You’re probably familiar with the term “crunch the numbers.” Well, in a tumultuous industry like construction, it’s all too easy to let crisp, timely financials go soggy with outdated data and flat-out mistakes. Here are six common accounting errors to avoid.
- Inaccurate allocation of overhead
To develop a realistic picture of your job costs — and, therefore, the profitability of your projects — you need reliable methods for allocating overhead among jobs. Overhead generally refers to costs that benefit all jobs. Examples include rent, office equipment and supplies, salaries for executives and clerical staff, insurance, taxes, advertising and marketing expenses, and accounting and legal fees.
Construction companies often allocate overhead among jobs based on direct labor costs or direct labor hours. But, in some cases, this approach causes over- or underallocation of overhead, which creates a distorted picture of job profitability.
For example, if your projects tend to be equipment or material intensive, rather than labor intensive, it may make sense to allocate overhead based on one of those costs or perhaps some blend of direct job costs. The key is to develop a method for allocating overhead costs to the jobs that drive them.
- Improper cutoff of job costs
Many construction businesses use the accrual basis of accounting, which means they record revenues when earned and expenses when incurred. Cutoff errors occur when expenses are omitted from a period covered by a financial statement — typically, because invoices aren’t received until after the period is closed.
Are you susceptible to this problem? If so, consider implementing a voucher system or some other mechanism to ensure costs are recorded as liabilities or accrued costs in the period in which they’re incurred.
- Erroneous change orders
Change orders represent both great opportunities and potential pitfalls for contractors. What’s more, the accounting rules for dealing with them are complex and can lead to errors.
For instance, if you’re overly optimistic that a change order will lead to additional revenue, you may overestimate profits — resulting in profit fade as the job progresses. This may happen if you begin out-of-scope work before the change order is approved, or if you and the owner agree on scope but leave discussions of price for another day.
- Inaccurate job cost estimates
For contractors that use the percentage-of-completion (POC) method to account for jobs, estimated job costs is a key factor driving revenue recognition. Errors may be caused by:
- Poor estimating or forecasting,
- Inaccurate recording of actual costs, or
- Mishandling of change order accounting.
Among the best ways to avoid the effects of estimating errors is to reconcile actual to estimated costs on a monthly basis.
- Failure to recognize loss contracts
Construction companies that use the POC method sometimes fail to consider whether a job is likely to generate a loss. Under such circumstances, Generally Accepted Accounting Principles require them to fully recognize the loss at the time it’s determined.
If you’ve encountered this issue in the past, be sure to stay informed. Regularly review each project’s job cost schedule. In the event estimated costs exceed the contract amount, be prepared to accrue a loss.
- Improper treatment of joint ventures
Joint ventures, like change orders, are potentially valuable opportunities that come with their own accounting rules. Without going into detail, the manner in which costs and profits are shared among the participants depends on the way in which the joint venture is structured and on the terms of their agreement.
To avoid errors, leave nothing to chance. Be sure you and the other party agree on the proper accounting treatment before starting work. From there, implement procedures to ensure that the venture’s activities are properly documented.
Construction is characterized by thin profit margins and a high degree of uncertainty. So accurate financial reporting is important not only to operating successfully, but also to looking good in the eyes of sureties, lenders and other stakeholders. And to make the challenge even greater, contractors should begin to prepare for new revenue recognition rules that take effect in 2018. (See “Accounting changes on the horizon.”)
Accounting changes on the horizon
If your construction company follows Generally Accepted Accounting Principles (GAAP), important changes are ahead. A new accounting standard that rewrites the rules for revenue recognition is scheduled to take effect in 2018 for calendar-year private companies. It prescribes a five-step model for recognizing revenue:
- Specify the contract.
- Identify performance obligations.
- Determine the transaction price.
- Allocate the price among the performance obligations.
- Recognize revenue when (or as) performance obligations are satisfied.
What does this mean for contractors? For one thing, a contract previously treated as a single performance obligation — such as one that calls for construction as well as equipment installation — may have to be accounted for as two separate performance obligations with different revenue recognition schedules.
Also, the new rules will eliminate the percentage-of-completion method of accounting for long-term contracts. This doesn’t mean you won’t be able to recognize revenue gradually over a project’s life. But, for that to happen, you must gradually cede control to the owner. Whether you’ll be able to do so will depend on various factors, including the nature of the job and contract terms.
Between now and the end of 2017, you’d be well advised to evaluate how the new standard will impact your construction company. You may need to consider contractual or other changes to ensure compliance with GAAP. Your CPA can help you get ready.