabilities, focusingon how these assetsgenerate revenue. For all of the valuesused in an efficiency ratio, it?simportant to look at the same range of time.

5. EQUITY TURNOVER RATIO Another common efficiency ratio and capacity ratio isthe equity turnover ratio. Like the working capital turnover ratio, the equity turnover ratio looksat how efficiently a businessisusingitsvalue ? in thiscase, equity ? to drive construction revenue. It?scalculated by dividingsalesby total equity.

EQUITY TURNOVER RATIO = NET ANNUAL SALES / EQUITY Let?s say Matt calculates the following sales and equity for last year:





From this, Matt is able to calculate his equity turnover ratio as 2.5 ? well below the acceptable ceiling around 15.0.

USING FINANCIAL RATIOS When using financial ratios, it?s important to remember that there?s no one financial ratio to rule them all. No single ratio covers all the bases. Even with a stellar current ratio, a construction firm might be financing too much of its growth through debt. Or they may not be using its equity effectively to generate revenue. Because of this, it?s a good idea to take a cue from financial analysts and review multiple ratios to determine the financial health of your business. When viewed together, financial ratios blend like paint on a canvas, creating a larger and more complete picture of your construction company?s overall standing.

ABOUT CLB NETW ORK CLB measures our partnership success in Revenue, New Projects, and Net Profit. We want you to achieve your goal of putting a minimum of $1M in profits in the bank and achieving 10% net profit for the business and building a valued asset. CLB takes a bright and innovative approach to offering easy-to-understand, customizable, and fractional solution options at a significant value compared to hiring employees or firms that do not understand your business, your best-fit clients or the luxury home building and remodeling industry. CLB Network is backed by a team of seasoned professionals who explicitly understand what it takes to be a high performance luxury custom homes and remodeling business and how to deliver a 5-star experience to best-fit strategic partners. prospects, and clients. Our combined experience and solutions allows CLB to offer you and your business genuine peace of mind knowing that we are on your team and will help you achieve your goals years sooner than if you had to do it on your own.


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GUIDE: What Makes Construction Accounting Different?  

GUIDE: What Makes Construction Accounting Different?  

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