The financial success of a construction contractor can depend on a variety of factors including the quality of its product, its reputation, the management of the enterprise, and its ability to sell profitable contract work. The financial success of a construction contractor is also dependent on disciplined project management, which is intrinsically linked to a fundamentally sound accounting and financial reporting system. These two functions, when coordinated, will contribute to the financial success of a construction contractor. The relationship requires these two functions to effectively communicate and work together over the estimating, forecasting, cost accounting, revenue recognition, and cash flow processes. Each one of these processes will require the input from each function to ensure the completeness and accuracy of job, management, and financial reporting.
The estimating process is extremely critical to a contractor’s success, since the accomplishment of a project always starts with the initial estimate of how much the project will cost the contractor, and how those costs will be funded. Dependable estimates provide a baseline for monitoring project progress, and financial performance assessments throughout the project’s lifetime. The project management function is typically responsible for project estimates; however, many contractors may have a dedicated estimating department, in which case, project management may be less involved. To that end, if the project is awarded to the Company based on a bid with an estimate developed by an estimating department, it is then typically handed over to project management for conversion into a project budget. It is at this point, where project management should work together with accounting to ensure the project budget is added to the accounting system appropriately, and that all cost items have the appropriate cost codes when entered into the system and measured against the project budget. The other processes, forecasting, job costs, revenue recognition and cash flow, will operate more effectively if initial project estimates are set up correctly.
Forecasting is the act of focusing on future events, such as future billings, costs, and other potential project problems. In other words, forecasts are current estimates after the project begins and potentially changed since the initial project estimate. For project management to effectively make forecasts, strong project management and accounting controls must be in place to ensure the forecast data available is accurate. This entails an accounting system that allows project management and accounting to work together within, or communicate through, to ensure the information available, such as line-by-line project costs, change orders, and progress billings, is current, complete, and accurate. The underlying controls to allow for such a relationship would include a separation of duties that allows each function to check on the other – such as a project manager approving a material purchase initiated by the purchasing department, which is then added to the job cost accounting system by the accounts payable department (accounting function). If this shared system correctly reflects the history of the project’s costs, billings, etc., then the project manager will be able to more accurately forecast the future events that are expected to occur. These forecasts then assist in the other processes including job costs, revenue recognition, cash flows and financial reporting.
The management of job costs requires complete collaboration from project management and accounting. The accounting function is responsible for developing and maintaining a chart of accounts with cost codes that project management can use to manage and forecast the project effectively. Project costs are generally entered into the accounting system by the accounting function upon the approval of project management. These job costs are categorized and measured against initial project estimates and subsequently revised estimates to monitor project performance, and assist in forecasting the project. Accounting then uses these revised estimates and job costs incurred-to-date to determine the percentage of completion, which translates directly to the revenue earned (assuming the percentage of completion method is used by the contractor for financial reporting). Project management often uses percentage of completion to measure the actual progress of a job determining it’s reasonability, and to identify potential project issues requiring further estimate revisions.
One such category that can often have issues is the project labor cost category. Project management and accounting should work to ensure labor hours are properly approved, coded to the proper project, and calculated for the correct amount. The job costing process also requires strong checks in balances between project management and accounting to maintain data integrity job-by-job. In other words, job costs need to be charged correctly or forecasting, cash flow projections and financial reporting will have errors. Finally, a strong job costing process allows for upper management to properly monitor the progress of projects and identify additional potential issues.
The revenue recognition process for financial reporting is completely dependent on the three previously discussed processes functioning correctly, in addition to progress billings occurring regularly (cash flow process). As previously discussed, the most commonly practiced revenue recognition method is the percentage of completion method. Percentage of completion is measured by comparing costs incurred to-date against estimated costs expected to be incurred. This calculation results in a percentage that in theory represents the overall progress of the job. This percentage is then taken against the agreed upon contract price with the customer to determine what portion of the overall contract price has been earned-to-date. (There are variations in this approach to consider, but this is the most commonly practiced method for determining revenue recognition). The accounting function will have errors in this calculation if the project management and accounting functions have errors or issues within the estimating, forecasting and job costing functions. The functions with the greatest degree of variability in this calculation are the estimating and forecasting functions in tandem. Inaccurate cost-to-complete estimates can cause misreported revenue and if not caught in time can result in losses being carried on the balance sheet instead of being recognized, or revenues being smoothed to manage year over year profitability. Though the percentage of completion method for revenue recognition is really representative of accrued accounting, it serves as barometer for final profitability and the cash needs of the project to ensure it will be properly funded through completion.
The cash flow process is the life blood of a company and each of its construction projects. The cash flow process can often be more of an art than a process and is a part of each phase of the project life cycle from pre-bid to close out. This process requires project management and the accounting function to work together in preparing customer bills, recording the bills to the accounting system, and collecting cash receipts from the customer. The accounting function will also hold project management accountable for being paid, and will notify project managers of delinquent collections if the accounting function notices any negative collection trends within the reports generated by the accounting system. In addition, if project management falls behind with billing the customer it will raise a signal to the accounting function that there could be issues with the revenue recognition and that the project could be less profitable than initially expected. Conversely, if project management is ahead in its billing relative to revenue recognized, especially during the later phases in the project life cycle, it will signal the possibility of a more profitable project. That being said, the cash flow process is a barometer for how well the project was initially estimated and subsequently forecasted. Of course, if project billings and collections are not funding the job costs being incurred, it will also signify possible issues within the estimating and forecasting process. Either way, direct communication between the project management and accounting functions will be required to determine a solution.
Disciplined project management and a fundamentally sound accounting function are essential to a construction contractor. The relationship these two functions share together within the estimating, forecasting, cost accounting, revenue recognition and cash flow processes will contribute to the financial success of a construction contractor by effectively communicating and working together to ensure accurate job, management and financial reporting.
For assistance or more details on how you can improve your accounting function, please reach out to Michael Corcoran, Senior Manager, in Aronson LLC’s Construction and Real Estate Group at 301.231.6200.