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Midterm Group5

The document discusses accounting methods for construction projects. It describes construction accounting as allocating expenses to individual projects. There are two main revenue recognition methods: completed contract method and percentage of completion method. The completed contract method only recognizes revenue and profits upon project completion while percentage of completion recognizes revenue over the project lifetime based on completion percentage. Both methods have advantages and disadvantages for accurately reflecting financial performance and tax implications.

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33 views15 pages

Midterm Group5

The document discusses accounting methods for construction projects. It describes construction accounting as allocating expenses to individual projects. There are two main revenue recognition methods: completed contract method and percentage of completion method. The completed contract method only recognizes revenue and profits upon project completion while percentage of completion recognizes revenue over the project lifetime based on completion percentage. Both methods have advantages and disadvantages for accurately reflecting financial performance and tax implications.

Uploaded by

jek vin
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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engineering management

➢ Construction accounting is a field of accounting that


allocates expenses to individual construction projects. It is a
tool that helps you figure out how much money you’re
getting from completed work, unbilled work, and unpaid
invoices to minimize your business’s financial challenges.

➢ Proper accounting for construction also helps to ensure that


you are pricing your services fairly (for both you and your
clients), maintain the profitability of your business, and can
accurately plan for the future.
Construction accounting has its own set of unique rules
for both generally accepted accounting principles (GAAP) and
taxes. The rules adapt the central principles of GAAP and
taxation to the unique characteristics of the construction
business including; a project-based workstyle, decentralized
production with operations at job sites instead of inside a
factory, and long-term production cycles.
A system of principles by which revenues and
expenses are presented in financial statements is known as
an accounting method. Depending on the method used,
different amounts of profit may be reported in the short
term. The Internal Revenue Service (IRS) requires a
company to use only one accounting method consistently,
this is because switching between methods would potentially
allow company to manipulate revenue to minimize their tax
burdens.
In the construction industry there are two main
methods that are used to recognize revenue. One is called the
completed contract method and the other is called the
percentage of completion method. The Completed Contract
Method states that all revenues, costs and income are only
recognized upon the completion of the construction project.
While the Percentage of completion method states that the
contractor recognizes revenue over the life of the construction
contract based on its completion percentage.
1. Completed Contract Method

2. Percentage of Completion
CCM is a concept in accounting that refers to a
method in which all of the revenue and profit associated with
a project is recognized only after the completion of the
project. This method is used when there is unpredictability in
the collection of funds from the customer. It is simple to use,
as it is easy to determine when a contract is complete. In
addition, under the completed contract method, there is no
need to estimate costs to complete a project – all costs are
known at the completion of the project.
➢ The contractor knows the actual results of the ➢ The biggest disadvantage is uneven
contract & not the estimated results, which revenues or results of operations of the
entity.
usually happens in the case of the percentage ➢ The contractor is unaware whether the
completion method. contract is profitable as of today or not since
➢ Deferment of tax liability is the biggest none of the usual accounting methods is
advantage from the cashflow point of view. No followed.
revenue means no profit & no profit means no ➢ This method is untidy in the case of long-
term contracts.
liability to pay tax. ➢ This method reflects the ambiguity in the
➢ If the contractor follows this method for all his accounts. Even if the contract is aware of
projects, he gets a better picture of his profits & the losses in any particular contract, he can
set off such loss against profits from other
his analysis will be based on real-time figures. contracts only when this loss-making
➢ As against the percentage completion method, contract is completed.
this method saves efforts to make lumpsum ➢ If all the contracts finish off in a single year,
estimates at the end of the accounting year. the financials picture will be untidy & the
analyst may observe huge fluctuations. This
➢ Estimates are usually reversed in the next year & shows inconsistency in the contract.
actual entries are passed. Thus, the efforts are
saved.
The percentage of completion method is a method of
accounting in which long-term contract income and expenses
are calculated as a percentage of the work accomplished over
the time. This accounting method requires the reporting of
revenues and expenses on a period-by-period basis, as
determined by the percentage of the contract that has been
fulfilled.
➢ Two conditions to use the percentage of completion method
1. Collections by the company must be reasonably assured.
2. Costs and project completion must be reasonably estimated.

➢ Components of a percentage of completion method


1. Cost-to-cost method
In this method, the only cost of the raw material and equipment purchased and
used in the project is used in the calculation of the revenue recognized for the period.
2. Efforts expended method
In this method, the cost is calculated in terms of the efforts instead of raw
material purchased and used in the project.
3. Units of delivery method
In this method, the revenue for the period is recognized to the extent of the
units delivered to till date with respect to the estimated units be delivered for the entire
length of the contract..
Logger Construction Company is building a maintenance facility on a military base.
Logger has thus far accumulated 4,000,000 of costs related to the project, and billed the
customer 4,500,000. The estimated gross margin on the project is 20%
• Cost incurred to date: 4,000,000
• Gross margin: 20%
• How much is the estimated contract cost?4,000,000 x ÷ 80 % = 5,000,000
Since we only recognized or billed the client an amount of 4,500,000 we will be recognizing
additional amount of 500,000

To recognized proportional amount of expense to offset500,000 x 80% portion = 400,000.


➢ It allocates the cost and revenue pertaining to a ➢ Since construction projects take a long time to
particular period based on the extent of completion complete, the estimation of the costs and
of the contract or project, and hence there is no associated revenues is a daunting task as not
need to wait till the project is completed to recognize much information is available at the start of the
the cost and revenues incurred in the duration of the project.
contract or project. ➢ If the initial estimate of revenue and costs for
➢ It does not allocate the proportion of cost that is the project are not accurate, then there may be
incurred but is not currently use in the project. changes and adjustments to them quite
Hence it gives a more real-time estimate of the costs frequently, which may show fluctuation in the
and revenues associated with the project. revenue and costs realized in the accounting
➢ The financial statements reflect what is happening books. This will not reflect a good picture in
on the ground. Monthly statements, if prepared, front of the stakeholders of the company.
would proceed the completed contract method by
several months or more.
➢ With current information on hand, management
could take immediate corrective actions to minimize
losses.
Some contractors think that their financial statements will look better
to bankers and investors under the completed contract method. Not always. If
you closed KShs. 5,000,000 of projects in year one, but only KShs. 3,000,000
in projects in year two, it appears that sales are down 40%. It may be that
sales are really up because you have several large and profitable projects in
progress. The percentage of completion method would reflect this rise in
sales. In most cases, bankers are quite familiar with the effects of both the
completed contract and percentage of completion methods on financial
statements.

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