CHAPTER 6: CONSTRUCTING ACCOUNTING METHODS

6.1 ACCOUNTING METHODS

There are two main accounting methods that construction companies use to record revenue and
expenses. One is called the completed contract method and the other is called the percentage of
completion method. They are very different from each other and the one you choose can
dramatically affect your business.

6.1.1 Completed Contract Method

In the completed contract method, only completed projects are reflected in the income statement.
Costs for uncompleted projects are accumulated in an asset account called Work in Progress. The
principal advantage of the completed contract method is that reported revenue is based on final
results rather than estimates of unperformed work. The major disadvantage is that it does not reflect
current performance when the period of the contract extends into more than one accounting period.

If you only worked on a KShs. 1,000,000 project in a year and did not complete that project until
January of the following year, no revenue would be shown on the income statement for that year. If
in the following year another contract for KShs. 500,000 was started and completed, the revenue on
the income statement for that second year would be KShs. 1,500,000 which is all the revenue from
both projects covering the two-years.

The disadvantages of this method

 Income statement does not reflect what is happening from day to day. Year one looked as if no
sales occurred.
 Does not supply swift financial feedback of uncompleted projects.
 Financial reports would not reflect a significant loss on a project until it was closed, which
might not be until the following year.
 Several jobs significantly over-budget could cause cash flow problems that require immediate
action. Finding out after the project is completed may be too late and jeopardize your
relationship with customers, bankers and subcontractors.

6.1.2 Percentage Completion Method

Revenues and gross profit are recognized each period based upon the progress of the construction,
i.e., the percentage of completion. To determine the percentage of completion of a project, simply
divide actual costs by estimated costs. Calculating the amount of revenue to claim for the year is
determined by multiplying the percentage of completion by the contract price.

The advantages of this method

 The financial statements reflect what is happening on the ground. Monthly statements, if
prepared, would precede the completed contract method by several months or more.
 With current information on hand, management could take immediate corrective actions to
minimize losses.

6.2 MISCONCEPTIONS
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

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familiar with the effects of both the completed contract and percentage of completion methods on
financial statements.

6.3 FINANCIAL STATEMENTS AND THEIR USERS

A financial statement (or financial report) is a formal record of the financial activities of a business.
The basic objective of financial statements is to communicate useful and meaningful information
that meets the needs of the users of the financial statements.

6.3.1 Qualitative characteristics

Qualitative characteristics of useful and meaningful financial statements are:
 Understandability – financial statements that are unduly complicated can send up a red flag to
banks, surety companies and potential investors; transparency is key to success in today’s
business environment.
 Relevance – financial statements provide feedback on a company’s performance (normally over
1 to 5 years) and are used by banks and surety companies to predict the future success of a
company; timeliness of the preparation of financial statements is also important as outdated
information may not be useful to users in assessing a bond or loan application.
 Reliability – financial statements are management’s responsibility and to be reliable,
representational faithfulness is key – the substance of a transaction must be consistent with how
it is presented in the financial statements; the underlying transactions in financial statements
must normally be verifiable to an economic event and neutral or free from bias;
 Comparability – financial statements that are comparable allow users to compare a company to
another similar company or to compare a company’s performance over a period of time; both
are techniques used by banks, surety companies and potential investors to evaluate a company’s
performance.

6.3.3 Internal Users

Internal user such as management, owners and shareholders of private companies rely on financial
statements to:
 Assess the appropriateness of the company’s policies (pricing, credit, payment) to improve
profitability and evaluate success by comparing its financial benchmarks to those of its
competitors; for example, gross profit comparisons to industry standard (note that these are
more meaningful if everyone in the industry prepares their financial information in the same
way).
 Determine net income after taxes, which results from recognizing revenue when it has been
earned and matching the corresponding expenses against that revenue in the same period;
this enables management to determine how profitable the company was in a given year and
measure return on equity invested.
 Measure the company’s true growth from year to year.

6.3.4 External Users

External users such as potential partners, investors or shareholders rely on financial statements to:
 Assess the financial health of a company and its ability to generate long term returns on
investment, including a risk premium reflecting the nature of the industry; for example, a
private company may want to grow without adding debt by admitting another partner or
shareholder, or an owner may want to sell the company as a going concern and retire.
 Assess the company’s exposure to liability through lawsuits.

6.3.5 Other External Users

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External users such as banks and surety companies rely on financial statements to:
 Assess the credit worthiness of the contractor, as well as ongoing credit worthiness once the
initial position is established (i.e. credit risk);
 Determine the price for which lines of credit, long term debt and surety bonds will be
offered (i.e. premiums, interest rates);
 Determine the terms and conditions (set out in covenants) and security requirements based
on an overall assessment of risk (i.e. financial risk);
 Assess the company’s exposure to foreign exchange fluctuations which may negatively
impact net income (exchange risk); and
 Assess overall company liquidity and its ability to handle any difficult situations that may
arise.
 Determine the debt load or bonding capacity that a potential customer can carry and ability
to service debt and meet its obligations (i.e. liquidity risk);

6.4 BOOK-KEEPING

6.4.1 What is Book-keeping?

Bookkeeping is the process of recording and classifying business financial transactions, or to put it
another way, the process of maintaining the records of a business’s financial activities. The
objective in bookkeeping is to create a useable summary of financial transactions, which provides a
snapshot of the business’s financial stability.

6.4.2 Types of Book-keeping Systems

The most basic form of accounting is the single-entry system. In this system, you record each
transaction only once, as either a deposit or as an expense. This system is generally used to
determine the profit/loss of a business.

However, the preferred system is the double-entry system. The double-entry system is more
accurate, and has built-in checks and balances. In this system, each transaction is recorded twice, in
each “account” it affects. This is a more thorough method of keeping a business’s financial
transaction in order.

6.4.3 Basic Elements of Book-keeping

There are three basic elements of book-keeping: assets, liabilities, and net assets.
 Assets are all items used in the operation or investment activities of a business. This
category includes all property, or items of value, owned by a business. Examples include
cash, buildings, land, plant, equipment, vehicles, tools, inventory, office supplies, furniture,
investments, and accounts receivable (any funds owed to the business). Increases in assets
are called debits. Decreases in assets are called credits. Generally, various assets are referred
to as debit accounts.
 Liabilities are claims by creditors to the assets of a business, or debts owed by the business
to others. Types of liabilities include loans, notes payable, and lines of credit.
 Net assets are the equity earned by the business. Net assets are the value of the business
once all liabilities have been paid. It can also be called owner’s equity, capital, net worth,
profit, or proprietorship. Increases in liabilities or net assets are called credits, and decreases
in liabilities or net assets are called debits. Generally, a company’s liabilities and net assets
are referred to as credit accounts.

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There are also several other things to keep in mind when considering a company’s net assets:
 Revenue is the increase in net worth resulting from the operations and other activities of the
business. Revenue includes income earned through the business’s services, interest earned
on investments, and contributions from individuals or foundations.
 Expenses are the costs of doing business. This includes the cost of goods, fixed assets, and
services/supplies used in the business’s operations. Examples of expenses include salaries,
rent, travel expenses, and the costs of supplies and utilities. Expenses are credit accounts.

Net assets are calculated by subtracting total expenses from total revenue, on a yearly basis.
Whenever revenue is received, net assets increase. Whenever expenses are paid, net assets decrease.

6.4.4 The Book-keeping Equation

The basic elements of book-keeping can be expressed in a simple equation:
Assets = Liabilities + Net Assets
In other words, the property of a business must be equal to the claims against that property. A
bookkeeper wants to track not only the properties acquired by the business, but also how those
properties were acquired and from whom.

Another way to think of this equation, which is helpful when considering bookkeeping documents,
is:
Assets – Liabilities = Net Assets

6.4.5 Types of Business Transactions

All business transactions result in at least two changes to the bookkeeping equation. In other words,
a transaction that changes a business’s assets must also change that business’s liabilities or net
assets.

Some transactions increase accounts. If a business’s assets increase, then there must also be an
increase in either liabilities or net assets.

For example, Business X has KShs. 5,000,000 worth of assets, which is equal to KShs. 2,000,000
worth of liabilities plus KShs. 3,000,000 worth of net assets.
5,000,000 = 2,000,000 + 3,000,000
(Assets) = (Liabilities) + (Net assets)

Business X then borrows KShs. 2,000,000 from the Bank. This is a liability, because it is a debt
owed to the Bank. The transaction could be expressed thus:
5,000,000 = 2,000,000 + 3,000,000
2,000,000 = 2,000,000 + 0
7,000,000 = 4,000,000 + 3,000,000

Later, Business X receives KShs. 5,000,000 grant. This is a new asset, as it is an item of value now
owned by the business. The new equation would be:
7,000,000 = 4,000,000 + 3,000,000
5,000,000 = 0 + 5,000,000
12,000,000 = 4,000,000 + 8,000,000

Other transactions can decrease accounts. If a business’s assets decrease, so must either its liabilities
or its net assets.

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Business X decides to pay back half of the amount it owes the Bank (Kshs.1, 000,000). The new
equation is:
12,000,000 = 4,000,000 + 8,000,000
1,000,000 = 1,000,000 + 0
11,000,000 = 3,000,000 + 8,000,000

We can illustrate double entry book-keeping with the following sample transactions:
 If a company borrows Kshs1,000,000 from its bank, the company debits its Cash account for
KShs 1,000,000 and credits its Notes Payable account for Kshs1,000,000.
 When a company records wages for hourly employees, it debits Wages Expense and credits
Wages Payable.
 If a company makes a sale "on credit," it debits Accounts Receivable and credits Sales.

6.5 FEASIBILITY STUDIES OF CIVIL ENGINEERING PROJECTS

6.5.1 DEFINITION
A feasibility study is an analysis and evaluation of a proposed project to determine if it
1. is technically feasible,
2. is feasible within the estimated cost, and
3. will be profitable.
Feasibility studies are almost always conducted where large sums are at stake.

6.5.2 TYPES OF FEASIBILITY STUDIES

a) Technical Feasibility
In technical feasibility the following issues are taken into consideration.
 Whether the required technology is available or not
 Whether the required resources are available
Once the technical feasibility is established, it is important to consider the monetary factors also.
Since it might happen that developing a particular system may be technically possible but it may
require huge investments and benefits may be less. For evaluating this, economic feasibility of the
proposed system is carried out.

b) Economic Feasibility
For any project if the expected benefits equal or exceed the expected costs, the project can be
judged to be economically feasible. In economic feasibility, cost-benefit analysis is done in which
expected costs and benefits are evaluated. Economic analysis is used for evaluating the
effectiveness of the proposed system.

In economic feasibility, the most important is cost-benefit analysis. As the name suggests, it is an
analysis of the costs to be incurred in the project and benefits derivable out of it.

If the benefits outweigh the costs, then the decision is made to design and implement the proposed
project.

c) Operational Feasibility

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Operational feasibility is mainly concerned with issues like whether the proposed project will be
used if it is developed and implemented. Whether there will be resistance from users that will affect
the possible application benefits.

d) Legal Feasibility
What are the legal implications of the project? What sort of ethical considerations are there? You
need to make sure that any project undertaken will meet all legal and ethical requirements before
the project is on the table.

6.5.3 COST-BENEFIT ANALYSIS

6.5.3. 1 Overview
Cost-benefit analysis (CBA) is a method of evaluating the net economic impact of a public project.
Projects typically involve public investments, but in principle the same methodology is applicable
to a variety of interventions, for example, subsidies for private projects, reforms in regulation, new
tax rates etc. The aim of CBA is to determine whether a project is desirable from the point of view
of social welfare, by means of the algebraic sum of the time-discounted economic costs and benefits
of the project.

The technique used is based on:

1. CBA estimates the net present value (NPV) of the decision Forecasting the economic effects
of a project.
2. Quantifying them by means of appropriate measuring procedures.
3. Monetizing them, wherever possible, using conventional techniques for monetizing the
economic effects.
4. Calculating the economic return, using a concise indicator that allows an opinion to be
formulated regarding the performance of the project.
by discounting the investment and returns. Though employed mainly in financial analysis, a CBA is
not limited to monetary considerations only. It often includes those environmental and social costs
and benefits that can be reasonably quantified.

6.5.3.2 The Purpose of the Technique

The justification for an investment project tallies with the feasibility and economic performance.

The objective of a feasibility study is to find out if an information system project can be done, and if
so, how. A feasibility study should tell management:
 Whether the project can be done;
 What are alternative solutions?
 What are the criteria for choosing among them?
 Is there a preferred alternative?
After a feasibility study, management makes a go/no-go decision.

6.5.3. 2 Identifying Costs

In order to successfully identify all potential costs of a project, one must follow the subsequent
steps.
1. Make a list of all monetary costs that will be incurred upon implementation and throughout
the life of the project. These include start-up fees, licenses, production materials, payroll
expenses, user acceptance processes, training, and travel expenses, among others.

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 2. Make a list of all non-monetary costs that are likely to be absorbed. These include time, lost
production on other tasks, imperfect processes, potential risks, market saturation or
penetration uncertainties, and influences on one’s reputation.
3. Assign monetary values to the costs identified in steps one and two. To ensure equality
across time, monetary values are stated in present value terms. If realistic cost values cannot
be readily evaluated, consult with market trends and industry surveys for comparable
implementation costs in similar businesses.
4. Add all anticipated costs together to get a total costs value.

6.5.3. 3 Identifying Benefits

The next step is to identify and quantify all benefits anticipated as a result of successful
implementation of the proposed action. To do so, complete the following steps.
1. Make a list of all monetary benefits that will be experienced upon implementation and
thereafter. These benefits include direct profits from products and/or services, increased
contributions from investors, decreased production costs due to improved and standardized
processes, and increased production capabilities, among others.
2. Make a list of all non-monetary benefits that one is likely to experience. These include
decreased production times, increased reliability and durability, greater customer base,
greater market saturation, greater customer satisfaction, and improved company or project
reputation, among others.
3. Assign monetary values to the benefits identified in steps one and two. Be sure to state these
monetary values in present value terms as well.
4. Add all anticipated benefits together to get a total benefits value.

6.5.4 SELECT EVALUATION METHOD

When all the financial data have been identified and broken down into cost categories, the analyst
selects a method for evaluation.

There are various analysis methods available. Some of them are following.
1. Discounted cash flow method; Present Value and Net Present Value analysis.
2. Payback analysis
3. Break-even analysis

6.5.4.1 Discounted Cash Flow Analysis (DCF)

Discounted Cash Flow is a cash flow summary adjusted to reflect the time value of money. DCF
can be an important factor when evaluating or comparing investments, proposed actions, or
purchases. Other things being equal, the action or investment with the larger DCF is the better
decision. When discounted cash flow events in a cash flow stream are added together, the result is
called the Net Present Value (NPV).

A. Present Value analysis:

It is used for long-term projects where it is difficult to compare present costs with future benefits. In
this method cost and benefit are calculated in term of today's value of investment. What future
money is worth today is called its Present Value (PV). The right to receive a payment one year
from now for KShs. 100 (the future value) might be worth to us today KShs. 95 (its present value).
Present value is discounted below future value.

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 F
PV =
( 1+i )n
Where:
N - the time of the cash flow
i - the discount rate (the rate of return that could be earned on an investment in the
financial markets with similar risk.)
F - the Future Value at time n, or the net cash flow (the amount of cash, inflow
minus
outflow) at time n.
Example 6.1:
Present value of $3,000 invested at 15% interest at the end of 5thyear is calculates as;
P = 3,000/ (1 + 0.15)5 = Kshs.1, 491.53
Table 6.1 shows present value analysis for 5 years
Table 6.1: Present value analysis

B. Net Present Value (NPV)

The sum of all PVs is the net present value.
Net Present Value= Sum of all PVs

What NPV means

NPV is an indicator of how much value an investment or project adds to the firm. With a particular
project, if F is a positive value, the project is in the status of discounted cash inflow in the time of t.
If F is a negative value, the project is in the status of discounted cash outflow in the time of t.
Appropriately risked projects with a positive NPV could be accepted.

Example 6.2: Comparing Competing Investments with NPV

Consider two competing investments. Each calls for an initial cash outlay of KShs. 100M and each
returns a total a KShs. 200M over the next 5 years making net gain of KShs. 100M. But the timing

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of the returns is different, as shown in the table below (Case A and Case B), and therefore the
present value of each year’s return is different. The sum of each investment’s present values is
called the Discounted Cash flow (DCF) or Net Present Value (NPV). Using a 10% discount rate
again, we find:

Comparing the two investments, the larger early returns in Case A lead to a better net present value
(NPV) than the later large returns in Case B. Note especially the Total line for each present value
column in the table. This total is the net present value (NPV) of each "cash flow stream." When
choosing alternative investments or actions, other things being equal, the one with the higher NPV
is the better investment.

Example 6.3
Suppose a firm is considering an investment of $300,000 in an asset with a useful life of five years.
The firm estimates that the annual cash revenues and expenses will be $140,000 and $40,000,
respectively. The annual depreciation based on historical cost will be $60,000. The required rate of
return on a project of this risk is 13%. The marginal tax rate is 34%. The 13% required rate of return
is a nominal required return including inflation.
a) What is the NPV of this project?
b) Suppose the firm has forgotten that revenues and expenses are likely to increase with
inflation at a 5% annual rate. Recalculate the NPV. Is this a more attractive proposal
now that inflation has been taken into account?
NB: The marginal tax rate is the rate on the income earned.

Solution a)
Calculate the after-tax cash flows: (DCF) or Net Present Value (NPV). Using a 10% discount rate
again, we find:

Calculate the PV of the cash flows:

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 86,400 86,400 86,400
PV (13 % )= + + …+
( 1.132 ) ( 1.13 )2
( 1.13 )5
The PV of the cash flows is $303,889. The initial outlay is $300,000 so the NPV of the project is
$3,889.

Solution b)
Calculate the after-tax cash flows:

Calculate the PV of the cash flows:

89,700 93,165 96,804 100,624 104,634

PV (13 % )= + + + +
( 1.132 ) ( 1.13 )2 ( 1.13 )3 ( 1.13 )4 ( 1.13 )5

The PV of these cash flows is $337,938. With the initial outlay of $300,000, the NPV is $37,938.
The project is far more attractive now.

NB: The marginal tax rate is the rate on the income earned.

Assignment 6.1
A corporation must decide whether to start a new project. The new product will have startup costs,
operational costs, and incoming cash flows over six years. This project will have an immediate (t=0)
cash outflow of KShs.200M (which might include machinery, and employee training costs). Other
cash outflows for years 1–6 are expected to be KShs. 10M per year. Cash inflows are expected to be
KShs. 60M each for years 1–6. All cash flows are after-tax, and there are no cash flows expected
after year 6. The required rate of return is 10%. The present value (PV) can be calculated for each
year:

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