The Top Five Accounting Errors Construction Companies Make
Every construction company owner and financial executive has dealt with a financial statement. Financial statements are either an ongoing tool used to manage a business or as a required deliverable for a lender or bonding company related to borrowing requirements or securing coverage on jobs. It is critical for the individual responsible for the financial statement’s final review to know what errors might be lurking behind the numbers.
Following are five common accounting errors that can appear in construction company financial statements prepared using generally accepted accounting principles.
5. IMPROPER JOB COSTS CUTOFF
Most contractors use the accrual basis of accounting (i.e., accounts receivable, accounts payable, etc.). When using this basis, the theory is that revenues and costs are recorded in the period earned or incurred. The cutoff error arises even in non-construction companies and is the result of omitting costs incurred in the period being reported on. It generally is the result of receiving invoices after the period that are not picked up as part of the closing process in accounts payable. To avoid this error, a process should be implemented in which a voucher system of costs incurred records these as liabilities in the period incurred. The accrued costs can then be matched up with invoices as received and set up for payment as recorded in accounts payable.
4. FAILURE TO RECORD 100 PERCENT OF LOSS CONTRACTS IN THE PERIOD
Because most contractors use the percentage-of-completion method for revenue recognition, an error often occurs as a result of applying the percentage of completion multiplied by the contract amount without considering whether the job is estimated to be a loss. Generally accepted accounting principles require that a loss contract be fully recognized at the time a loss is determined.
This error can be avoided by monitoring the detailed job schedule consisting of estimated total job revenue, estimated costs and the related estimated gross profit (loss). When an estimated loss is determined, then an accrual for the loss should be recorded.
3. INACCURATE APPLICATION OF OVERHEAD TO JOBS
Most contractors use an overhead rate to allocate indirect costs (e.g., rent, utilities, depreciation, etc.) to individual jobs using a percentage multiplied by either direct labor costs or materials costs-although there are variations, such as direct labor hours or a blending of these. When the rate used is not monitored to assess whether it is an accurate representation of the company’s current overhead costs, an over- or under-allocation of costs can be created.
To prevent this error, revisit the rate annually to assess that the correct costs are being included and the most appropriate method is being applied. Assessing which method is most appropriate for a contractor should be based on the most critical component of the construction activity, labor or materials.
2. INCORRECT RECOGNITION OF JOINT VENTURE ACTIVITY
A joint venture is common in the construction world, and the proper accounting for the activity is often misunderstood. Because there are varying methods of recording a joint venture (consolidation, equity or cost), it is critical to assess the correct accounting at the beginning of the activity. Consolidation is required when there is direct or indirect “control” of the entity, generally presumed to begin at a 50 percent ownership interest. The equity method is required where there is significant influence over the entity, generally presumed to begin at a 20 percent ownership interest. The cost method may be used generally below a 20 percent ownership interest when there is not significant influence over the entity.
1. MISSTATEMENT OF ESTIMATED JOB COSTS
Because most contractors use the percentage-of-completion method for revenue recognition, the most important factor is estimated job costs. Errors occur most often as a result of poor estimating/forecasting, inaccurate actual costs accumulation or improperly excluding revisions due to change orders. To prevent estimating errors, compare actual costs to estimated costs on a monthly basis, ensure estimated costs include the same elements as actual costs, consider increasing prices and wages in the future and revise the estimates accordingly on a monthly basis.
Preparing accurate financial statements for construction companies is never easy. Construction company owners should regularly seek the advice of accounting professionals to help ensure their finances stay error-free.