CHAPTER 3

CONSTRUCTION
ACCOUNTING SYSTEMS
Contents of the chapter
3.1 Introduction
3.2 Financial statements in Construction
3.3 Financial analysis

Wondyefraw A.
October 2024
 3.1. Introduction: Accounting System
 In this section we look at how to account for the company’s financial
resources. Accounting for these resources is build around a company’s
accounting system.
 The accounting system is a processes where the cash receipts (collecting
payments) and disbursements (paying bills) for the company are made.
 Construction accounting systems include the software, hardware, and
personnel necessary to operate a construction accounting system.
 Construction accounting systems serve three purposes.
– The accounting system collects and reports the data needed to prepare
financial statements of a company that are used to report the financial status of
the company to shareholders and lending institutions. These reports are
needed to assure shareholders and lending institutions that the company is
solvent and is managing its financial assets in a wise manner.
– The accounting system collects and reports the data needed to prepare income
taxes, employment taxes, and other documents required by the government.
– The accounting system collects and provides the data needed to manage the
finances of the company, including data for the company as a whole, each
project, and each piece of heavy equipment.
 Cont’d.
 LEDGERS: (financial record book)

It is financial record book or page with columns for debits and credits, on which
to transcribe financial records.

The accounting system for many companies have three different ledgers:

a) The general ledger tracks financial data for the entire company and
is used to prepare the company’s financial statements and income
taxes. It consists of all financial data needed to prepare the entire
company’s balance sheet, income statement, and income taxes.
b)
c) The job cost ledger is used to track the financial data for each of
the construction projects.
d) The equipment ledger is used to track financial data for heavy
equipment and vehicles.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 3.1. Introduction: Accounting System
In order to successfully manage the company‘s financial
resources, the accounting system must provide this data quick
enough for management to analyze the data and make
corrections in a timely manner. Accounting systems that fail to
do this are simply reporting costs

Managers
(internal)

Reports
information
to decision Investors
Collects and processes makers and
financial information Creditors
(external)
 Cont’d.

Accounting System

Financial Accounting Managerial Accounting

System: System:
• Periodic financial statements • Detailed plans and
• continuous performance reports

External Decision
Makers: Investors, Internal Decision
creditors, suppliers, Makers
customers, government. Managers throughout
the organization
 Cont’d.
 COST REPORTING VERSUS COST CONTROL

Cost Reporting
 This accounting system provides management with the accounting
data after the opportunity has passed for proactive management
decision to respond and correct the problems.
For Example: When companies wait to enter the cost of their
purchases until the bills are received, management does not
know if they are under or over budget until the bills are entered,
at which time the materials purchased have been delivered to the
project and may have been consumed.
 The extreme case of cost reporting is where companies only look at
the costs and profit for each project after the project is finished.
 It is useful for financial accounting system: for preparing periodic
financial statements and related disclosures, for the use of external
decision makers such as Investors, creditors, suppliers, customers,
etc.
 Cont’d.
Cost Controlling
 Cost control is characterize by identifying problems early and giving
management the chance to Actively address the problem by
analyzing the collected data and make corrections in a timely
manner.

A lot of money can be saved by addressing dominant problems,

such as excessive waste at early in the project. By What?

Companies enter material purchase orders and subcontracts,

along with their associated costs, into their accounting system as
committed costs before purchase order or subcontract.

 It used for Managerial Accounting System: for preparing Detailed

plans and continuous performance reports.
 This accounting systems track committed costs that give
management time to identify the cause of the overrun early on,
identify possible solutions, and take corrective action before ordering
the materials or work..
 METHOD OF ACCOUNTING:
 The construction industry is characterized by:
 The long-term nature of projects,
 The involvement of several uncertainties, and
 The frequent change orders observed in projects.

This calls for a slightly different approach in accounting

processes, especially when it comes to recognizing the
revenue. There are different methods used to demarcate
revenue recognition. These are:
a. Cash methods,
b. Accrual methods,
c. Percentage of completion methods, and
d. Completed contract methods.
 The key difference between these methods is how and when
they recognize income, expenses, and profits.
 The percentage-of-completion and completed contract methods
are used when companies enter long-term contracts
 METHOD OF ACCOUNTING: Cont’d.

a) Cash Method:
 This is the easiest of the accounting methods.
 In this method
 Revenue is recognized when payment is received from the owner
 Expenses are recognized when bills are paid
 Gross profit at any time= Revenue at that time – Expense at that time
ADVANTAGE OF CASH METHOD
 It is favorable for small construction companies; this is because of it’s
easiness.
 Can easily be used to defer the company’s income tax.
To decrease the company’s tax liability for the current year:
1. Inhibiting project owner from making payments during the last few
weeks of the current year in order the payment to be hold and made
in the next new fiscal year. This moves the revenue from the current
year into the next year; reduces the profits for this year and hence
reduces income tax.
2. Paying any bills that are due during the first few weeks of the next
year on the last days of the current year.
 DISADVANTAGE OF CASH METHOD
Delay in recognizing revenue and expense. Due to this financial
institutions may not accept financial statements that are prepared by
cash accounting methods. For this a contractor who uses this method
are forced to adopt other methods in order to prepare financial
statements for external financing institutions.
b) Accrual Method:
 Provide a more accurate financial picture
Revenue is recognized when the company has the right to receive
revenues
Expense is recognized when the company is obliged to pay for the
expenses
Gross profit = All revenue rights (even if the revenues are not
collected) – costs incurred to date (even if the cost is not yet paid)
ADVANTAGE OF ACCRUAL METHOD
Financial statements that are prepared using the accrual method are
more useful for financial management.
DISADVANTAGE OF ACCRUAL METHOD
Paying income taxes for revenues not yet received
Paying income taxes on imaginary or unearned profits when
companies use front loading.
c)Percentage of Completion: This method requires construction companies to
recognize revenues, expenses, and estimated profits on a construction project
through the progress of the project.
Provides best picture of the companies financial situation.

Example: if the project is 40% completed ; a company would recognize:-

40% expected revenue
40% expected expense
 40% expected profit
At the actual completion of the project the construction company must
look back over the life of the project and determine if income taxes were
OVER/UNDER paid.
If over paid, the contractor must: a) be paid the over paid tax
b) be paid interest for the over paid amount
 If under paid; the contractor must: a) pay under paid tax
b) pay interest for the under paid amount
Larger construction companies are required to adopt this method in order
to allocate general overhead to individual projects.
 Gross profit calculated by:

Revenue = Percentage complete * Contract value

Gross profit = (revenue recognized) - (cost incurred to
date)
d) Completed Contract: Revenues and Expenses are recognized
when the project is actually completed.

ADVANTAGES OF Completed Contract METHOD:

 Revenues and Expenses are accurately known at the completion
of the project (not estimates)

DIS ADVANTAGES OF Completed Contract METHOD:

 Creates larger swings in profit
To get the best picture of a company’s financial health, a
construction company should use the method that best
matches its costs to its revenues and profits.
 For most higher level General Contractors the percentage-of-
completion accounting method is best.
 For smaller construction companies cash method of
accounting are best preferred.
 Under Billing and Over Billing
• Under billing is expressed in the balance sheet as
“Costs and estimated earnings in excess of billings
on work in progress” under Current Assets.
• Over billing is expressed as “Billings in excess of
costs and estimated earnings on work in progress”
under Current Liabilities.
Let us look at an example of what it is and how it is
evaluated.
A construction company has the following project
financial data:
Contract sum $8,000,000
Billed to date $4,700,000
Cost incurred to date (i.e cost of revenue) $3,700,000
Estimated cost to complete $3,000,000

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Under Billing and Over Billing
Up to the present moment, the percentage of completion
= [Cost incurred to date / (Cost incurred to date + Estimated cost to
complete)] × 100%
= [$3,700,000 / ($3,700,000 + $3,000,000)] × 100%
= 55.22%
Revenue to date = (Contract sum) × (% of completion)
= $8,000,000 × 55.22% = $4,417,600
Gross Profit to date = Revenue to date – Cost of Revenue to date
= $4,417,600 – $3,700,000 = $717,600
Over billing = Billed to date – Revenue to date
= $4,700,000 – $4,417,600 = $282,400
If overbilling is a negative value, then it is called under billing.
Hence,
Under-billing = Revenue to date – Billed to date.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Under Billing and Over Billing
• There is an interesting point to note in the above example. The
difference of the ‘billed to date’ and ‘cost incurred to date’ is
$1,000,000 (i.e. $4,700,000 – $3,700,000).

This $1,000,000 is the gross profit obtained based on the so called

‘Straight Accrual Method’. (This method of calculating gross
profit is rarely used in construction). The true gross profit
(calculated by the Percentage of Completion Method shown just
earlier) is $717,600,

However. $1,000,000 – $717,600 = $282,400, and it can be seen

that $282,400 is the overbilling. In other words, the construction
company billed the client for $4,700,000. It also incurred
$3,700,000 as the ‘cost of revenue’, leaving it with $1,000,000 in
hand. A part of this $1,000,000 is the true gross profit ($717,600),
which belongs to the construction company, and the remaining part
is over billing ($282,400), which belongs to the client.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Overbilling means that the construction company is
borrowing money from the client by billing the later an
amount of revenue more than what the company has
actually done. This does not mean that the total (final)
revenue is to be billed wrongly, but is just the case that
more money is received at an earlier stage of the work. on
the contrary,
under billing means that the company is allowing he
client to borrow money from it, because it has incurred cost
for doing work but without appropriately billed for the work.

A project can either be over billed or under billed and

cannot be both. A construction company usually has a
number of projects in its hand at the same time. Some of
the projects may be under billed and some may be over
billed.
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies
 3.2 Financial Statements in construction
 A financial Statement is a collection of financial data
and information organized according to logical and
consistent accounting procedures.
 Financial statements paint a picture of the
transactions (financial activities of the business.)
that flow through the business.
 In all businesses, financial statements are important for
reflecting the financial health of a company.
 Major Forms of Financial Statements: Among various
financial statements, two of them are the most important ones.
A Flow of Funds Statement Statement of Retained Earnings

Balance Sheet Income Statement

(or Profit & Loss

Account)

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Cont’d.

 Purpose of Financial Statements in Construction Accounting

System: To inform the following parties of the financial performance
and position of the entity:
1) Management – for reviewing their performance during the
reporting period.
To successfully manage the company’s financial resources, the
accounting system must provide this data quickly enough for
management to analyze the data and make corrections in a timely
manner.
2) Shareholders and Investors – for assessing the worth of their
investments and reviewing the effectiveness of the Management
and for judging the worth of the entity before deciding to invest
2) Suppliers and Lenders – for judging the creditworthiness of the
entity before deciding to extend credit
2) Government – for calculating the amount of tax to be collected.
 Cont’d.

A. Balance Sheet
 It shows the financial position of the firm at a moment of
reporting (usually the last date of the company’s fiscal year).
 There are three major items in a balance sheet:
(1) Assets, (2) Liabilities, and (3) Equity (or called Net Worth).
 It matches resources (assets) with sources (liabilities and
equity).

Basic Accounting Equation

Assets
Assets == Liabilities
Liabilities ++ Equity
Equity
 Balance Sheet
Owns Owes
Assets are economic resources Liabilities and Equity
owned by the business as a result of Liabilities: When a construction
past transactions company owes obligations to
[Link] assets: construction some third parties, we call these
company have high liquidity (i.e. can obligations Liabilities.
be turned into cash easily). 1. Current liabilities: They are debts
 Cash & securities the company has to pay within a
 Receivables year.
 Inventories
 accounts payable
 short term bank loan,
[Link] assets: they also called
2. Long-term liabilities: These long-
Long-term Assets that means they
term debts are usually repaid by
cannot be readily turned into cash in
installments.
a short time.
•When Current Assets and Fixed • Liabilities are added together, the
Assets are added together, the sum sum is called Total Liabilities.
is called Total Assets. Equity: Equity is the capital invested
by the owner(s) of a company.
Another name for it is ‘Net Worth’.
 Let’s look at
ECO-CON CORP.’s
financial
statements as the
general ledger

 The general ledger tracks financial data for the entire company
and is used to prepare the company’s financial statements and
income taxes.
 Example of ECO-CON CORP: Balance Sheet
Assets As at 31/12/2012 31/12/2011
Current Assets
Cash 2,589,000 1,967,890
Accounts receivable- Trade 5,767,000 5,403,670
Accounts receivable- Retention 1,641,750 1,350,918
Material Inventory 850,000 520,000
Costs and estimated earnings in excess of billings on work in 547,250 450,306
Progress
Prepaid expenses and others 894,500 983,944
Total Current Assets 12,289,500 10,676,728
Fixed assets
Property and equipment 15,536,900 13,800,000
Construction plant 2,680,040 2,039,480
Vehicles/Trucks 2,070,000 1,812,000
Furniture and fixtures 345,000 379,000
Total depreciable assets 20,631,940 18,030,480
Less accumulated depreciation 12,529,373 11,158,000
Net Fixed Assets 8,102,567 6,872,480
Total Assets 20,392,067 17,549,208
 ECO-CON CORP.
Balance Sheet
Liabilities As at 31/12/2012 31/12/2011
Current Liabilities
Accounts payable 4,325,250 4,773,240
Accrued expenses 1,586,037 1,475,918
Notes payable 647,250 491,973
Retention money payable 919,380 756,514
Billings in excess of costs and estimated earnings on 617,205 678,922
work in progress(Over Billing)
Total Current Liabilities 8,450,835 8,469,266
Long-term Liabilities 3,528,557 3,695,267
Total Liabilities 11,979,392 12,164,533
Equity (i.e. Net Worth) Capital stock 3,500,000 2,500,000
Additional paid-in capital 1,000,000 1,000,000
Retained earnings 3,912,675 1,884,675
Total Equity 8,412,675 5,384,675
Equity + Total Liabilities 20,392,067 17,549,208
 B. The Income Statement

 An ‘income statement’ shows the profit made or the loss

incurred by a company in a period of time(usually each month
and the fiscal year. ), that is why it is sometimes also called
a ‘profit and loss account’.
 It shows the revenues and expenses of the firm, the effect of
interest and taxes and the net income for the period.
 Income statements is prepare for a period of time between
two balance sheets.
 The purpose of the income statement is to show company’s
business is profitable or loss to stockholders and creditors.
 ECO-CON CORP.
The Income Statement
As at 31/12/2012
Revenue 40,185,000 100.0%
Cost of Revenue
Materials 13,000,000 32.35%
Labor 5,500,000 13.69%
Subcontracts 12,500,000 31.11%
Other direct costs 1,087,000 2.70%
Total Cost of Revenue 32,087,000 77.11%
Gross Profit 8,098,000 18.66%
Operating Expenses 0.00%
Variable overhead 2,036,500 4.84%
Fixed overhead 3,358,500 7.41%
Total Operating Expenses 5,395,000 12.25%
Operating Profit 2,703,000 6.41%
 ECO-CON CORP.
The Income Statement
As at 31/12/2012
Other Income/Expense
Gain/loss on sale of assets 30,000 0.07%
Miscellaneous income/expense (5,500) -0.01%
Interest income 19,000 0.05%
Interest expense (42,500) -0.11%
Total Other Income/Expense 1,000 0.00%
Net Profit before Tax 2,704,000 6.73%
Tax Expense (25% tax rate) 676,000 1.68%
Net Profit after Tax 2,028,000 5.05%
 Statement of Cash Flows
Because . . . and expenses
revenues reported reported do not
do not always equal always equal
cash collected. . . cash paid . . .

net income is
usually not equal
to the change
in cash for
the period.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 3.3 Financial Analysis

• Assessment of the firm’s past, present and

future financial conditions
• Done to find firm’s financial strengths and
weaknesses
• Primary Tools:
– Financial Statements
– Financial ratios

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Ratio Analysis
• Liquidity: Can we make required payments?
• Leverage management: Right mix of debt and
equity?
• Asset management: Right amount of assets vs.
sales?
• Profitability: Do sales prices exceed unit costs,
and are sales high enough as planned?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 a) Liquidity Ratios

• An asset that can be converted to cash quickly

without having to reduce asset’s price very much.
• Current Ratio:

Current assets
Current ratio 
Current liabilities

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Liquidity Ratios (cont’d)

• Quick, or Acid Test Ratio:

Is calculated by deducting inventory from current
assets as a proportion of current liabilities

Current assets - Inventories

quick / acidtestratio 
Current liabilities

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 b) Leverage Ratios (cont’d)

• Debt Ratio
The ratio of total debts to total assets:
measures the percentage of funds
provided by creditors
Total Debt
Debt Ratio 
Total Assets

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Leverage Ratios (cont’d)

• Interest Coverage Ratio

The ratio of earnings before interest and
taxes (EBIT) to interest charges; a measure
of the firm’s ability to meet its annual
interest payments.
EBIT
Interest coverage ratio 
Interest charges

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 c) Asset Management Ratios (Turnover)

The asset management ratios measures how

effectively the firm is managing its assets

• Inventory turnover ratio

This ratio is calculated by dividing sales by
inventories

Sales
Inventory turnover ratio 
Inventories

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Asset Management Ratios
(Cont’d)

• Total Asset turnover ratio

Measures how efficiently assets are employed

Sales
Total Asset turnover ratio 
Total Assets
• Fixed Asset turnover ratio
Measures how efficiently fixed assets are
employed

Sales
Fixe Asset turnover ratio 
Fixed assets

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 d) Profitability Ratios
• A group of ratios that show the combined effects
of liquidity, asset management, and debt on
operating results.
• Gross profit margin
This ratio shows the margin left after meeting
production costs. It measures the efficiency of
production and pricing.

Gross profit
Gross profit margin 
Income

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 Profitability Ratios (cont’d)
• Return on Capital Employed
A measure of how efficiently the capital is
employed. A key indicator of profitability of a firm.
Firms that are efficiently using their assets have a
relatively high return. Less efficient firms have a
lower return.

Net profit
Return on capital employed 
Current Assets
• Return on Equity
Profit indicator to shareholders. The ratio indicates
the degree to which the firm is able to convert
equity to generate net profit that eventually can be
claimed by shareholders
Net profit
Return on equity 
Total equity
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