Co-authored by Jovana Krajewski, CPA
You’re probably familiar with the term “crunch the numbers.” Well, in a turbulent industry like construction, it’s all too easy to let crisp, timely financials go soggy with outdated data and flat-out mistakes.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.
1. 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 officers and office 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 rate may be incorrect or may not provide the exact depiction of the current overhead costs of the Company, and as a result, 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.
2. 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, this occurs because invoices aren’t received until after the period is closed.
To avoid having this cutoff problem, your Company should 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.
3. Erroneous change orders
Change orders represent both great opportunities and potential pitfalls for contractors. The accounting rules for dealing with change orders are complex and can lead to errors and misstatements.
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.
4. Inaccurate job cost estimates
For contractors that use the percentage-of-completion method to account for jobs, estimated job costs is a key factor driving revenue recognition. Errors may be caused by:
Among the best ways to avoid the effects of estimating errors is to reconcile actual to estimated costs on a monthly basis.
5. Failure to recognize loss contracts
Construction companies that use the percentage-of-completion method sometimes fail to consider whether a job is likely to generate a loss. Under such circumstances, Generally Accepted Accounting Principles (GAAP) require them to fully recognize the loss at the time it’s determined.
Your Company should regularly review each project’s job cost schedule. In the event estimated costs exceed the contract amount, be prepared to accrue a loss.
6. Improper treatment of joint ventures
Joint ventures, like change orders, can be valuable opportunities, however, they too come with their own accounting rules. Without going into great 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, 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 and risk. 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. (See “Accounting changes on the horizon”, below.)
Accounting Changes on the Horizon
A new accounting standard that rewrites the rules for revenue recognition took effect on January 1, 2018 for all public companies. The effective date for non-public entities is for periods beginning after December 31, 2018, with early adoption permitted.
Under this new standard, there are five steps to of revenue recognition:
For more information on this and on how to prepare for the new standard, see Prepare now for Revenue Recognition Changes, written by Andrew Donohoe and Dan Owens.