In this article, you will learn:
It is indispensable for the construction companies to implement procedures for project control as well as keep accounting records. This is because such records act as important tools for accounting managers and other participants in the construction process.
Such tools not only give a snapshot of the financial transactions but also indicate the progress and challenges associated with a project.
The key construction accounting challenges that an accounting manager encounters while maintaining records include how to recognize income, expenditure, allocation of costs, recognition of expected losses, change in estimates, etc.
This article deals with all the key construction accounting challenges in detail.
When to Combine or Segment Construction Contracts?
There are circumstances where a group of contracts or separate components of a single contract needs to be combined together in order to reflect the essence of such contract or contracts.
When a construction contract covers a number of assets, the construction of each asset is considered as a separate contract when the following conditions are satisfied:
- Separate proposals have been submitted for each asset
- Separate negotiation has been carried out for each asset. Both contractor and customer have accepted or rejected part of the contract relating to each asset
- The cost and revenues of each asset can be identified separately
However, a group of construction contracts must be treated as a single construction contract when the following conditions are satisfied:
- A group of contracts is negotiated as a single package
- The contracts are so closely interrelated that they form part of a single project having an overall profit margin
- These contracts are carried out concurrently or in a continuous sequence
In addition to the above, there can be situations where a customer may demand the construction of an additional asset in a given construction contract. Such additional asset should be treated as a separate construction contract when:
- Additional asset varies dramatically in design, technology or function from assets covered in the original contract
- Price of the additional asset is negotiated without considering the price of the original contract
What Constitutes Construction Contract Revenue and Costs?
As per AS 7, a contract revenue should comprise of:
The initial amount of revenue agreed in the contract
Any variations in the contract work, claims, and incentive payments:
- To the extent that it is possible that such variations will result in revenue
- They can be reliably measured
Typically, contract revenue is nothing but the consideration received or receivable. However, such revenue is impacted by a variety of uncertainties due to which revenue estimates need to be revised. Such uncertainties may include escalation of costs, penalties due to delays, variations in specifications or design of the asset, and changes in the duration of the contract, etc.
But, the accounting manager needs to consider such uncertainties and variations only if there is a probability that a customer will approve variations and variation revenue and it is possible to reliably measure such revenue. Likewise, a claim is an amount that a contractor needs to collect from the customer as a reimbursement of costs not included in the contract price. Such claims may occur due to delays caused by a customer, errors in design, etc. Therefore, the accounting manager needs to include claims in contract revenue when there is a probability that the customer will accept the claims and that it can be reliably measured.
Lastly, incentive payments refer to the additional amounts that a contractor receives if he meets or exceeds the standards of performance. For example, early completion of the project by a contractor. Thus, an accountant needs to include incentive payments in contract revenue only when there is a probability that:
- contractor exceeds the performance standards
- amount of incentive payments can be measured reliably
As per AS 7, construction contract costs include:
- Costs directly related to specific contract – For example, site labor cost, material cost, depreciation of plant and machinery, costs of design and technical assistance, etc
- General costs pertaining to contract activity that can be allocated to the contract – For example, construction overheads, insurance, design, and technical assistance cost not directly related to a specific contract, etc. These costs are allocated using systematic and rational methods based on the normal level of construction activity.
- Other costs that are specifically chargeable to the customer as per the terms of the contract. These costs include general administration and development costs for which reimbursement is mentioned in the terms and conditions of the construction contract.
Besides the above costs, there are certain costs that cannot be allocated to the construction contract and hence are excluded from the contract. For example, selling costs; R&D and general administration costs for which reimbursement is not specified in the contract, etc.
How to Recognise Construction Contract Revenue and Expenses?
The contract revenue and costs associated with a construction contract must be recognized as revenues and expenses respectively when the result of a construction contract can be estimated reliably.
Such costs and revenues are recognized according to the stage of completion of the contracting activity on the reporting day. If there is an expected loss on such a construction contract, it must be recognized as an expense immediately.
Now, in the case of construction contracts, the contract revenues and expenses are recognized as per the stage of completion of the contract. This is referred to as the percentage of completion method under which contract revenue is matched with contract costs that are incurred in reaching the stage of completion. As a result, revenues, expenses, and profit pertaining to the proportion of work completed must be reported. Thus, as per this method, an accountant must recognize the contract revenue as well as the contract costs in the statement of P&L in the accounting periods in which such a work is carried out.
Further, if any contract costs are incurred that relate a future activity on the contract, such costs must be recognized as an asset. Provided there is a probability that it will be recovered.
Also, the firm must have proper budgeting and reporting system at place to make reliable estimates as well as estimates of contract revenue and costs as the contract progresses.
- The allocation of overhead expenses is another key construction accounting challenge. Unlike normal projects, where it is quite easy to allocate overhead costs, in case of a construction contract, it is quite challenging to do ss as there are various jobs involved. There are various ways to allocate such costs including estimated or actual hours worked, pro-rata basis according to the contract sale size.
- Unlike other businesses, the calculation of break-even point in case of a construction contract is not a standard rule, but just a guideline. The Break-even point is the level of sales at which variable costs are equal to the fixed costs. In the case of a construction contract, each construction job is unique and hence has different expenses. Therefore, the break-even point has to be measured for each job separately. Once the break-even is determined, the amount of sales revenue can be known to cover fixed costs and variable costs. Job Costing can be used to determine the break-even points of various jobs.
- If there are delays in the project, then the contractor may not have enough funds to complete the project. Thus, accountant needs to ensure timely billing and collection. Further proper accounting system needs to be in place to adjust to any changes occurring throughout the project.