Key Principles of Accounting for Construction Costs

Construction accounting is a form of financial tracking tailored to the project-based nature of the industry. Unlike general accounting, it focuses on the costs and revenues of individual projects. This approach is necessary because construction work spans long periods, involves unique contracts, and occurs at various job sites.

Properly managing project finances allows a company to monitor profitability on a job-by-job basis. This provides the detailed financial data needed to make informed decisions, manage cash flow, and ensure compliance with industry regulations. These principles provide a framework for tracking financial performance from a project’s start to its completion.

Identifying and Categorizing Construction Costs

A primary function of construction accounting is to track and classify all expenses associated with a project. Costs are separated into three categories, which determines their accounting treatment.

The most straightforward category is direct costs. These are expenses traced directly to a specific construction project. Examples include:

• Raw materials like lumber, steel, and concrete
• Wages and benefits paid to on-site labor
• Fees paid to subcontractors for specialized work
• Project-specific equipment rental fees or depreciation

Indirect costs, or project overhead, are also tied to a specific project but are not incorporated into the final product. These supportive expenses are necessary to keep a job running smoothly. Examples include:

• Salaries of project managers and site superintendents
• Job site security services
• Temporary utilities like water and electricity
• Building permits and project-specific insurance policies

Separate from project-specific expenses are general and administrative (G&A) costs. These are ongoing operational expenses required to run the business as a whole and are not allocated to a single project. G&A costs include corporate office rent, salaries of executives, company-wide marketing, and legal fees. G&A costs are treated as period expenses and recorded on the income statement as they are incurred.

Core Construction Accounting Methods

Because projects can span multiple accounting periods, specialized methods are required to reflect a company’s financial performance accurately. The choice of method is dictated by accounting standards and the ability to reliably estimate project outcomes.

The most prevalent approach for long-term contracts is the Percentage of Completion (PoC) method, which allows a contractor to recognize revenue and profit as work progresses. The common way to measure progress is the cost-to-cost approach, calculated with the formula: Total Costs Incurred to Date ÷ Total Estimated Project Costs = Percentage Complete. This percentage is then multiplied by the total contract value to determine the revenue recognized for the period.

For example, if a contractor has incurred $200,000 on a project with a total estimated cost of $1,000,000, the project is 20% complete. If the total contract price is $1,200,000, the contractor can recognize $240,000 in revenue.

An alternative is the Completed Contract Method (CCM), where all revenue and profit are deferred until the project is substantially complete. This method is simpler but can distort financial performance. Generally Accepted Accounting Principles (GAAP) permit CCM only for short-duration contracts or when project uncertainties make reliable estimates of progress impossible.

Current guidance is governed by the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification Topic 606. This standard requires revenue to be recognized as a contractor satisfies its performance obligations over time, an approach similar to PoC.

The Work in Progress Schedule

The Work in Progress (WIP) schedule is an internal report used to monitor the financial health of all ongoing construction projects. It is a dynamic tool for management that translates project data into a clear financial picture, enabling contractors to track progress and identify potential issues.

A WIP schedule is a table that tracks key financial metrics for each project. It shows the original contract price plus any approved change orders, which form the total contract value. The schedule also includes the total estimated cost for the project, which serves as the baseline for measuring profitability and progress.

The schedule tracks actual performance against these estimates, including a column for “Costs Incurred to Date.” This figure is used with the total estimated cost to calculate the “Percent Complete,” as described in the Percentage of Completion method. The resulting percentage determines the “Earned Revenue to Date.”

The WIP schedule also compares what has been earned to what has been billed. The “Billings to Date” column is compared against “Earned Revenue to Date” to calculate over-billings or under-billings, a key indicator of project cash flow.

Financial Statement Presentation

The data from the Work in Progress schedule informs how a company’s performance is reported on its official financial statements. The WIP schedule acts as a bridge, translating ongoing job site activities into standardized line items on the balance sheet and income statement.

The balance sheet is impacted by the over/under billings calculation. When a project’s earned revenue exceeds the amount billed, the resulting under-billing is reported on the balance sheet as a current asset called a “Contract Asset.” This represents revenue that has been earned but not yet invoiced.

Conversely, when billings are greater than earned revenue, the over-billing is reported as a current liability called a “Contract Liability.” This signifies that the company has received cash for work not yet performed.

The income statement reflects the revenue and cost figures from the WIP schedule for a specific period. The “Earned Revenue” is reported as the company’s total Revenue, and the “Costs Incurred” are reported as the Cost of Earned Revenue. This presentation matches revenues with the costs expended to generate them, providing a clear picture of profitability.