Construction accounting is a form of project accounting applied to construction projects.
Construction accounting is a vitally necessary form of accounting, especially when multiple contracts come into play. The construction field uses many terms not used in other forms of accounting, such as draw and progress billing. Construction accounting may also need to account for vehicles and equipment, which may or may not be owned by the company as a fixed asset. Construction accounting requires invoicing and vendor payment, more or less as to the amount of business done.
Construction Costs: Construction accounting involves charging construction costs to the applicable contract. Costs fall into three categories. Direct costs are labor, material, and subcontracting costs.
Indirect costs include indirect labor, supervision, tools, equipment costs, supplies, insurance, and support costs. Selling, general and administrative costs are generally excluded from contract costs.
Revenue Recognition: Construction accounting requires unique revenue recognition rules for contracts in progress.
In most cases, revenue is recognized using the Percentage of Completion Method. Under this method, revenue is recognized using an estimate for the overall anticipated profit for a particular contract multiplied by the estimated percent complete of that contract. This involves the inherent risk of relying upon estimates.
Under SOP 81-1, revenue is also allowed to be computed using the Completed Contract Method. Under this method, contract revenues and costs are not recognized until the contract is substantially complete. However, this method is not allowable if the results are significantly different than results using the Percentage of Completion Method. The Completed Contract Method is allowed in circumstances in which reasonable estimates cannot be determined. However, these types of circumstances can be construed as a lack of internal control.
Construction Loans and alternative construction finance sources
One of the major problems facing any business enterprise is that of obtaining finance. This is a problem not merely of quantity but also of type. The situation is further compounded by legislation. a the dynamism of the economy, but fundamentally by the requirement to minimize costs.
The construction industry comprises a wide variety of firms from the single person enterprise to the large multinational public company. The sources of capital available to any firm are quite numerous but public companies have the great variety of sources available for their use and the single person enterprise, the least variety.
Construction Loans
It can be classified into short term and long term borrowings:
Long term Finance: It is that capital required for five to ten years, either to start a business or to carry out expansion programs. Broadly the capital is used to purchase buildings, plant and equipment. The risks to the lender are high because of the time scale involved, consequently only established firms are generally considered by the lending institutions.
Short term Finance: The firm when established often needs short term capital to overcome immediate cash flow problems. Materials have to be purchased, plant hired, labor and sub-contractors paid and so on before payment is received from the Employer.
The common types of Finance
1. Shares: Shares may be of several types, each with different rights. Ordinary shares which are called equity of the company represent the major ownership and risk bearing element of the entrepreneurship. The shareholder is entitles to the residual profits in the company after all other commitments have been met. Ordinary shares usually entitle the holder to voting rights.
Preference shares are also common, entitling the shareholder to a dividend up to a prescribed level prior to any distributions being made to holder of ordinary shares. Cumulative preference shares are less common and carry a right for any unpaid to be carried forward for payment out of the profits of future trading periods. A new issue of shares for sale raise capital for the company
2. Debentures: These are loans made to the company. They differ from conventional loans insofar as they are offered to the market at a fixed interest rate and are repayable at a set time.
The loan is either secured by mortgage on the firm's property or simply on the basis of the firm's reputation. Debenture holders rank ahead of almost any other creditors in the case of liquidation of the firm's assets. Like other loans, Debentures represent a cost to the company and as such the interest payment made is deducted from profits before allowance is made for tax income. In addition, the payments rank ahead of any dividend declared to shareholders.
3. Bank Loans: Loans are not easy to obtain. Most institutions are reluctant to lend long term, particularly to construction firms. They often request the borrower to provide a proportion of the
finance from internal resources. Merchant banks tend to demand higher rate of interest than the clearing banks since they are normally dealing with a large loan.
4. Retained earnings: Retained earnings is profit retained within the firm instead of being distributed to the owners.
5. Bank overdrafts: A bank overdraft is a process whereby a customer of a commercial bank is permitted to overdraw on that account up to an agreed limit for a prescribed period. This is rather similar to a bank loan except that interest is payable for the amount overdrawn only for the period it remains overdrawn and the account is usually repayable on demand or upon the termination of the overdraft period.
6. Trade creditors: Delayed payments to creditors and prompt ones from debtors, if handled with care, ease cash flow problems. The construction industry is well suited for this sort of financial arrangement since completed work is paid for by the client in periodical stages. CFF3 Cash Flow Forecasting software is a unique construction management software for estimating the difference between cash in and cash out amounts for construction projects, and hence you can realize the construction loan or external finance required for completion of the project.
7. Short Term Loans: Short term loans are available from individuals, banks, and other financial institutions. They are required for the provision of working capital, carry a prescribed rate of interest upon the entire sum and can not be recalled prior to the due date. Usually short term loan are obtained from commercial banks
Internal sources of capital
Provision for corporation tax: Payment of this tax is usually made one year in arrears. The cash therefore remains in the business during that time and acts as a valuable source of short term funds.
Depreciation: Depreciation is a bookkeeping and costing exercise by which the initial cost of an asset is written off over its useful life. It can be regarded as a source of capital. If no depreciation was charged on, say equipments, a great amount of profit would be available for distribution to the owners. Thus, reserves created by the process of depreciating fixed assets represent a stake in the firm by the owners, in a similar manner to retained earnings. For purposes of corporation tax, the
method to be used for depreciating any asset is prescribed in the tax regulations and so it may be necessary to produce two accounts, one for internal purposes and the other for taxation purposes