Construction accounting and fin. mgmt. 2nd ed. s. peterson (pearson, 2009) bbs, Study notes of Trade and Commerce

Download Construction accounting and fin. mgmt. 2nd ed. s. peterson (pearson, 2009) bbs and more Study notes Trade and Commerce in PDF only on Docsity! MS : Construction Accounting Prem she ntet MW ene ton torts aecnn CONSTRUCTION ACCOUNTING AND FINANCIAL MANAGEMENT SECOND EDITION Steven J. Peterson, MBA, PE Weber State University Prentice Hall Upper Saddle River, New Jersey Columbus, Ohio This page intentionally left blank Preface Several years ago I was asked to teach a course on construction accounting and fi- nance. The course was to cover the fundamental principles needed by construc- tion managers to successfully manage the finances of construction companies. In preparing to teach this course I found that these principles were scattered among many disciplines, including business management, engineering economics, ac- counting, estimating, project management, and scheduling. After I reviewed the available textbooks, two things were apparent. First, the material was often pre- sented in a generic fashion and failed to address how the principles applied to the construction industry. For example, in most accounting textbooks only a few pages were devoted to the accounting procedures for long-term contracts, which comprise a bulk of the projects for general construction companies. Second, with the topics scattered among many disciplines and textbooks, the topic of how the different components of construction financial management were interrelated and interacted was being ignored. Financial management may be defined as the use of a company’s financial resources and encompasses all decisions that affect a company’s financial health. Many everyday decisions affect a company’s financial health. The difference be- tween a marginally profitable and a very profitable company is good financial management. Business schools teach the fundamental principles of financial management; however, because of the many unique characteristics of the con- struction industry, the usefulness of these financial principles as taught by busi- ness schools is limited. To be useful, these principles must be adapted specifically to the construction industry. For example, in the construction industry equip- ment is mobile and may be needed for multiple jobs during a single month. Tra- ditional accounting methods and financial statements do not allow a company to properly manage and account for its equipment. This book was written to help construction professionals—both those who are working in the construction industry and those seeking a degree in construction management—learn how the principles of financial management can be adapted to and used in the management of construction companies. This book will be most useful for general managers and owners of companies who are responsible for managing the finances of the entire company; however, many of these principles are useful to project managers and superintendents. For the project manager or v superintendent who desires to stand out in a company, there is no better way than to improve the profitability of their project through the principles of sound finan- cial management. The book also discusses how owners and general managers can manage construction projects by sound management of their project managers, superintendents, and crew foreperson. This book explains common financial principles, demonstrating how these principles may be applied to a construction situation and how these principles af- fect the financial performance of a company. Many of the examples included in this book are based on actual situations encountered by the author. This book is organized in five parts: introduction to construction financial management, accounting for financial resources, managing costs and profits, managing cash flows, and making financial decisions. The first part—comprising Chapter 1—introduces the reader to construction financial management, explains why construction financial management is different than financial management in other industries, and defines the role of a construction financial manager. The second part—comprising Chapters 2 through 6—describes how to account for a company’s financial resources. Accounting for these resources is built around a company’s accounting system. The third part—comprising Chapters 7 through 11—examines how to manage the costs and profits of a construction company. This must be done at the project level as well as at the company level. The fourth part—comprising Chapters 12 through 16—looks at how to manage a company’s cash flows and how to evaluate different sources of funding cash needs. The fifth part—comprising Chapters 17 and 18—explores ways to quantita- tively analyze financial decisions. After reading this book, you should have a better understanding of the following: ❑ The basic financial principles that are widely used in the business world and how to modify them so that they work for the construction industry. Application of these principles will help you better manage your business. ❑ Construction accounting systems, which will help you manage the accounting systems and use accounting information to manage a company. ❑ Financial and accounting principles, so that you may interact with accountants and bankers at a professional level. To access supplementary materials online, instructors need to request an instruc- tor access code. Go to www.pearsonhighered.com/irc, where you can register vi PREFACE ix Contents PART I INTRODUCTION TO CONSTRUCTION FINANCIAL MANAGEMENT 1 CHAPTER 1 CONSTRUCTION FINANCIAL MANAGEMENT 3 What Is Financial Management? 5 Why Is Construction Financial Management Different? 5 Project Oriented 6 Decentralized Production 7 Payment Terms 7 Heavy Use of Subcontractors 7 Who Is Responsible for Construction Management? 8 What Does a Financial Manager Do? 8 Accounting for Financial Resources 8 Managing Costs and Profits 10 Managing Cash Flows 11 Choosing among Financial Alternatives 13 Conclusion 13 Problems 13 PART II ACCOUNTING FOR FINANCIAL RESOURCES 15 CHAPTER 2 CONSTRUCTION ACCOUNTING SYSTEMS 17 Cost Reporting versus Cost Control 18 The General Ledger 20 Method of Accounting 20 Cash 20 Accrual 22 Percentage of Completion 22 Completed Contract 23 The Balance Sheet 24 Assets 24 Liabilities 27 Owner’s Equity 29 The Income Statement 30 Revenues 31 Construction Costs 31 Equipment Costs 33 Overhead 36 Other Income and Expenses 36 Income Tax 36 The Job Cost Ledger 37 The Equipment Ledger 43 Conclusion 45 Problems 46 CHAPTER 3 ACCOUNTING TRANSACTIONS 47 Invoice Charged to a Job without Retention 48 Invoice Charged to a Job with Retention 49 Paying Invoices 50 Labor Charged to a Job 51 Labor Charged to General Overhead 53 Paying an Employee’s Wages 55 Paying Payroll Taxes 56 Paying for Benefits 56 x CONTENTS Vacation Time for Jobsite Employees 57 Recording Office Rent 58 Recording Office Depreciation 59 Recording General Overhead Invoices 60 Billing a Client 61 Billing for Retention 62 Receiving Payment from a Client 62 Purchase of Equipment with a Loan 63 Loan Payment 64 Equipment Depreciation 64 Leased Equipment with an Operating Lease 65 Leased Equipment with a Capital Lease 66 Lease Payments on a Capital Lease 67 Amortization of a Capital Lease 68 Invoice for Equipment Repairs 69 Equipment Charged to a Job 70 Equipment Charged to an Employee 71 Sale of Equipment 72 Purchase of Inventory 73 Charging Inventory to a Job 74 Recording Changes in Costs and Profits in Excess of Billings 75 Recording Changes in Billings in Excess of Costs and Profits 76 Conclusion 77 Problems 77 CHAPTER 4 MORE CONSTRUCTION ACCOUNTING 81 Committed Costs and Estimated Cost at Completion 81 Overbillings and Underbillings 86 Internal Controls 89 Computerized Accounting Systems 90 Conclusion 92 Problems 92 CHAPTER 5 DEPRECIATION 95 Straight-Line Method 96 Sum-of-the-Years Method 98 Declining-Balance Method 102 CONTENTS xi CHAPTER10 SETTING PROFIT MARGINS FOR BIDDING 221 The Profit Equation 221 Contribution Margin 223 Projecting Break-Even Volume of Work 224 Projecting Break-Even Contribution Margin Ratio 226 Adjusting the Financial Mix 228 Profit and Overhead Markup 230 Conclusion 233 Problems 233 CHAPTER11 PROFIT CENTER ANALYSIS 237 Sources of Profit 237 Allocation of General Overhead 241 Profit Center Analysis 244 Crews as Profit Centers 244 Project Management as Profit Centers 246 Estimators as Profit Centers 247 Types of Jobs as Profit Centers 247 Customers as Profit Centers 251 Equipment as Profit Centers 252 Conclusion 253 Problems 254 PART IV MANAGING CASH FLOWS 257 CHAPTER12 CASH FLOWS FOR CONSTRUCTION PROJECTS 259 Cash Flow for Projects with Progress Payments 260 Cash Flow for Projects with a Single Payment 285 xiv CONTENTS Conclusion 288 Problems 289 CHAPTER13 PROJECTING INCOME TAXES 295 Corporate versus Personal Income Tax 295 Taxable Income 296 Payment of Income Taxes 298 Income Tax Rates 298 Marginal or Incremental Tax Rate 302 Capital Gains and Losses 303 Tax Consequences of Depreciation 304 Nondeductible Expenses/Costs 308 Tax Credits 309 Alternate Minimum Tax 309 Projecting Taxable Income 310 Conclusion 310 Problems 311 References 312 CHAPTER14 CASH FLOWS FOR CONSTRUCTION COMPANIES 313 Incorporating Construction Operations 314 Incorporating General Overhead 325 Income Taxes, Interest, Loan Payments, and Cash Balance 328 Determining the Minimum Monthly Balance 333 Fine Tuning, What If, and Sensitivity Analysis 334 Conclusion 336 Problems 337 CONTENTS xv CHAPTER15 TIME VALUE OF MONEY 341 Equivalence 342 Single-Payment Compound-Amount Factor 343 Single-Payment Present-Worth Factor 347 Uniform-Series Compound-Amount Factor 350 Uniform-Series Sinking-Fund Factor 352 Uniform-Series Present-Worth Factor 355 Uniform-Series Capital-Recovery Factor 357 Cash Flow Diagrams 359 Complex Cash Flows 360 Find Unknown Periodic Interest Rates 366 Inflation and Constant Dollars 371 Conclusion 372 Problems 372 CHAPTER 16 FINANCING A COMPANY’S FINANCIAL NEEDS 377 Interest 378 Simple Interest 378 Compound Interest 378 Yield or Annual Percentage Yield 380 Fixed versus Variable Interest Rates 383 Loans and Lines of Credits 383 Loans 385 Long-Term Loans 386 Amortization Schedule 394 Closing Costs 396 Short-Term Loans 404 Lines of Credits 407 Compensating Balance 407 Commitment Fee 411 Leasing 413 Trade Financing 413 Credit Cards 415 Equity Financing 416 Selecting a Banker 416 xvi CONTENTS In this section we introduce you to construction financial management, how it is dif- ferent from financial management in other industries, and why construction compa- nies need to use good financial management. This section includes: ❑ Chapter 1: Construction Financial Management 1 P A R T I Introduction to Construction Financial Management This page intentionally left blank 3 In this chapter you will learn what financial management is and why the financial management of construction companies is different from financial management of most other companies. In 1997, 10,8671 construction companies in the United States failed, bringing the total for the eight-year period beginning in 1990 to more than 80,0002 construc- tion companies. These failures include only those business failures that resulted in a loss to their creditors and do not include contractors who closed their doors without leaving their creditors with a loss. The 1997 failure rate translates to 118 failures per 10,0003 construction companies or 1.18% of the construction com- panies. These failures are divided among companies of all ages. Figure 1-1 shows the breakdown of these failures by age of the business. During 1997 the greatest number of business failures was for construction companies that had been oper- ating for longer than 10 years.4 C H A P T E R 1 Construction Financial Management 1Dun & Bradstreet, Business Failure Record, 1986–97, annually as quoted by The Center to Protect Worker’s Rights, The Construction Chart Book, 3rd Edition, September 2002. Note: Dun & Bradstreet stopped publishing business failure data after 1997. 2Dun & Bradstreet, Business Failure Record, 1986–97, annually as quoted by Surety Information Of- fice, Why Do Contractors Fail?, downloaded from http://www.sio.org/html/whyfail.html down- loaded on April 3, 2003. 3Dun & Bradstreet, Business Failure Record, 1986–97, annually as quoted by The Center to Protect Worker’s Rights, The Construction Chart Book, 3rd Edition, September 2002. 4Dun & Bradstreet, Business Failure Record, 1986–97, annually as quoted by The Center to Protect Worker’s Rights, The Construction Chart Book, 3rd Edition, September 2002. 5Dun & Bradstreet, Business Failure Record, 1986–97, annually as quoted by The Center to Protect Worker’s Rights, The Construction Chart Book, 3rd Edition, September 2002. FIGURE 1-1 Business Failure by Age5 3. After mixing, the ingredients are fed into a furnace, where they are heated to make molten glass. 4. The molten glass is passed through a machine that spins the glass into fibers, cools the fibers, and adds liquid binders which causes the glass fibers to stick together. 5. The spun glass is placed on a conveyor belt, where the speed of the conveyor belt controls the thickness of the insulation. 6. As the insulation proceeds along the conveyor belt, it is cut to width, and paper backing is added if required. 7. Finally, the insulation is cut to length, packaged, and stored for shipment. Now that you have a basic understanding of the process used to manufac- ture fiberglass insulation, let’s compare the management of this process to the management of a construction company. Project Oriented The insulation manufacturer is process oriented, whereas the construction com- pany is project oriented. Although the insulation manufacturer produces differ- ent types of insulation, the range of products that they produce is limited. In the above example the insulation produced may be of different thickness or R values, different widths, and with or without paper backing and packaged in rolls or bundles of 8-foot batts. All of these products are similar with slight variations. For many construction companies, each product is unique but often the products are very different. It is not uncommon for a construction company to be working on a tenant finish in a high-rise tower, a fire station, and an apartment complex at the same time. Even when a construction company is working on similar products—such as a homebuilder or a company building a number of conven- ience stores—the projects are often different due to site conditions and locations, which affects the availability of labor and materials. Because insulation manufacturers have a limited number of products they produce repeatedly, it is easier for them to determine their production costs. When a manager has produced a million square feet of R-11 insulation with paper backing packaged in a 15-inch-wide by 40-foot-long roll it is easier to project the cost to pro- duce the next 10,000 square feet than it is if the product has never been produced before. Construction companies often give clients fixed prices for a product that the company has never built or for a product that the company has never built using the local group of suppliers and subcontractors available at the project location. The insulation manufacturer sells the same product to a wide variety of buyers at locations other than the place the insulation is manufactured. In the construction industry, projects are often custom built for a specific owner on a specific location. The insulation manufacturer can deal with fluctuation in de- mand by producing and storing extra products when demand is slower for use when the demand is higher. It is relatively easy to store 5,000 square feet of in- sulation for immediate shipment to meet some future demand. With most of a 6 CHAPTER 1 construction company’s work occurring at the individual project’s location, the construction company cannot store unused production during slow times for use on future projects. How can you store 500 cubic yards of excavation for immediate use on some future project? To deal with this, the construction com- pany must constantly bid new work to keep the company’s employees workforce fully utilized or build speculative projects—projects without owners or buyers. Speculative building is a risky venture for the company because the product can- not be moved and often must be modified before it can be sold to another buyer. No other industry is as project based as is the construction industry. Almost everything a construction company does is a project. Because of this, a construc- tion company must keep accurate construction costs for each and every project that it constructs. Not only must the cost be kept for each project, but also the cost must be kept for each group of components on a project. This data is neces- sary to control the costs of the current project and also so the cost of the compo- nents may be used in the bidding of future projects. With each project requiring a different mix of labor, materials, and equipment, knowing the cost of the com- ponents of a project is necessary to bid future projects. Decentralized Production The insulation manufacturers perform all of their work at a centralized location, whereas the construction company performs its work at a number of decentral- ized locations. Insulation manufacturing plants are set up at a fixed location with the equipment being dedicated to a specific manufacturing process for years. Em- ployees come to the same plant year after year. In the construction industry the equipment and employees are seldom dedicated to a single project year after year. Equipment and employees may move from job to job on a regular basis. As a re- sult, the location of each employee and piece of equipment must be tracked to ensure that their costs are charged to the correct job. Additionally, each crew and piece of equipment must be managed as a project center. Payment Terms The insulation manufacturer bills the buyer at the time the insulation is shipped or when it is ordered with the expectation that the buyer will pay the full bill within a specified number of days. For many construction companies, their work consists of long-term contracts for individual projects with monthly progress pay- ments being made by the owner as the project is being built. Additionally, the owners often withhold retention—funds used to ensure the contractor completes the construction project—thus deferring payment of a portion of the progress pay- ment. As a result, construction companies have unusual cash flows and require modification to accounting and other financial procedures to handle retention. Heavy Use of Subcontractors The insulation manufacturer would never subcontract out a step in its manufac- turing process, yet many construction companies rely heavily on subcontractors’ CONSTRUCTION F INANCIAL MANAGEMENT 7 work. The use of subcontractors allows a construction company to tap into a sub- contractor’s financial assets during the construction process. The use of subcon- tractors has a great impact on the finances of a construction company. Because of these unique characteristics it is important for the manager of a construction company to have a sound understanding not only of financial man- agement but also of how financial management principles are applied to the con- struction industry. The tools that financial managers are taught in business schools must be modified to take into account the unique characteristics of the construction industry if they are to be useful to construction managers. WHO IS RESPONSIBLE FOR CONSTRUCTION MANAGEMENT? The person ultimately responsible for the financial management of a construc- tion company is often the owner or general manager. Often (especially in smaller companies) many of these tasks are delegated to estimators, superintendents, or project managers—particularly those tasks that are project specific. For this rea- son, and because many project managers, superintendents, and estimators aspire to move up within the company or start their own construction business, it is im- portant for all construction management students to understand the principles of financial success for a construction company. Nothing will put an employee on the fast track to success within a company faster than increasing the com- pany’s profitability through sound construction financial management. In this book the term financial manager is used to designate superintendents, project managers, estimators, general managers, or owners who are responsible for all or part of the financial management of a construction company. WHAT DOES A FINANCIAL MANAGER DO? The financial manager is responsible for seeing that the company uses its finan- cial resources wisely. A financial manager’s responsibilities may be broken down into four broad areas that include accounting for financial resources, managing costs and profits, managing cash flows, and making financial decisions. Accounting for Financial Resources Financial managers are responsible for accounting or tracking how the company’s financial resources are used, including the following: ❑ Making sure that project and general overhead costs are accurately tracked through the accounting system. ❑ Ensuring that a proper construction accounting system has been set up and is functioning properly. ❑ Projecting the costs at completion for the individual projects and ensuring that unbilled committed costs—costs that the company has 8 CHAPTER 1 or a general manager or owner who wants to know how well your project man- agers and superintendents are running their projects. In Chapter 8 you will learn to determine the labor burden markup. This helps you better understand how to project these costs, whether they are to be used to bid a new job, price a change order, or project the cost to complete the project. This helps the general manager and owner determine the labor costs needed to prepare a general overhead budget. In Chapter 9 you will learn how to prepare a general overhead budget that may be used to track overhead costs. It is easy for a company to squander its profits by failing to control general overhead costs. Construction managers often spend enormous amounts of time and effort budgeting, tracking, and controlling con- struction costs while ignoring general overhead costs. Just as a project manager or superintendent tracks and manages construction costs on a project, the general manager or owner needs to track and manage the general overhead costs. The key to doing this is to set and follow a general overhead budget. A general overhead budget is also needed to prepare the company’s annual cash flow projection, which is discussed in Chapter 14. In Chapter 10 you will learn to set profit margins for use in bidding and how the profit changes as the volume of work changes. You will also learn to de- termine the volume of construction work and profit and overhead markup nec- essary to cover the costs associated with the general overhead. Profits are used to pay for general overhead costs and provide the owners with a profit. If the profits are insufficient to cover the general overhead costs the company will consume its available cash and fail. If the profits fail to provide the owner with a reasonable profit, the owner may decide there are better places to invest his or her money and the company will lose financing. In Chapter 11 you will learn to analyze the profitability of different parts of the company and identify where the company needs to make changes to improve profitability. You will learn to choose between hiring a subcontractor and self- performing work. You will also learn to monitor the profitability of different cus- tomers and identify which customers should be developed and which customers your company would be better off without. Managing Cash Flows Financial managers are responsible for managing the cash flows for the company. Many profitable companies fail because they simply run out of cash and are unable to pay their bills. The duties of a financial manager include the following: ❑ Matching the use of in-house labor and subcontractors to the cash available for use on a project. ❑ Ensuring that the company has sufficient cash to take on an additional project. ❑ Preparing an income tax projection for the company. CONSTRUCTION F INANCIAL MANAGEMENT 11 ❑ Preparing and updating annual cash flow projections for the company. ❑ Arranging for financing to cover the needs of the construction company. Chapters 12 through 16 will help prepare you to perform these functions. In Chapter 12 you will learn to develop a cash-flow projection for a construc- tion project from both the perspective of a construction company that is receiving progress payments or draws from the project’s owner and from the perspective of a construction company that receives a single payment when the project is sold— such as is the case with many homebuilders. For companies in either of these situ- ations, the company must pay for some or all of the construction costs—especially labor—from the company’s funds before being reimbursed for these costs. To cover these costs the company needs cash. Because inadequate funding of the construc- tion company can spell doom to a construction project as well as to all of the com- panies involved, it is important that managers accurately project both the amount and timing of the cash required by a construction project. Understanding the cash flow for a construction project is a prerequisite to preparing a cash flow for an en- tire construction company, which is discussed in Chapter 14. In Chapter 13 you will learn the fundamentals of income taxes and how to prepare an income tax projection. Income taxes are a significant expense to the company and need to be included in the company’s annual cash flow projection. Having an unexpected income tax bill can reduce the funds available for use on construction projects to a dangerously low level. In Chapter 14 you will learn how to prepare an annual cash flow projection for a construction company. This is necessary to ensure that the company has sufficient cash for the upcoming year. Should a financial manager find that there are insufficient funds, he or she will have time to arrange for the necessary financing to provide the necessary funds. Annual cash flow projections for a company are prepared by projecting the annual revenues and construction costs for the construction company by combining the cash flows from the individual jobs or are based on historical data. The financial manager must then combine the projected revenues, construction costs, the general overhead budget, and the projected income taxes with the company’s available cash to determine the cash needs of the company. In Chapter 15 you will learn to convert cash flows occurring in one time period to an equivalent cash flow occurring at another time period or into a uni- form series of cash flows occurring over successive periods. Understanding the time value of money is a prerequisite to understanding debt financing and how to compare two or more financial options, which are the topics of Chapters 16, 17, and 18. Additionally, you will learn how to adjust interest rates for inflation. In Chapter 16 you will learn about financial instruments that can be used to provide the necessary cash for a construction company’s operation. You will also learn to compare debt instruments with different conditions and learn how loan provisions and closing costs can increase the effective interest rate on a loan or line of credit. An understanding of these principles helps you reduce borrow- ing costs and determine the best way to provide the cash needed to operate a 12 CHAPTER 1 construction company. Success in obtaining financing for a company can allow the company to take on additional projects, whereas failure to obtain financing can spell the doom of a company. Choosing among Financial Alternatives Financial managers are responsible for selecting among financial alternatives. These decisions include the following: ❑ Selecting which equipment to purchase. ❑ Deciding to invest the company’s limited resources in which area of the business. There are many financial tools that are available to quantitatively analyze the alternatives. In Chapters 17 and 18 you will learn to use these tools. In Chapter 17 you will learn ten quantitative methods that may be used to analyze financial alternatives and choose the alternative that is best for the com- pany. Without some quantitative method it is hard for managers to determine which option is best. Understanding these skills is necessary for any manager who must decide where to invest limited capital. In Chapter 18 you will learn how income taxes can influence the choice of financial decisions and how to incorporate income taxes into the decision-making tools from Chapter 17. If income taxes affected all alternatives in the same way, income taxes would not be an issue; however, income taxes can make some finan- cial alternatives preferable. With income tax rates of up to 38.6% financial man- agers must take income taxes into account by weighing financial alternatives. CONCLUSION A construction company is a risky venture. Each year, many construction compa- nies go out of business. Operating a successful construction company requires a specialized set of financial management skills, because of the unique nature of the construction industry. Unlike other industries, the construction industry faces a number of challenges: (1) constantly building unique, one-of-a-kind projects, (2) building a project at a different location each time, (3) dealing with retention and progress payments, and (4) relying heavily on the use of subcontractors to com- plete the projects. This book is designed to help the reader develop the financial management skills required to become a successful construction manager. PROBLEMS 1. According to the Surety Information Office, what are the six warning signs that a construction company is in financial trouble? CONSTRUCTION F INANCIAL MANAGEMENT 13 This page intentionally left blank 17 In this chapter you will be introduced to the structure of construction financial state- ments, including the different ledgers used by construction accounting systems. You will also learn the difference between accounting systems that are used for cost re- porting and systems that are used for controlling costs, as well as the different ac- counting methods available to construction companies. Because of the unique characteristics of construction companies, there are some key differences between accounting systems and financial statements for the construction industry and other industries. Before you can understand how to read construction company financial statements or understand how construction costs are tracked and managed, you must understand how construction accounting systems operate. Construction accounting systems include the software, hardware, and personnel necessary to operate a construction accounting system. Construction accounting systems serve four purposes. First, the accounting system processes the cash receipts (collecting payments) and disbursements (paying bills) for the company. The accounting system should ensure that revenues are billed and collected in a timely fashion and that timely payments are made only for bona fide expenses incurred by the company. Failure to collect revenues or careless payment of bills can quickly deplete the cash reserves of a company and, if left unchecked, can bankrupt a company. Second, the accounting system collects and reports the data needed to prepare company financial statements that are used to report the financial status of the company to shareholders and lending institutions. These reports are needed to assure shareholders and lending institutions that the company is solvent and is managing its financial assets in a wise manner. Third, the accounting system collects and reports the data needed to prepare income taxes, employment taxes, and other documents required by the C H A P T E R 2 Construction Accounting Systems government. Failure to pay taxes and file other required documents—such as W-2s and 1099s—on time results in the assessment of penalties. And, finally, the accounting system collects and provides the data needed to manage the finances of the company, including data for the company as a whole, each project, and each piece of heavy equipment. To successfully manage the company’s financial resources, the accounting system must provide this data quickly enough for management to analyze the data and make corrections in a timely manner. Accounting systems that fail to do this are simply reporting costs. COST REPORTING VERSUS COST CONTROL Cost reporting is where the accounting system provides management with the ac- counting data after the opportunity has passed for management to respond to and correct the problems indicated by the data. When companies wait to enter the cost of their purchases until the bills are received, management does not know if they are under or over budget until the bills are entered, at which time the materials purchased have been delivered to the project and may have been consumed. The extreme case of cost reporting is where companies only look at the costs and profit for each project after the project is finished. Cost reporting is typified by the accounting reports showing where a company has been financially without giving management an opportunity to proactively respond to the data. Cost control is where the accounting system provides management with the accounting data in time for management to analyze the data and make corrections in a timely manner. Companies that enter material purchase orders and subcon- tracts, along with their associated costs, into their accounting system as committed costs before issuing the purchase order or subcontract allow management time to address cost overruns before ordering the materials or work. Committed costs are those costs that the company has committed to pay and can be identified before a bill is received for the costs. For example, when a contractor signs a fixed-price sub- contract he or she has committed to pay the subcontractor a fixed price once the work has been completed and, short of any change orders, knows what the work is going to cost. Accounting systems that track committed costs give management time to identify the cause of the overrun early on, identify possible solutions, and take corrective action. Cost control is typified by identifying problems early and giving management a chance to proactively address the problem. A lot of money can be saved by addressing pervasive problems—such as excessive waste—early in the project. If a company’s accounting system is going to allow management to control costs rather than just report costs, the accounting system must have the follow- ing key components: First, the accounting system must have a strong job cost and equipment tracking system. The accounting system should update and report costs, including committed costs and estimated cost at completion on a weekly 18 CHAPTER 2 CONSTRUCTION ACCOUNTING SYSTEMS 21 CHART OF ACCOUNTS 110 Cash 730 Repairs and Maintenance 120 Accounts Receivable-Trade 740 Fuel and Lubrication 121 Accounts Receivable-Retention 750 Taxes, Licenses, and Insurance 130 Inventory 798 Equipment Costs Charged to Employees 140 Costs and Profits in Excess of Billings 799 Equipment Costs Charged to Jobs 150 Notes Receivable 160 Prepaid Expenses 805 Advertising 199 Other Current Assets 806 Promotion 810 Car and Truck Expenses 210 Building and Land 811 Computer and Office Furniture 220 Construction Equipment 812 Repairs and Maintenance 230 Trucks and Autos 819 Depreciation 240 Office Equipment 820 Employee Wages and Salaries 250 Less Acc. Depreciation 821 Employee Benefits 260 Capital Leases 822 Employee Retirement 299 Other Assets 823 Employee Recruiting 824 Employee Training 310 Accounts Payable-Trade 825 Employee Taxes 311 Accounts Payable-Retention 830 Insurance 320 Billings in Excess of Costs and Profits 835 Taxes and Licenses 330 Notes Payable 840 Office Supplies 340 Accrued Payroll 841 Office Purchase 341 Accrued Payables 842 Office Rent 342 Accrued Taxes 843 Office Utilities 343 Accrued Insurance 844 Postage and Delivery 344 Accrued Vacation 845 Janitorial and Cleaning 350 Capital Leases Payable 846 Telephone 360 Warranty Reserves 850 Charitable Contributions 379 Other Current Liabilities 855 Dues and Memberships 380 Long-Term Liabilities 860 Publications and Subscriptions 865 Legal and Professional Services 410 Capital Stock 870 Meals and Entertainment 420 Retained Earnings 875 Travel 430 Current Period Net Income 880 Bank Fees 881 Interest Expense 500 Revenue 885 Bad Debts 891 Unallocated Labor 610 Materials 892 Unallocated Materials 620 Labor 893 Warranty Expense 630 Subcontract 898 Miscellaneous 640 Equipment 899 Overhead Charged to Jobs 650 Other 910 Other Income 710 Rent and Lease Payments 920 Other Expense 720 Depreciation 950 Income Tax FIGURE 2-1 Chart of Accounts construction companies. Another advantage of the cash method of accounting is that it can easily be used to defer income tax. For example, to decrease the company’s tax liability for the year all the company has to do is to have any of the project’s owners who are going to make payments during the last few weeks of the company’s fiscal year hold the checks until the beginning of the next fis- cal year. This moves the revenues from the current year into the next year, re- duces the profit for the year, and thereby reduces the income tax liability for the year. The company can further reduce the profit by paying any bills that are due during the first few weeks of the next year on the last day of the current year. Regular “C” corporations whose average annual receipts for the last three tax- able years are more than $5,000,000 may not use the cash method of account- ing for income tax purposes. The big disadvantage of the cash method is that financial statements based on the cash method are of little use for financial management because of the delay in recognizing revenue and expenses. Because of this, many financial insti- tutions will not accept financial statements based on the cash accounting method. Construction companies that use the cash method of accounting for in- come tax purposes often use another accounting method for preparing financial statements for use in financial management. Accrual The accrual method tries to provide a more accurate financial picture by recog- nizing revenues when the company has the right to receive the revenues and by recognizing the expenses when the company is obligated to pay for the expenses, rather than when its cash flows occur. Revenues are usually recognized when the company bills the project’s owners. Because the company does not have the right to receive the retention until the project is complete, the revenue associated with the retention is usually not recognized until the project is complete and the com- pany has the right to receive the retention. Expenses are often recognized when the company receives a bill from the supplier or subcontractors. Because the ac- crual accounting method recognizes revenues and expenses before the revenues are received and the bills have been paid, financial statements prepared using the accrual method are more useful for financial management. Use of the accrual accounting method may also result in the payment of income taxes on revenues not received. Furthermore, companies that front-end load their contracts—put most or all of the profit at the beginning of the contract—may be paying income taxes on imaginary or unearned profits. Percentage of Completion The percentage-of-completion method requires construction companies to recog- nize revenues, expenses, and estimated profits on a construction project through the course of the project. Revenues are recognized when the company bills the project’s owners. The revenue associated with the retention is recognized, along 22 CHAPTER 2 with the revenues from the bill, unlike with the accrual accounting method, which allows the company to defer recognizing retention as revenue until it has the right to receive the retention. Expenses are recognized when the company receives a bill from the supplier or subcontractors. Under the percentage-of- completion method the estimated profits must be equally distributed over the en- tire project based on the expected cost of the project. Revenues, expenses, and the estimated profits are calculated based on the percentage of the project that is complete. For example, if the project were 40% complete a company would rec- ognize 40% of the expected revenue, 40% of the expected costs, and 40% of the expected profit. At the completion of the project the construction company must look back over the life of the project and determine if income taxes were overpaid or underpaid for each tax year. For underpayments of income taxes the construc- tion company must pay interest to the Internal Revenue Service on the amount underpaid in addition to paying the underpaid taxes. For overpayment the Inter- nal Revenue Service must pay interest to the construction company on the over- payment in addition to refunding the overpaid taxes. Larger construction companies are required to allocate general overhead to the individual projects when using the percentage-of-completion method. The percentage-of-completion method provides the best picture of the company’s financial situation. Completed Contract The completed contract method recognizes revenues and expenses at the comple- tion of the project. The benefit of recognizing revenues and expenses at the com- pletion of the project is that the revenues and expenses are known. Historically, speculative builders used the completed contract method because the contract amount was not known until the project was sold. The disadvantage of the com- pleted contract method is that it creates large swings in income. To get the best picture of a company’s financial health, a construction com- pany should use the method that best matches its costs to its revenues and prof- its. For most general contractors this is the percentage-of-completion method. For smaller companies the added cost and complexity of using the percentage- of-completion method may not be warranted and the company may use the cash method. For tax purposes construction companies must use the percentage-of- completion accounting method for long-term contracts except for (1) contracts entered into by a construction company whose average annual receipts for the last three taxable years is less than $10,000,000 and who estimates that the con- tract can be completed within a two-year period beginning at the contract com- mencement date or (2) home construction contracts, including improvements to dwelling units and the construction of new dwelling units in buildings contain- ing no more than four dwelling units. Because the income tax regulations are very complex and ever changing, it is a good idea for construction companies to employ the services of a certified public accountant when determining what method of accounting to use for financial and tax purposes. CONSTRUCTION ACCOUNTING SYSTEMS 23 ACCOUNTS RECEIVABLE: Accounts receivable are invoices owed to the company that will likely be paid within one year and have not been formalized by a written promise to pay, such as a note receivable. For construction companies the monthly bills or draws to the owners of the construction projects constitute an ac- count receivable until the bill is paid. When retention is held, it is common prac- tice to divide the accounts receivable into two categories: accounts receivable-trade and accounts receivable-retention. The retention that is being held by the project’s owner for which the company has not met the requirements for its release is recorded in the accounts receivable-retention category. The monthly bills—less retention—and retention for which the company has met the requirements for its release are recorded in the accounts receivable-trade category. This separation lets management quickly see which of the receivables are tied up in the form of reten- tion, whose release is contingent on the completion of construction projects. INVENTORY: Inventory includes materials that are available for sale or are avail- able and expected to be incorporated into a construction project within the next year. Many construction companies have little or no inventory. Subcontractors are the most likely group of contractors to carry inventory. COSTS AND PROFITS IN EXCESS OF BILLINGS: Costs and profits in excess of billings may also be referred to as costs and estimated earnings in excess of billings or underbillings. Construction companies using the percentage-of-completion ac- counting method are required to recognize the estimated profits on a construction project as the project is being completed rather than at the completion of the proj- ect. In these situations, the estimated profits must be equally distributed over the entire project based on the expected cost of the project. Costs and profits in excess of billings occur when the company bills less than the costs incurred plus the esti- mated profits or earnings associated with the completed work. If the billings are in excess of the costs and estimated profits, the difference is recorded as a liability under the billings in excess of costs and profits category. Costs and profits in ex- cess of billings can be the result of cost overruns on the completed work or as a re- sult of the profit not being equally spread over the items listed on the schedule of values. For companies using the completed contract accounting method, this cat- egory is replaced with a category entitled cost in excess of billings. For companies using the cash or accrual accounting method this category is not included on the financial statements. NOTES RECEIVABLE: Notes receivable includes all invoices due to the company that will likely be paid within one year and have been formalized by a written promise to pay. Invoices, short-term loans, or advances to employees that have been formalized by a written promise to pay and are likely to be paid within a year are considered notes receivable. PREPAID EXPENSES: Prepaid expenses are payments that have been made for fu- ture supplies and services. Examples of prepaid expenses include prepaid taxes, insurance premiums, rent, and deposits. 26 CHAPTER 2 OTHER CURRENT ASSETS: Other current assets are all current assets not recorded elsewhere. TOTAL CURRENT ASSETS: Total current assets represent the total value of the cur- rent assets. Fixed and other assets include assets with an expected useful life of more than one year at the time of their purchase. Fixed assets are recorded on the bal- ance sheet at their purchase price and with the exception of land are depreciated for financial purposes. Fixed and other assets include fixed assets, accumulated depreciation, net fixed assets, and other assets. Let’s look at what would be in- cluded in each of these categories. FIXED ASSETS: On the balance sheet shown in Figure 2-2 the fixed assets have been broken down into the following categories: land, buildings, construction equip- ment, trucks and autos, and office equipment. Land and buildings include all real property (real estate) owned by the company. Construction equipment includes heavy construction equipment, such as excavators and dump trucks, and other de- preciable construction tools, such as compressors. Trucks and autos include pickup trucks and automobiles used by office and field personnel. Office equipment includes all depreciable office equipment and furnishings such as desks and com- puters. These subcategories are then summed up to get the total fixed assets. ACCUMULATED DEPRECIATION: The losses in value to date of the fixed assets are recorded as accumulated depreciation. The depreciation method used in financial statements may be different from the depreciation method used for tax purposes. The depreciation taken for a fixed asset may never exceed the purchase price of the asset. The accumulated depreciation account is a contra account because it is subtracted from another account. NET FIXED ASSETS: The net fixed assets equals the total fixed assets less the accu- mulated depreciation. The net fixed assets is also known as the book values for all of the fixed assets or the value of the fixed assets on the accounting books. OTHER ASSETS: Other assets include assets not elsewhere classified. Common other assets include inventory that will not be sold within a year, investment in other companies, and the cash value of life insurance policies. TOTAL ASSETS: Total assets represent the total value of the current, fixed, and other assets. Liabilities Liabilities are obligations for a company to transfer assets or render services at some future time for which the company is already committed to. Loans and war- ranty reserves are common liabilities. Liabilities are divided into two broad cate- gories: current liabilities and long-term liabilities. CONSTRUCTION ACCOUNTING SYSTEMS 27 Current liabilities are those liabilities that are expected to be paid within one year. Current assets are usually used to pay current liabilities. Current liabil- ities include accounts payable, billings in excess of costs and estimated earnings, notes payable, accrued payables, capital lease payments, warranty reserves, and other current liabilities. ACCOUNTS PAYABLE: Accounts payables are debts that the company owes and ex- pects to pay within one year that are not evidenced by a written promise to pay. For construction companies the monthly bills that they receive from their suppliers and subcontractors constitute accounts payable until the bill has been paid. When retention is withheld from the subcontractor payments, it is common practice to divide accounts payable into two categories: accounts payable-trade and accounts payable-retention. The retention that is being withheld from the supplier or sub- contractor’s payments on projects that the requirements for release of the reten- tion have not been met is recorded in the accounts payable-retention category. The monthly bills from the suppliers and subcontractors, less retention, and retention on projects where the requirements for release of the retention have been met are recorded in the accounts payable-trade category. The separation of these two cate- gories allows management to see quickly how much of its accounts payable are being held until the requirements for the release of retention have been met. BILLINGS IN EXCESS OF COSTS AND PROFITS: Billings in excess of costs and profits may also be referred to as billings in excess of costs and estimated earnings or overbillings. Billings in excess of costs and estimated profits is the opposite of costs and profits in excess of billings. Construction companies using the percent- age-of-completion accounting method are required to recognize the estimated profits on a construction project as the project is being completed rather than at the completion of the project. In these situations, the estimated profits must be equally distributed over the entire project based on the expected cost of the proj- ect. Billings in excess of costs and estimated profits occur when the company bills more than the costs incurred plus the estimated profits or earnings associated with the completed work. If the costs and estimated profits are greater than the billings, the difference is recorded as an asset under the costs and profits in ex- cess of billings category. Billings in excess of costs and profits can be the result of cost savings on the completed work or as a result of the profit not being equally spread over the items listed on the schedule of values. For companies using the completed contract accounting method, this category is replaced with a category entitled billings in excess of costs. For companies using the cash or accrual ac- counting method this category is not included on the financial statements. NOTES PAYABLE: Notes payable includes all debts that will likely be paid within one year and have been formalized by a written promise to pay. ACCRUED PAYABLES: Accrued payables are monies owed for supplies and services that have not been billed. They include accrued taxes, rents, wages, and employee vacation time that have not been paid. For example, from the time an employee’s 28 CHAPTER 2 The income statement includes the following items: revenues, construction costs, equipment costs, overhead, other income and expense, and income tax. The income statement reports the value of each of the accounts in the income state- ment portion of the chart of accounts. Like the balance sheet, multiple accounts on the income statement may be combined and unneeded accounts left out. Revenues Revenue is the income recognized from the completion of part or all of a con- struction project. For a company using the percentage-of-completion or accrual accounting methods, revenue is recognized at the time the project’s owner is billed for the work. For a company using the completed contract method, revenue is recognized at the completion of the project. For a company using the cash method, revenue is recognized when the company is paid for the work by the project’s owner. Revenue may also be referred to as contract revenue on a con- struction company’s income statement and is equivalent to net sales used by other industries. Income from nonconstruction operations is usually classified as other income. Construction Costs Construction costs include both direct costs and indirect costs. Construction costs are the same as cost of sales in other industries. Direct costs are the cost of materials, labor, and equipment that are incor- porated into the construction of a project. Direct costs can be specifically identi- fied to the completion of a specific construction component of a specific construction project, such as a wall, a road, a tree, and so forth. Direct costs in- clude the cost of all materials incorporated into the completed construction proj- ect and the cost of the labor and equipment to install them. For example, for the task of installing a door the direct costs would include the material cost for the door—including sales tax and delivery costs—and the labor cost with burden to install the door. Most work in Divisions 2 through 49 of the MasterFormat13 is specified as direct costs. The key is that direct costs can be billed to a specific component of a specific project. Indirect costs consist of those costs that can be specifically identified to the completion of a specific construction project but cannot be identified with the completion of a specific construction component on that project. Indirect costs may also be referred to as indirect project costs, project overhead, or direct over- head costs. For example, job supervision and the jobsite trailer are indirect costs. Although these costs are required to complete the construction project, they are not directly incorporated into the construction project. Most work in Division 1 of the MasterFormat is specified as indirect costs. The key is that indirect costs can be billed to a specific project but cannot be billed to a specific component on the project. CONSTRUCTION ACCOUNTING SYSTEMS 31 13MasterFormat is a registered trademark of Construction Specification Institute (CSI). All construction costs should be charged to a specific construction project. Construction costs are commonly broken down into five types or groups that in- clude materials, labor, subcontract, equipment, and other costs. Some companies break labor down into labor and labor burden and equipment down into equip- ment rental and equipment owned. One reason for this breakdown is that a com- pany often pays a different liability insurance rate on each of these types of costs. MATERIALS: The materials cost type includes supplies or material that are pur- chased by the company and incorporated into the finished project, such as lum- ber, windows, and concrete. The transportation and storage of the materials should be included in the cost of the materials as well as any sales tax on the pur- chase. The materials cost type does not include any labor for the installation of the material. Purchases that include labor would be considered a subcontract cost type. LABOR: The labor cost type includes only the labor that is processed through the construction company’s payroll system and is charged to a construction project. Labor includes all labor burden costs, including social security, Medicare, Federal Unemployment Tax (FUTA), State Unemployment Tax (SUTA), vacation al- lowance, company-paid health insurance, company-paid union fees, and other company-paid benefits. Labor that does not pass through the company’s payroll system, including temporary labor services, would be considered a subcontract cost type. When the labor cost type is separated into labor and labor burden, the employee’s wages would be considered a labor cost type, whereas all burden costs would be considered a labor burden cost type. SUBCONTRACT: The subcontract cost type includes work that is performed by subcontractors for a construction project. Subcontracts must always include labor being performed by the subcontractor and may include the supplying of materials, equipment, and other items. Subcontract does not include labor that is processed through the contractor’s payroll system. EQUIPMENT: The equipment cost type includes equipment costs that have been charged to a construction project. These charges come from the equipment cost section of the income statement. When equipment is charged directly to the con- struction costs section of the income statement it should be categorized as an other cost type or the company should break the equipment cost type into equip- ment rented and equipment owned. When this is done, the equipment that is charged directly to the construction costs section of the income statement is cate- gorized as an equipment rented cost type, whereas charges coming from the equip- ment cost section of the income statement are categorized as an equipment owned cost type. When a company does not use the equipment portion of the income statement, all equipment costs are charged directly to the jobs as an equipment cost type and there is no need to break down the equipment category. This separa- tion is necessary to maintain checks and balances within the accounting system. 32 CHAPTER 2 OTHER: The other cost type includes all costs that are not classified as labor, ma- terials, equipment, or subcontract cost types and are performed on a construc- tion project. Other costs include services (such as surveying, temporary toilets, and utilities) and materials that are not incorporated into the construction proj- ect (such as materials used on temporary office facilities). Equipment Costs When equipment is used on multiple construction projects the allocation of equipment costs to construction jobs is much more complicated than the billing of materials, labor, and subcontractor’s services. When equipment is used on a single construction project, all costs go to the project. When a construction com- pany spends $5,000 on tires for a front-end loader that is used on dozens or maybe hundreds of jobs during the life of the tires, it becomes unclear which con- struction project should be charged for the costs of the tires. Suppose the front- end loader was used on a construction project for two days. After the first day the company’s maintenance personnel came to the project and changed the tires on the front-end loader. Even though the costs associated with the new tires occurred while the front-end loader was on the project, it would be unfair to charge the en- tire cost of the tires to the project. To do so would unfairly skew the costs of the project and render the data obtained from the accounting systems less meaning- ful. To fairly handle construction equipment costs, the costs must be allocated. The equipment costs portion of the income statement is where these costs are held until they can be allocated to specific projects. In the case of the front-end loader, the cost of the tires would be recorded under equipment costs and then would be allocated to the individual jobs based on the project’s usage of the equipment. The equipment cost portion of the income statement is a unique feature of income statements for construction companies that own their own equipment. Equipment costs are considered construction costs that have yet to be allocated or charged to specific projects and should not be confused with company overhead costs. Some companies and accountants require that all of the equipment costs be allocated by the end of the company’s fiscal year. Let’s look at how the equipment section of the income statement works. Suppose that your company had a front-end loader whose costs for depreciation, taxes, licenses, and insurance were $3,200 per month and whose preventative maintenance, fuel, and lubrication were $35 per billable hour. During the month of April the tires were replaced on the loader at a cost of $6,000. No other costs were incurred during the year. The loader was only used during the months of April through October. The monthly costs and billable hours by job are shown in Table 2-1. If a company were to bill the monthly costs to the jobs the loader worked on during the month, for the months of January, February, March, November, and December the monthly costs would go unbilled. During the remaining months the average hourly cost ranged from $52.78 to $150.00 per hour. To more evenly dis- tribute the costs and to ensure all costs incurred during the year are billed to jobs, CONSTRUCTION ACCOUNTING SYSTEMS 33 Overhead Overhead are those costs that cannot be charged to a specific construction project or be included in the equipment costs section of the income statement. Overhead is often referred to as general overhead, general and administrative expense, or indirect overhead. Because the term project overhead is often used to describe indirect costs, this book often uses the term general overhead in the place of overhead to avoid confusion. In other businesses general overhead is often referred to as operating expenses. General overhead includes all main office and supervisory costs that cannot be billed to a specific construction project. General overhead is discussed in detail in Chapter 9. Some large com- panies may be required to allocate general overhead to the individual construc- tion projects. NET PROFIT FROM OPERATIONS: Net profit from operations equals the gross profit less the overhead and also equals the revenues less the construction costs, equipment costs, and overhead. Other Income and Expenses Other income and expenses is a catchall category that includes all income and expenses not associated with construction operations. A common source of other income and expenses is interest and the operation of a rental property. PROFIT BEFORE TAXES: Profit before taxes or before-tax profit equals the net profit from operations less other income and expenses. Income Tax Income tax consists of income tax liabilities as well as deferred income taxes. In- come tax consists of income taxes levied by the federal, state, and local govern- ments. Some companies pay income taxes at the corporate level, whereas other companies pass their tax liability on to their shareholders. Deferred income tax occurs when a construction company uses a different accounting method for in- come tax purposes than they do for financial purposes. For example, a company may use the cash accounting method for income tax purposes because it allows the company to defer income tax, but uses the percentage-of-completion method for preparation of financial statements because it provides the most accurate fi- nancial picture of the company. In this case, the difference in the income tax cal- culated using the cash method and the percentage-of-completion method would be reported on the financial statement as deferred income tax. Income taxes are discussed in Chapter 13. PROFIT AFTER TAXES: Profit after taxes equals the profit before taxes less income taxes. 36 CHAPTER 2 There are three key relationships that must be maintained in the general ledger. First, the sum of the asset accounts on the balance sheet must equal the sum of the liability and the equity accounts on the balance sheet. For a company using the chart of accounts in Figure 2-1, the sum of accounts 110 through 299 must equal the sum of accounts 310 to 430. Second, the profit for the period re- ported on the income statement must equal the total revenue for the period— including other income—less the sum of the expenses, including all construction costs, equipment costs, overhead costs, other expenses, and income tax. For the company using the chart of accounts in Figure 2-1, the profit would be equal to the sum of accounts 500 and 910 less the sum of accounts 610 through 899, 920, and 950. Third, the profit for any period must equal the change in equity for that same period. For a company using the chart of accounts in Figure 2-1, the change in equity would occur in accounts 410 through 430. Changes in the eq- uity that occur throughout a period are usually recorded in the current period net income category and are then transferred to another equity category at the end of the period. THE JOB COST LEDGER For management to monitor and control the cost of construction projects, the costs for each project must be tracked against a budget. Additionally, the cost recorded to the job cost ledger, become part of company’s historical records. These historical records are used to prepare estimates and bids, which are the basis for the budgets used in the job cost ledger. This cost information cycle is depicted in Figure 2-4. Although construction costs are recoded in the general ledger, the general ledger lacks the necessary details to meet these two needs. These needs are met through the job cost ledger. The job cost ledger tracks the costs for each project as well as individual components within each of the projects. The job cost ledger tracks costs using a cost coding system based on a company’s work breakdown structure. Most accounting systems allow for four levels of tracking: project, CONSTRUCTION ACCOUNTING SYSTEMS 37 FIGURE 2-4 Cost Information Cycle Historical Records Actual Costs Estimates & Bids Budgets phase or area, cost code, and cost type. A graphical representation of the break- down of the job cost ledger is shown in Figure 2-5. The first level of breakdown is by project. Each construction project is as- signed a project code and is tracked separately. An easy way to set up project codes is to use the first one or two digits of the project code to represent the year that the project was started. The remaining digits are assigned sequentially start- ing with 1 for the first project of the year, 2 for the second project of the year, and so forth. Each project may then be broken down into phases, which are assigned a number. The phases may be used to separate different structures within a proj- ect—such as different apartment buildings within an apartment complex—or may be used to separate the costs into groups—such as site costs versus building costs. Some companies may not separate the projects into phases. The phases—if phases are not used, the projects—are then broken down into cost codes. Sample cost codes for a commercial contractor are found in Figure 2-6 and cost codes for a residential contractor are found in Figure 2-7. A cost code often consists of two parts, with the first two digits representing a group of codes and the remaining digits representing a cost category within that group. The job cost codes are often based on the Construction Specification Institute’s MasterFormat or Uniformat. The job cost codes provide standard cat- egories for costs, which are used by both the estimating and accounting depart- ments to ensure that the costs are tracked the same way they are estimated. The scheduling department uses the same job cost codes when developing tasks to ensure each task has only one job cost code; although there can be multiple 38 CHAPTER 2 FIGURE 2-5 Breakdown of Job Cost Ledger CONSTRUCTION ACCOUNTING SYSTEMS 41 tasks assigned to one job cost code. The first two digits of the cost codes in Fig- ure 2-6 correspond with the divisions of the 16 division MasterFormat. The last three digits of the cost code loosely follow the MasterFormat. Modifications were made to the MasterFormat numbers to prevent the cost codes from bunch- ing up and to meet the individual needs of the company. Not all of these cost codes are used for every job—only those codes for which costs have been bud- geted. The cost codes are then broken down into a cost type. Typically the cost types should match the types used on the income statement. In the case of the income statement in Figure 2-3 the cost types would be materials, labor, subcon- tracts, equipment, and other. A complete cost code—consisting of the job number, phase code, cost code, and cost type—is used to describe each account on the job cost ledger. The job cost code may be written as follows: ###.##.#####A where the three numbers to the left of the first decimal point represent the job number, the two numbers between the decimal points represent the phase code, the five numbers to the right of the second decimal point represent the cost code, and the last alphanumeric character represents the cost type. For the company using the income statement in Figure 2-3 the cost types would be M, L, S, E, and O, representing materials, labor, subcontracts, equipment, and other. The job cost code of 102.01.07200L for a company using the cost codes in Figure 2-6 would represent the labor component for the insulation work on Phase 1 of Pro- ject 102. Delimiters other than dots, such as dashes, may be used in the job cost code. For example, the previous code could be written 102-01-07200L. For the job cost coding system to work, the system must be standardized, follow a common-sense format, match the way the company does business, and allow for expansion. It is also important that all parties who use the system— estimators, field employees, the accounting department, and management— must be using the same coding and must be consistent in how items are coded. If field employees code framing hardware to a different code than the estima- tors, tracking the project’s costs against the estimator’s budget will be of little use when trying to manage costs and cost data from past projects will be of little use to the estimating department when bidding future projects. For this consistency to occur there must be a written, companywide standard that ex- plains the coding system and how items are to be coded. This document should include a list of the cost codes with a description of what is to be included in each cost code. Developing a job cost coding system that follows an easy, common-sense format makes it easier to ensure that items are coded correctly and easier to use for cost control. A hard-to-follow format will create confusion and increase the number of coding errors. The coding systems should be set up so that only one vendor or subcontractor is coded to any one of the costs codes; thereby mak- ing it easy to determine which vendor or subcontractor is responsible for costs overruns. It should also not require bills from vendors to be split up among dif- ferent cost codes unless it is required for the tracking of costs; as is the case when invoices are broken up by building or when plumbing is divided into sub-rough (underground), rough, and finish. Splitting of invoices between job codes often leads to errors and inaccurate historical costs and should be avoided when it does not foster improved job cost control. The job cost coding system must match the way the company buys out a construction project and tracks the costs on the project. Looking at the cost codes in Figure 2-6, we see that 02610 Site Conc.-Labor and 02620 Site Conc.-Concrete have been included under 02000 Site Work. The contractor set this up this way so that building costs could be easily separated from the site costs. In this case the building costs are 3000 Concrete through 16000 Electrical. Additionally, the con- tractor uses both subcontractors and in-house crews to form and pour the site concrete, but the contractor always provides the concrete. By separating the forming and pouring costs from the concrete costs the contractor can easily com- pare the cost of using a subcontractor to the cost of using in-house crews by charging all costs usually paid by the subcontractor to the labor cost code when the company’s work crews pour the concrete. For example, if the concrete sub- contractor typically includes the costs of tie wire, form oil, and other materials in their bid, when the company uses in-house crews to pour the concrete, these costs would be billed to 02610M the materials portion of the 02610 Site Conc.- Labor cost code. Similarly, equipment costs incurred by the in-house crew would be billed to 02610E and labor costs would be billed to 02610L, the equipment and labor portion of the 02610 Site Conc.-Labor cost code. Materials which are pro- vided by the contractor regardless of who is performing the labor (subcontractor or in-house) are billed to 02620M the materials portion of the 02620 Site Conc.- Concrete cost code. This makes it possible for management to directly compare the cost of performing the work in-house to hiring a subcontractor to perform the work by comparing the costs recorded to 02610 Site Conc.-Labor on one job where the concrete was poured by an in-house crew to the costs recorded to 02610 Site Conc.-Labor on a second and similar job where the concrete was poured by a subcontractor. If the material costs for tie wire, form oil, and so forth were mixed with concrete costs it makes it difficult to make a direct comparison. Finally, the system must allow for expansion. Companies often set up a cod- ing system to fit their current business operations. Later they find that their busi- ness has expanded, requiring additional codes that cannot be supported by their current coding system. The company then must change its coding system, which leads to confusion and coding problems. Common mistakes in this area are not leaving enough space between cost codes to allow for the addition of cost codes between two codes and not setting up the project and phase codes with enough places to allow for the increase in the number of projects or phases. For the job cost ledger to be of use, budget must be recorded for each cost code. These budgets come from the cost estimate for the project that was gener- ated when the project was bid and must be updated when changes occur. When- ever a cost is recorded to the general ledger as a construction cost it should also be 42 CHAPTER 2 recorded to the job cost ledger. Many job cost ledgers also allow revenues to be credited to individual jobs. Many job cost ledgers allow the company to track com- mitted costs. Committed costs should be tracked to get a more accurate picture of the project’s financial status. If the job cost ledger does not allow for the tracking of committed costs, the project’s management should perform these calculations on a regular basis. Committed costs are discussed in detail in Chapter 4. Two key relationships must be maintained between the general ledger and the job cost ledger. First, the total of the revenue on the job cost ledger must equal the revenue from the core business—exclusive of interest received and other in- come—on the income statement for a specific period of time. For the company using the chart of accounts in Figure 2-1, the amount in account 500 Revenue must be equal to the total revenue recorded on the job cost ledger for the period. Second, the total of the costs—exclusive of committed costs that have not been recognized as an expense—on the job cost ledger must equal the construction costs on the income statements for a specific period of time. The total in each of the five subcategories—labor, material, equipment, sub- contract, and other—on the job cost ledger must equal the construction costs on the general ledger in the associated account for any given period. For the com- pany using the chart of accounts in Figure 2-1, the amount in accounts 610 Ma- terials, 620 Labor, 630 Subcontract, 640 Equipment, and 650 Other must equal the costs recorded in the job cost ledger for the period. Additionally, 610 Materi- als must equal the total of all costs on the job cost ledger with a material cost type, 620 Labor must equal the total of all costs on the job cost ledger with a labor cost type, 630 Subcontract must equal the total of all costs on the job cost ledger with a subcontract cost type, 640 Equipment must equal the total of all costs on the job cost ledger with an equipment cost type, and 650 Other must equal the total of all costs on the job cost ledger with an other cost type for a spe- cific period. Again, committed costs that have not been recognized as expenses are not included in these calculations. At the end of each month, the company’s accountant should verify that these relationships are being adhered to and make the necessary corrections. It is important to note that the costs on the job cost ledger span multiple months or years; therefore, the cost comparison between the job cost ledger and the general ledger must only include the costs recorded during a specific month, quarter, or year. THE EQUIPMENT LEDGER Many construction companies have major investments in equipment that is moved from job to job. Some equipment, such as a dump truck, may be on multi- ple jobs during one day. For a construction company to effectively manage equip- ment and to ensure that the equipment costs are being billed to projects and that they are making enough money on each piece of equipment to warrant the invest- ment in the equipment, the costs and billings for each piece of equipment must be tracked. This tracking is accomplished through the equipment ledger. CONSTRUCTION ACCOUNTING SYSTEMS 43 PROBLEMS 1. Describe the purposes of the accounting system. 2. Describe the difference between cost reporting and cost control. 3. What are the key components of an accounting system that facilitates cost control? 4. Describe the different accounting ledgers used by construction companies and explain their purpose. 5. Describe the relationship among the chart of accounts, the balance sheet, and the income statement. 6. Compare and contrast the different accounting methods that are available to construction companies. 7. Describe the key relationships that must be maintained within the general ledger. 8. Describe the key relationships that must be maintained between the general ledger and the job cost ledger. 9. Describe the key relationships that must be maintained between the general ledger and the equipment ledger. 46 CHAPTER 2 47 C H A P T E R 3 Accounting Transactions In this chapter you will gain a better understanding of how different accounting transactions are processed in the accounting system. There are a number of unique transactions that take place in construction accounting that do not occur in other in- dustries. Most of these transactions are a result of the construction industry’s focus on job costing, equipment tracking, and accounting for long-term contracts. Under- standing these transactions is important for three reasons: First, some project costs— such as labor burden and equipment costs—are often generated by the accounting system rather than an invoice or time card. Understanding how these costs are ob- tained will help you gain a better understanding of how to estimate these costs and incorporate them in the financial analysis of the project. Second, financial managers must review the accounting reports for errors—improperly billed costs and omitted costs—and ensure that the necessary corrections are made. Understanding how the costs are generated will help you better understand how to interpret the accounting reports. Finally, for the general manager and owner, understanding construction ac- counting is necessary to ensure that the accounting system is set up to meet the needs of the company. Many construction companies are using substandard ac- counting systems because management does not understand how accounting sys- tems should be structured to meet the needs of the construction industry. Now that we have looked at the different ledgers used in a construction account- ing system, it is important to understand how common construction transac- tions affect the different ledgers and how the ledgers are interrelated. These transactions may be referred to as journal entries. Transactions or journal entries that occur on the balance sheet portion of the general ledger consist of both deb- its and credits, with the total of the debits equaling the total of the credits. Deb- its increase the balance of asset accounts and decrease the balance of liability and owners’ equity accounts, whereas credits decrease the balance of asset accounts and increase the balance of liability and owners’ equity accounts. The relation- ship between debits and credits and the accounts on the balance sheet is shown in Figure 3-1. To make it easier to understand how a transaction affects the different accounts, this book indicates simply whether the transaction in- creases or decreases the balance of the account. As we look at these transactions, we need to keep in mind the key relation- ships discussed in the previous chapter. Let’s look at some common transactions that occur in construction companies. For these transactions we use the chart of accounts in Figure 2-1 and the cost codes in Figure 2-6. The chart of accounts will also be broken into its two separate components: the balance sheet and the income statement. INVOICE CHARGED TO A JOB WITHOUT RETENTION When a material, subcontract, or other cost type invoice that is billable to a con- struction project—on which the contractor will not hold retention from the pay- ment—is received and entered into the accounting system it affects the income statement, balance sheet, and job cost ledger. Most commonly this type of invoice is an invoice for materials. For discussion purposes we look at how a material in- voice is handled. On the income statement the material invoice is recorded as a cost in the material section of the construction costs. The increase in the con- struction costs decreases the profit on the income statement by the amount of the invoice. This decrease in profit is not offset until revenues are recorded. On the balance sheet the materials invoice is recorded as an accounts payable-trade in the liability section. This increase in liability results in a reduction in the cur- rent period net income equal to the amount of the invoice. As per the relation- ships previously discussed, the reduction in profit on the income statement is equal to the reduction in the current period net income on the balance sheet. On the job cost ledger the materials invoice is recorded as a cost with a material cost DEBIT DEBIT CREDIT CREDIT D E C R E A S E IN C R E A S E ASSET LIABILITY EQUITY FIGURE 3-1 Debits and Credits 48 CHAPTER 3 Example 3-3: Determine the changes to the balance sheet that occur when the invoices in Examples 3-1 and 3-2 are paid. The retention will not be released at this time. The company uses the chart of accounts in Figure 2-1. Solution: The contractor will use a check drawn against the cash account to pay $10,000 from Example 3-1 and $9,000 from Example 3-2, for a total of $19,000. The changes are shown in Table 3-3. LABOR CHARGED TO A JOB When an employee’s time—whose costs are to be charged to a project—is entered into the accounting system it affects the income statement, balance sheet, and job cost ledger. On the income statement the employee costs—including labor bur- den—are recorded as a cost in the labor section of the construction costs. The in- crease in the construction costs decreases the profit on the income statement by the total cost of the employee. On the balance sheet the employee costs will be- come accrued liabilities. For a company using the chart of accounts in Figure 2-1 the accrued liabilities have been broken down into five accounts: 340 Accrued Payroll, 341 Accrued Payables, 342 Accrued Taxes, 343 Accrued Insurance, and 344 Accrued Vacation. The amount due to the employee—after withholdings and deductions—is recorded in the 340 Accrued Payroll account. Social security taxes, Medicare taxes, FUTA, and SUTA paid by the employer; social security taxes and Medicare taxes paid by the employee; and state and federal withholding taxes withheld from the employee’s paycheck are recorded in the 342 Accrued Taxes ac- count. Workers’ compensation insurance, liability insurance, and health insur- ance costs are recorded in the 343 Accrued Insurance account. Because it is unfair to charge an employee’s vacation time to the job he or she is working on when the employee takes vacation, funds to pay for the employee’s vacation must be accrued throughout the year. These funds are recorded in the 344 Accrued Vacation ac- count. All other benefits would be recorded in the 341 Accrued Payables account. This increase in liability on the balance sheet results in a reduction in the current period net income equal to the total cost of the employee. As per the relationships previously discussed, the reduction in profit on the income statement is equal to the reduction in the current period net income on the balance sheet. On the job cost ledger the labor cost, including burden, is recorded as a cost with a labor cost type against the job, phase, and cost code for which labor was performed. If the ACCOUNTING TRANSACTIONS 51 TABLE 3-3 Paying Invoices ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 110 Cash 19,000.00 Decrease (Credit) 310 Accounts Payable-Trade 19,000.00 Decrease (Debit) employee performed work on multiple cost codes, the labor is divided among the appropriate cost codes. The calculation of the burden costs (including social secu- rity tax, Medicare tax, FUTA, SUTA, workers’ compensation insurance, general lia- bility insurance, health insurance, and retirement) are discussed in Chapter 8. Example 3-4: Determine the change to the balance sheet, income state- ment, and job cost ledger of a finish carpenter when his or her time is en- tered into the accounting system. The finish carpenter is to be paid $895.90 for a week’s work. The employer has the following burden costs: $55.55 for social security tax, $12.99 for Medicare, $26.88 for SUTA, $7.17 for FUTA, $8.96 for liability insurance, $71.67 for workers’ compensation, $24.00 for the health insurance premium, and $38.00 is set aside for vacation. The employee has the following withheld from his or her check: $55.55 for so- cial security tax, $12.99 for Medicare, $75.25 as federal withholding, $33.86 for state withholding, and $76.08 for the employee’s part of the health insurance premium. The labor is charged to cost code 06210 Finish Carpentry on Phase 1 of Job Number 112. The company uses the chart of accounts in Figure 2-1. Solution: The amount payable to the employee is recorded in the 340 Ac- crued Payroll account on the balance sheet. The amount payable to the em- ployee equals wages less deduction and withholdings taken from wages and is calculated as follows: Payable  Wages  Social Security Tax  Medicare Tax  Federal Withholding  State Withholding  Health Insurance Payable  $895.90  $55.55  $12.99  $75.25  $33.86  $76.08 Payable $642.17 Both the state and federal government taxes are recorded in the 342 Ac- crued Taxes account on the balance sheet. This includes both taxes paid by the employer and taxes withheld from the employee’s check. Find the amount payable to the state government: Payable  SUTA  State Withholding  $26.88  $33.86  $60.74 Find the amount payable to the federal government: Payable  Social Security TaxEmployer  Medicare TaxEmployer  FUTA  Social Security TaxEmployee  Medicare TaxEmployee  Federal Withholding Payable  $55.55  $12.99  $7.17  $55.55  $ 12.99  $75.25 Payable  $219.50 52 CHAPTER 3 The total amount of taxes is $280.24 ($60.74  $219.50). The liability insurance, workers’ compensation insurance, and health insur- ance costs are recorded in the 343 Accrued Insurance account on the bal- ance sheet. Find the amount payable to the health insurance carrier: Payable  Health InsuranceEmployer  Health InsuranceEmployee Payable  $24.00  $76.08  $100.08 Find the total recorded to the 343 Accrued Insurance account: Total Liability Insurance  Workers’ Comp.  Health Insurance Total $8.96  $71.67  $100.08  $180.71 The money set aside for vacation pay is recorded in the 344 Accrued Vaca- tion account on the balance sheet. The changes are shown in Table 3-4. LABOR CHARGED TO GENERAL OVERHEAD When an employee’s—whose costs are to be charged to general overhead—time is entered into the accounting system, it affects the income statement and balance sheet. Because the employee’s time is not charged to a job it does not affect the job cost ledger. On the income statement the employee costs, including labor burden, are recorded as a cost in the general overhead section of the income statement. For a company using the chart of accounts in Figure 2-1 the employ- ees’ labor costs are broken down into the following accounts: 820 Employee Wages and Salaries, 821 Employee Benefits, 822 Employee Retirement, 825 Em- ployee Taxes, and 830 Insurance. The total wages—before withholdings and de- ductions are taken from the employee’s check—are recorded in the 820 Employee Wages and Salaries account. The health insurance costs, vacation, and other benefits paid by the employer are recorded in the 821 Employee Benefits account. Retirement ACCOUNTING TRANSACTIONS 53 TABLE 3-4 Labor Charged to a Job ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 340 Accrued Payroll 642.17 Increase (Credit) 342 Accrued Taxes 280.24 Increase (Credit) 343 Accrued Insurance 180.71 Increase (Credit) 344 Accrued Vacation 38.00 Increase (Credit) 430 Current Period Net Income 1,141.12 Decrease (Debit) Income Statement 620 Labor 1,141.12 Increase Profit 1,141.12 Decrease Job Cost Ledger 112.01.06210L 1,141.12 Increase PAYING PAYROLL TAXES When the employee’s costs were entered into the accounting system, a variety of state and federal taxes were set aside that have not yet been paid. When the state and federal taxes are paid, it affects the balance sheet. When taxes are paid, a company uses cash—an asset—to pay an accrued liability. In the case of a com- pany using the chart of accounts in Figure 2-1 the accrued liability is accrued taxes recorded in the 342 Accrued Taxes account. By reducing both an asset ac- count and a liability account by the same amount, the relationship between as- sets and liabilities on the balance sheet is maintained. No changes occur on the income statement or job cost ledger because the employee’s costs have already been charged to the income statement and job cost ledger. Example 3-7: Determine the changes to the balance sheet that occur when the federal taxes in Example 3-4 are paid. Solution: From Example 3-4, the company owes $219.50 in federal taxes on the employee’s wages. This includes funds withheld from the employee’s paycheck. The contractor uses a check drawn against the cash account to pay the federal government for the federal tax liability of all employees. In- cluded in this amount is $219.50 for the weekly wages for the employee in Example 3-4. The changes resulting from the single week of wages for the employee in Example 3-4 are shown in Table 3-7. PAYING FOR BENEFITS When the employee’s time was entered into the accounting system, funds were set aside to pay the health insurance premium for the employee but the premium has yet to be paid. When a company pays for a benefit, such as health insurance, 56 CHAPTER 3 TABLE 3-6 Paying an Employee’s Wages ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 110 Cash 642.17 Decrease (Credit) 340 Accrued Payroll 642.17 Decrease (Debit) TABLE 3-7 Paying Payroll Taxes ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 110 Cash 219.50 Decrease (Credit) 342 Accrued Taxes 219.50 Decrease (Debit) it affects the balance sheet. When paying for benefits a company uses cash—an asset—to pay an accrued liability. In the case of a company using the chart of ac- counts in Figure 2-1 the accrued liability is accrued insurance recorded in the 343 Accrued Insurance account. By reducing both an asset account and a liability ac- count by the same amount, the relationship between assets and liabilities on the balance sheet is maintained. No changes occur on the income statement or job cost ledger because these costs have already been charged to the income state- ment and job cost ledger. Example 3-8: Determine the changes to the balance sheet that occur when the monthly health insurance premium for the employee in Example 3-4 is paid. The insurance is paid every month (4.3333 weeks). Solution: From Example 3-4, the company owes $100.08 per week. The monthly premium is $433.68 ($100.08 per week × 4.3333 weeks per month). Each month the contractor will use a check drawn against the cash account to pay the health insurance premium. The health insurance pre- mium includes the health insurance premiums for all employees. Included in this amount is $433.68 for the employee in Example 3-4. The changes re- sulting from paying the health insurance premium for the employee in Ex- ample 3-4 are shown in Table 3-8. VACATION TIME FOR JOBSITE EMPLOYEES In Example 3-4, when the employee’s time was entered into the accounting sys- tem, funds were set aside to pay for the employee’s vacation time. This was done because it would be unfair to charge all of an employee’s vacation to the job he or she was working on when his or her vacation was taken. For example, if an em- ployee worked on a job for one day then took a week’s vacation and returned to the job for one day, it would distort the project costs to charge the job for seven days of work when only two days of work had been performed. When a jobsite employee takes vacation, the employer pays him or her for not working. The cost of this time is paid from funds set aside and charged to the jobs the employee worked on throughout the year. When an employee is paid for vacation time it affects the balance sheet. No costs are incurred because the company has been accruing these costs throughout the year. As a result, no ACCOUNTING TRANSACTIONS 57 TABLE 3-8 Paying for Benefits ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 110 Cash 433.68 Decrease (Credit) 343 Accrued Insurance 433.68 Decrease (Debit) changes occur on the income statement or job cost ledger. On the balance sheet the employee costs become an accrued liability, the same as they did when we looked at Labor Charged to a Job. This increase in liability on the balance sheet is offset by an equivalent reduction in accrued liability in the form of accrued vacation. For a company using the chart of accounts in Figure 2-1, the company would have an increase in liability recorded in the 340 Accrued Payroll, 342 Ac- crued Taxes, and 343 Accrued Insurance accounts, which would be offset by a reduction in liability in the 344 Accrued Vacation account. By increasing some liability accounts while decreasing another liability account by the same amount the relationship between assets and liabilities on the balance sheet is maintained. Example 3-9: Determine the change to the balance sheet when the em- ployee in Example 3-4 is paid for one week’s vacation time. Solution: The change to the 340 Accrued Payroll, 342 Accrued Taxes, and 343 Accrued Insurance accounts are the same as they were in Example 3-4. Money to cover these changes would be paid out of the 344 Accrued Vaca- tion account. Any money set aside from this week’s wages for accruing va- cation would come from the 344 Accrued Vacation account and would be recorded in the same account that was covering its costs, effectively wash- ing itself out. In this example, there would be an increase in the 344 Ac- crued Vacation account of $38.00 to cover the vacation accrued during the week and a decrease from the same account of $1,141.12 to cover the em- ployee’s costs for the week. This creates a net decrease in the 344 Accrued Vacation account of $1,103.12 ($1,141.12  $38.00). The changes are shown in Table 3-9. RECORDING OFFICE RENT When a construction company rents office space for the general office—space that cannot be charged to a job—it is handled differently than it would be if it purchased the office. When a bill for office rent is entered into the accounting system it affects the income statement and the balance sheet. On the income 58 CHAPTER 3 TABLE 3-9 Vacation Time for Jobsite Employees ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 340 Accrued Payroll 642.17 Increase (Credit) 342 Accrued Taxes 280.24 Increase (Credit) 343 Accrued Insurance 180.71 Increase (Credit) 344 Accrued Vacation 1,103.12 Decrease (Debit) When a general overhead invoice is paid it has the same affect on the bal- ance sheet as paying any other invoice; namely, reducing both accounts payable- trade while reducing cash. BILLING A CLIENT In previous examples we have looked at how invoices and labor affected the accounting system. Now it is time to bill the client for these costs. When a company bills a client for work performed it affects the income statement, balance sheet, and the job cost ledger. On the income statement the bill to the client is recorded as revenue. In the case of a company using the chart of accounts in Figure 2-1 the bill is recorded in the 500 Revenue account. The increase in revenue increases the profit on the income statement by the amount of the invoice. The portion of the bill withheld by the client in the form of retention is recorded as an accounts receivable-retention and the remaining portion of the bill is recorded as an account receivable-trade in the asset portion of the balance sheet. This increase in accounts receivable results in an increase in the current period net income equal to the amount of the invoice. As in the relationships previously discussed, the increase in profit on the income statement is equal to the increase in the current period net income on the balance sheet. On the job cost ledger the bill is credited to the job or jobs for which the bill represented. Not all companies track their revenues on the job cost ledger. In such a case, nothing is recorded to the job cost ledger. Example 3-13: Determine the change to the balance sheet, income state- ment, and job cost ledger of a $100,000 bill to a client for Job 120. The client holds 10% retention. Solution: The client holds $10,000 ($100,000 × 0.10) as retention until the project is complete. The changes are shown in Table 3-13. ACCOUNTING TRANSACTIONS 61 TABLE 3-12 Paying General Overhead Invoices ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 310 Accounts Payable-Trade 500.00 Increase (Credit) 430 Current Period Net Income 500.00 Decrease (Debit) Income Statement 846 Telephone 500.00 Increase Profit 500.00 Decrease BILLING FOR RETENTION In the previous example, retention was withheld by the client. When the company has met the requirement for the release of the retention it will need to recognize this in the accounting system. The company does this by sending a bill for the re- tention to the client. Billing for retention affects the balance sheet by moving the retention from the accounts receivable-retention account to the accounts receiv- able-trade account. Once the retention has been moved to the accounts receiv- able-trade account the company may begin tracking and treating it as a collectable invoice. Because the retention has already been recorded as income on the income statement and the job cost ledger, no change is made to either of these ledgers. Example 3-14: A contractor has completed a construction project on which the client is holding $10,000 in retention. Determine the changes to the bal- ance sheet when the contractor bills the client for the outstanding retention. Solution: The changes are shown in Table 3-14. RECEIVING PAYMENT FROM A CLIENT Now that the contractor has billed the client, the next step is to see how receiv- ing payment from the client affects the accounting system. When payment is re- ceived from the client it affects the balance sheet by changing an account 62 CHAPTER 3 TABLE 3-13 Billing a Client ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 120 Accounts Receivable-Trade 90,000.00 Increase (Debit) 121 Accounts Receivable-Retention 10,000.00 Increase (Debit) 430 Current Period Net Income 100,000.00 Increase (Credit) Income Statement 500 Revenue 100,000.00 Increase Profit 100,000.00 Increase Job Cost Ledger 120 Revenue 100,000.00 Increase TABLE 3-14 Billing for Retention ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 120 Accounts Receivable-Trade 10,000.00 Increase (Debit) 121 Accounts Receivable-Retention 10,000.00 Decrease (Credit) receivable-trade into cash. Because the payment is already recorded as income on the income statement and the job cost ledger when the bill was prepared, no changes are made to either of these ledgers. Example 3-15: Determine the changes that occur on the balance sheet when the contractor receives payment for the $90,000.00 bill that was sub- mitted in Example 3-13. Solution: The changes are shown in Table 3-15. PURCHASE OF EQUIPMENT WITH A LOAN When a contractor purchases a piece of equipment or other asset with a loan, the company obtains a new asset with a new liability; therefore, the purchase of the asset affects only the balance sheet. On the balance sheet the cash account is de- creased by any down payment the contractor makes. The asset purchased is recorded as a long-term asset in the asset section of the balance sheet. The loan used to purchase the asset is recorded as a long-term liability. If prepaid interest is included in the loan down payment, the prepaid interest may have to be amor- tized over the life of the loan. The net increase in the assets is offset by an equally large increase in the net liabilities. Example 3-16: Determine the changes that occur on the balance sheet when the contractor purchases a $120,000 hydraulic excavator with a $110,000 loan and a $10,000 cash down payment. Solution: The changes are shown in Table 3-16. ACCOUNTING TRANSACTIONS 63 TABLE 3-15 Receiving Payment from a Client ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 110 Cash 90,000.00 Increase (Debit) 120 Accounts Receivable-Trade 90,000.00 Decrease (Credit) TABLE 3-16 Purchase of Equipment with a Loan ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 110 Cash 10,000.00 Decrease (Credit) 220 Construction Equipment 120,000.00 Increase (Debit) 380 Long-Term Liabilities 110,000.00 Increase (Credit) jobs that use the equipment. Leasing equipment with an operating lease affects the income statement, balance sheet, and equipment ledger. On the income statement the monthly lease payment is recorded to the equipment portion of the income statement. In the case of a company using the chart of accounts in Figure 2-1, the lease payment would be recorded in the 710 Rent and Lease Pay- ments account. This increase in equipment cost decreases the profit on the in- come statement by the amount of the lease. On the balance sheet the lease payment is recorded as an account payable-trade. This increase in liability results in a reduction in the current period net income equal to the amount of the lease payment. As per the relationships previously discussed, the reduction in profit on the income statement is equal to the reduction in the current period net income on the balance sheet. Because the equipment has not been charged to a job, the lease payment does not affect the job cost ledger. The lease payment is recorded as a cost to the equipment ledger. When equipment is rented for a single job it could be treated as an invoice for that job. Example 3-19: Determine the change to the balance sheet, income state- ment, and equipment ledger for one month’s rent of an excavator. The ex- cavator rents for $2,500 per month and is used on multiple jobs. Solution: The changes are shown in Table 3-19. LEASED EQUIPMENT WITH A CAPITAL LEASE Capital leases are noncancelable leases that meet at least one of the following conditions: (1) The lease extends for 75 percent or more of the equipment’s use- ful life, (2) ownership transfers at the end of the lease, (3) ownership is likely to transfer at the end of the lease through a purchase option with a heavily dis- counted price, or (4) the present value of the lease payment at market interest rate exceeds 90% of the fair market value of the equipment. Capital leases look and act much like a loan and are treated similarly to a loan. When a company 66 CHAPTER 3 TABLE 3-19 Leased Equipment with an Operating Lease ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 310 Accounts Payable-Trade 2,500.00 Increase (Credit) 430 Current Period Net Income 2,500.00 Decrease (Debit) Income Statement 710 Rent and Lease Payments 2,500.00 Increase Profit 2,500.00 Decrease Equipment Ledger Excavator 2-Rent and Lease Payments 2,500.00 Increase takes on a new capital lease it not only obtains an asset that it can use for the life of the lease but also takes on the liability to pay for the leased equipment for the life of the lease. As such when a new capital lease is obtained it is recorded as both an asset and liability on the balance sheet. The amount recorded equals the present value of the capital lease. The calculation of present value is covered in Chapter 15. In the case of a company that uses the chart of accounts in Figure 2- 1, the present value of the lease would be recorded in the 260 Capital Leases ac- count on the asset portion of the balance sheet and in the 350 Capital Lease Payable account on the liability portion of the balance sheet. The increase in the assets is offset by the increase in liabilities. Example 3-20: Determine the changes that occur on the balance sheet when the contractor leases a front-end loader. The lease is considered a cap- ital lease with a present value of $120,000.00. Solution: The changes are shown in Table 3-20. LEASE PAYMENTS ON A CAPITAL LEASE As lease payments are made on a capital lease the payment must be split into two components: interest on the liability and reduction of the liability. The lease pay- ment affects the income statement and the balance sheet. On the income state- ment the interest component of the lease must be recorded as an interest expense in the general overhead portion of the income statement. In the case of a com- pany using the chart of accounts in Figure 2-1 it would be recorded in the 881 In- terest Expense account. Some companies may charge interest expense to other expenses rather than a general overhead account. The increase in the interest ex- pense decreases the profit on the income statement by the amount of the inter- est. On the balance sheet the lease payment reduces the cash account by the amount of the payment. The portion of the payment that is used to reduce the li- ability decreases the capital lease payable account. In the case of a company using the chart of accounts in Figure 2-1 it would be recorded in the 350 Capital Lease Payable account. Here the company is using cash—an asset—to reduce the capital lease payable—a long-term liability. Because of this, the portion of the lease pay- ment used to reduce the capital lease payable does not affect the income state- ment. The portion of the payment that is used to pay the interest on the liability ACCOUNTING TRANSACTIONS 67 TABLE 3-20 Leased Equipment with a Capital Lease ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 260 Capital Leases 120,000.00 Increase (Debit) 350 Capital Lease Payable 120,000.00 Increase (Credit) reduces the current period net income on the balance sheet. As in the relation- ships previously discussed, the reduction in profit on the income statement is equal to the reduction in the current period net income on the balance sheet. Example 3-21: Determine the changes that occur on the balance sheet and income statement when the contractor makes the first lease payment on the loader in Example 3-20. The amount of the payment is $2,433.17, of which $1,633.17 is used to reduce the capital lease payable and $800.00 is the interest on the liability. Solution: The changes are shown in Table 3-21. AMORTIZATION OF A CAPITAL LEASE Over time the asset value of a capital lease decreases. As a result, the asset value of the capital lease must be amortized. The amortization of a capital lease behaves much the same as depreciation of an asset. When the amortization of a capital lease is recorded it affects the income statement, the balance sheet, and the equipment ledger. On the income statement the amortization is recorded as equipment lease costs. In the case of a company that uses the chart of accounts in Figure 2-1 the amortization would be recorded in the 710 Rent and Lease Pay- ment account. This increase in equipment cost decreases the profit on the in- come statement by the amount of the amortization. The amortization reduces the capital lease asset on the balance sheet. Some companies may set up a contra account for capital leases. In the case of a company that uses the chart of ac- counts in Figure 2-1 the amortization would be recorded against the 260 Capital Lease account. This decrease in assets results in a reduction in the current period net income equal to the amount of the amortization. As in the relationships pre- viously discussed, the reduction in profit on the income statement is equal to the reduction in the current period net income on the balance sheet. Because the equipment has not been charged to a job, the amortization does not affect the job cost ledger. The amortization is recorded as a cost to the equipment ledger, thus 68 CHAPTER 3 TABLE 3-21 Lease Payments on a Capital Lease ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 110 Cash 2,433.17 Decrease (Credit) 350 Capital Lease Payable 1,633.17 Decrease (Debit) 430 Current Period Net Income 800.00 Decrease (Debit) Income Statement 881 Interest Expense 800.00 Increase Profit 800.00 Decrease Example 3-24: Determine the change to the income statement, the job cost ledger, and the equipment ledger of a $5,000 equipment charge to Job 105, Phase 1, cost code 02100 Grading and Excavation. Solution: The changes are shown in Table 3-24. EQUIPMENT CHARGED TO AN EMPLOYEE The IRS requires that employers report an employee’s personal use of company vehicles as compensation to the employee. The personal use of a company vehicle includes using the vehicle to commute to and from work. To do this many em- ployers deduct a flat monthly rate for use of the vehicle from the employee’s pay- check. Employers who do not want to charge the employee for use of the vehicle often add the monthly rate to the employee’s base wages—so that the use of the ve- hicle is recorded as wages—and then deduct the same monthly rate from the em- ployee’s check. The deduction is made after taxes are deducted from the employee’s paycheck. By doing this, the monthly charge for the vehicle is recorded as wages and the employee pays taxes on the use of the vehicle. When equipment is charged to an employee it affects the balance sheet, in- come statement, and equipment ledger. On the balance sheet the wages due to the employee—which are recorded as an accrued payroll—are decreased by the amount of the deduction. In the case of a company that uses the chart of ac- counts in Figure 2-1 the charge would reduce the 340 Accrued Payroll account. The reduction in the accrued payroll increases the current period net income by the amount of the deduction. On the income statement the deduction is recorded to the equipment costs charged to the employee’s contra account in the equipment portion of the income statement, which account offsets the equipment costs. In the case of a company that uses the chart of accounts in Figure 2-1 the charge would be recorded to the 798 Equipment Costs Charged to Employees ac- count. This charge increases the profit by the amount of the deduction. As per the relationships previously discussed the increase in profit on the income statement is equal to the increase in the current period net income on the balance sheet. ACCOUNTING TRANSACTIONS 71 TABLE 3-24 Equipment Charged to a Job ACCOUNT CHANGE IN AMOUNT ($) Income Statement 640 Equipment 5,000.00 Increase 799 Equipment Costs Charged to Jobs 5,000.00 Increase Job Cost Ledger 105.01.02100E 5,000.00 Increase Equipment Ledger Excavator 2-Equipment Costs Allocated 5,000.00 Increase On the equipment ledger the charge is recorded as a cost allocation for the piece of equipment. Example 3-25: Determine the change to the balance sheet, income state- ment, and the equipment ledger of a $50 deduction from an employee’s wages for personal use of a company vehicle. Solution: The changes are shown in Table 3-25. SALE OF EQUIPMENT The last equipment transaction we look at is what happens when a piece of equipment is sold. When the sale of a piece of equipment occurs, an asset— recorded in the fixed asset and less accumulated depreciation accounts—is ex- changed for cash. If the asset is sold for more or less than its book value, the gain or loss on the asset must be reported as an income or loss. The sale of equipment affects the balance sheet and if a gain or loss on the asset occurs, it also affects the income statement. On the balance sheet, when an asset is sold, the asset is removed from the fixed asset account and its depreciation is removed from the less accumulated depreciation account. This results in a change in the net fixed asset account equal to the book value of the asset. The depreciation re- moved to the less accumulated depreciation contra account is a debit even though it decreases the accumulated depreciation contra account, because con- tra accounts behave in the opposite manner from other accounts. This is because the less depreciation account is used to reduce the assets on the asset side of the balance sheet by subtracting its balance from the balance of the total fixed assets account; whereas, all other accounts on the asset side of the balance sheet are used to record (increase) assets. The sale of the asset increases the cash, note re- ceivable, or other asset account depending on the terms of the sale. If the asset is financed, the sale decreases the note payable or long-term liability associated with paying off the asset’s financing. If the asset is sold for a price different from 72 CHAPTER 3 TABLE 3-25 Equipment Charged to an Employee ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 340 Accrued Payroll 50.00 Decrease (Debit) 430 Current Period Income 50.00 Increase (Credit) Income Statement 798 Equipment Costs Charged to Employees 50.00 Increase Profit 50.00 Increase Equipment Ledger Truck 5-Equipment Costs Allocated 50.00 Increase the book value, the gain or loss on the sale will result in an increase or decrease in the current period net income equal to the gain or loss. On the income state- ment the gain or loss will be recorded as other income or other expense. Gains increase the profit on the income statement by the amount of the gain. Losses decrease the profit on the income statement by the amount of the loss. As per the relationships previously discussed, the reduction or increase in profit on the income statement is equal to the reduction or increase in the current period net income on the balance sheet. Example 3-26: Determine the change to the balance sheet and income statement of the sale of a crane. The crane was sold for $60,000 in cash. The crane was purchased for $120,000 and $62,400 of depreciation has been taken. Solution: The book value on the crane is $57,600 ($120,000  $62,400). The gain on the sale is $2,400 ($60,000  $57,600). The changes are shown in Table 3-26. PURCHASE OF INVENTORY When a company purchases materials and places them in inventory until they are ready to use them, the company is exchanging a liability (accounts payable) or an asset (cash) for an asset (inventory). When the materials are received they are recorded as an asset in the inventory category. In the case of a company that uses the chart of accounts in Figure 2-1 the cost of the materials would be recorded to the 130 Inventory account. If the materials were purchased on credit, the accounts payable-trade will increase by the amount of the purchase. If the materials were purchased with cash, the cash account would be reduced by the amount of the purchase. No changes are made to the income statement or job cost ledger until the materials are charged to a job. ACCOUNTING TRANSACTIONS 73 TABLE 3-26 Sale of Equipment ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 110 Cash 60,000.00 Increase (Debit) 220 Construction Equipment 120,000.00 Decrease (Credit) 250 Less Acc. Depreciation 62,400.00 Decrease (Debit) 430 Current Period Net Income 2,400.00 Increase (Credit) Income Statement 910 Other Income 2,400.00 Increase Profit 2,400.00 Increase RECORDING CHANGES IN BILLINGS IN EXCESS OF COSTS AND PROFITS When a company using the percentage-of-completion accounting method has billings in excess of costs and profits it has overbilled the revenue on its con- struction projects. The overbilling should not be recognized as profits, yet the company has done so when it billed its projects. To correct this situation, the company must reduce its revenues by the overbilled amount. This decrease in rev- enues decreases the company’s profits. The company also owes its clients for the work it has billed for but has yet to perform, which creates a liability recorded in the current liability portion of the balance sheet. The increase in the liability that results when an overbilling occurs reduces the current period net income. In the case of the company using the chart of accounts in Figure 2-1, the revenues would be recorded to the 500 Revenues account and the liability would be recorded to the 320 Billings in Excess of Costs and Profits account. The amount recorded each month is the difference between last month’s overbillings and this month’s overbillings. As in the relationships previously discussed, the reduction or increase in profit on the income statement is equal to the reduction or in- crease in the current period net income on the balance sheet. The calculation of the overbillings or billings in excess of costs and profits is covered in Chapter 4. Example 3-30: At the end of last month the company’s billings in excess of costs and profits was $10,000. At the end of this month it is $11,500. 76 CHAPTER 3 TABLE 3-29 Recording Changes in Cost and Profits in Excess of Billings ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 140 Costs and Profits in Excess of Billings 5,000.00 Increase (Debit) 430 Current Period Net Income 5,000.00 Increase (Credit) Income Statement 500 Revenue 5,000.00 Increase Profit 5,000.00 Increase TABLE 3-30 Recording Changes in Billings in Excess of Cost and Profits ACCOUNT CHANGE IN AMOUNT ($) Balance Sheet 320 Billings in Excess of Costs and Profits 1,500.00 Increase (Credit) 430 Current Period Net Income 1,500.00 Decrease (Debit) Income Statement 500 Revenue 1,500.00 Decrease Profit 1,500.00 Decrease Determine the change to the balance sheet and income statement when this change is recorded. Solution: The change in the billings in excess of costs and profits is an in- crease of $1,500 ($11,500  $10,000). The changes are shown in Table 3-30. CONCLUSION There are a number of unique transactions that take place in construction ac- counting that do not occur in other industries. Most of these transactions are a result of the construction industry’s focus on job costing, equipment tracking, and accounting for long-term contracts. In this chapter we looked at how ac- counting transactions affect the general ledger—balance sheet and income state- ment—as well as the job cost ledger and the equipment ledger, while maintaining the proper balance between these ledgers. Some of the unique transitions that we examined were accruing vacation time for field employees, recording and allocat- ing equipment costs, recording costs and profits in excess of billings, and record- ing billings in excess of costs and profits. PROBLEMS 1. The following invoices are being entered into the accounting system. Using the chart of accounts in Figure 2-1, determine the changes to the balance sheet, income statement, job cost ledger, and equipment ledger as the result of entering each of the following invoices: a. A $5,000 invoice for concrete charged to job cost code 302.01.02620M. b. A $12,350 invoice from a subcontractor for plumbing charged to job cost code 309.02.15100S. Ten percent retention is withheld from the invoice. c. A $255 phone bill charged to job cost code 315.01.01800O. d. A $1,352 bill for office rent. e. A $112 invoice for office supplies. f. A $375 invoice for repairs to Backhoe 2. g. A $563 invoice for nails. The nails will be placed in inventory until they are needed on the jobs, at which time they will be billed to the jobs. What are the changes to the balance sheet, income statement, job cost ledger, and equipment ledger as a result of all of these invoices? 2. Time cards are being entered into the accounting system for four employees. The costs for Employee 1 are to be billed to job cost code 302.01.01100L. Ten hours of Employee 2 time is to be billed to job cost code 302.01.06110L and the remaining 30 hours are to be billed to job cost code 302.01.06210L. ACCOUNTING TRANSACTIONS 77 Employee 3 took vacation this entire week and Employee 4 works in the main office. The employee costs and deductions withheld from the employee’s check are shown below. Using the chart of accounts in Figure 2- 1, determine the changes to the balance sheet, income statement, job cost ledger, and equipment ledger as the result of entering the employees’ time into the accounting system: 78 CHAPTER 3 EMPLOYEE ($) 1 2 3 4 TOTAL Employer’s Costs Wages 600.00 400.00 350.00 500.00 1,850.00 Social Security 37.20 24.80 21.70 31.00 114.70 Medicare 8.70 5.80 5.08 7.25 26.83 SUTA 18.00 12.00 10.50 15.00 55.50 FUTA 4.80 3.20 2.80 4.00 14.80 Liability Insurance 12.00 8.00 7.00 10.00 37.00 Workers’ Comp. 54.00 36.00 31.50 15.00 136.50 Health Insurance 40.00 40.00 40.00 40.00 160.00 Vacation 38.92 29.79 27.51 33.20 129.42 Total 813.62 559.59 496.09 655.45 2,524.75 Employee Deductions Social Security 37.20 24.80 21.70 31.00 114.70 Medicare 8.70 5.80 5.08 7.25 26.83 Federal Withholdings 59.85 29.85 22.35 44.85 156.90 State Withholdings 36.00 24.00 21.00 30.00 111.00 Health Insurance 60.00 60.00 60.00 60.00 240.00 Total 201.75 144.45 130.13 173.10 649.43 3. Using the chart of accounts in Figure 2-1, determine the changes to the balance sheet, income statement, job cost ledger, and equipment ledger as the result of paying the employees in Problem 2 for one week’s work. 4. Using the chart of accounts in Figure 2-1, determine the changes to the balance sheet, income statement, job cost ledger, and equipment ledger as the result of paying a $5,000 invoice for concrete charged to job cost code 302.01.02620M, $2,273.80 for federal employment taxes, and $1,732 for health insurance. The invoices were previously entered into the accounting system. 5. Using the chart of accounts in Figure 2-1, determine the changes to the balance sheet, income statement, job cost ledger, and equipment ledger as the result of billing a client $368,264 for Job 313. The bill includes $249,996 for work performed during the last month and $118,268 for retention withheld from the previous month’s payments. Retention will not be withheld on the $249,996.