Unique Issues for Speciﬁc Businesses – Building-Construction Transactions
As anyone who’s ever been a contractor or hired one knows, construction jobs take some time to complete. Since these jobs can run so long (months, even years), they sometimes call for some special accounting procedures. When a project won’t be completed during the accounting year in which it was started, it’s considered to be a long-term contract for accounting purposes; even if the actual contract covers only a two- month project, it counts as long-term if it straddles two accounting years.
Contractors and construction companies that deal with smaller jobs and residential real estate have more ﬂexibility in their accounting choices than do very big commercial companies. Big ﬁrms have to use something called the percentage-of-completion method to account for their construction con- tracts, which makes them recognize proﬁts every step along the way. Small real-estate construction contractors don’t have to use this method if they don’t want to. Instead, they have a choice; they can go with the long-term contract methods or they can use their regular accounting method (cost or accrual) to deal with revenues and expenses.
What Counts as Small
Your company can choose its preferred accounting method for a con- tract when:
- That contract is expected to be completed within two years of the start date.
- Your company’s average annual gross revenues for the past three years aren’t greater than $10 million.
- It’s a home construction contract.
If you think it’s ridiculous that a small construction company could bring in gross revenues of more than $10 million, consider this: in some areas, a single home can cost millions of dollars, and building just two or three such homes can put you over the limit.
The Basics of Percentage of Completion
The point of using the percentage-of-completion method for long-term contracts is to attempt to match up revenues and expenses with the actual work being done. As the job progresses, you record the revenues and expenses that go with that part of the process, and spread everything out over the entire length of the contract.
To ﬁgure out how much to account for at a particular point, you ﬁrst decide how to measure the percentage of completion. There are two main choices: one based on performance and one based on costs. Using performance, your percentage will be based the amount of work done so far com- pared to the estimated total work; for example, if you’re half done, you’d use 50 percent for your percentage of completion. The cost method is a little more concrete and is more commonly used. There you divide the construction costs that have come up so far by the total expected construction costs. For example, if you’ve spent $50,000 on this job so far and expect to spend $200,000 total, your percentage of completion would be 25 percent.
Once you know your current percentage of completion, you multiply it by the total revenue for the project (usually the contract price) to get the total revenue that should be recorded so far. If you’ve already recorded some revenue for this contract, subtract that from the new total to get the amount that goes with this period. For example, suppose your total contract is for $500,000 and you’ve already accounted for $100,000. Your new percent- age of completion is 30 percent, for a total revenue of $150,000. Since you already recorded $100,000, your new journal entry will include a $50,000 credit to revenue.