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BCN 3753 CONSTRUCTION ACCOUNTING

BCN 3753 CONSTRUCTION ACCOUNTING. Saturday mornings, 11:20 am – 2:00 pm. Instructor: Paul J. Schlachter Ph. D., C.M.A. Credit Manager Florida Export Finance Corp. E-mail: schlacht@fiu.edu http://cba.fiu.edu/acg/schlacht. MODULE 1. CONSTRUCTION ACCOUNTING. ACCOUNTING SYSTEMS AND RECORDS.

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BCN 3753 CONSTRUCTION ACCOUNTING

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  1. BCN 3753CONSTRUCTION ACCOUNTING Saturday mornings, 11:20 am – 2:00 pm Instructor: Paul J. Schlachter Ph. D., C.M.A. Credit Manager Florida Export Finance Corp. E-mail: schlacht@fiu.edu http://cba.fiu.edu/acg/schlacht

  2. MODULE 1 CONSTRUCTION ACCOUNTING ACCOUNTING SYSTEMS AND RECORDS

  3. OUR ORGANIZATION GOALS OF OUTSIDE PARTIES: RETURN ON INVESTMENT REPAYMENT OF LOANS • MEANS: • STANDARD REPORTS • ACCEPTED PRINCIPLES • REGULATIONS CONTRACTOR’S GOALS: GROWTH REPUTATION PROFITS INFLUENCE • MEANS: • STRATEGY • TECHNIQUES • PERFORMANCE MEASURES

  4. FUNCTIONS IN AN ORGANIZATION PLANNING STAFFING KNOW-HOW PRODUCTS SERVICES CONTROL DELIVERY MARKETING ACCOUNTING

  5. ORGANIZATIONAL TOOL • Long-range projects (capital investment) • Everyday operations Company resources (physical, human, financial) PLANNING CO-ORDINATION CONTROL TRACKING REPORTING (before) (during) (after)

  6. Forecast company’s future cash needs Bid on gov’t contract Qualify for bonding Approval for a loan Limit tax liability Recognize achievem’t of managers Cash budget Pro-forma statements Financial statements Income tax return Performance reports, balanced scorecard ACCOUNTING HAS A MEASURE!

  7. ACCOUNTING’S TIME FRAME Historical Reports for External Users Forecasts And Plans for Internal Users NOW 2003 2004 2005

  8. SIFTING, FILTERING, ANALYZING Sales Building costs Company Data Profitability Productivity

  9. PERSPECTIVES ON CONSTRUCTION JOB WIN CONTRACT CONTROL: FINISH (USAGE, COSTS, (PAYMENT) SUBCONTRACTORS, SAFETY, RISKS) COMPANY CO-ORDINATION: BIDDING, PURCHASING, TRAINING, SCHEDULING FINANCIAL REPORTS: FOR BORROWING, TAX SAVING, INSURING, BONDING, TAX PAYING

  10. ACCOUNTING IS BUILT ON BUSINESS TRANSACTIONS Owners contribute capital to their company Workers wages are paid Equipment and supplies are purchased for cash Equipment and supplies are purchased on credit Electric, telephone, water bills are paid Advertising is paid for Subcontractors complete and bill for their work Contract work is completed Contractor bills for work completed Contractor receives payment for work done

  11. TRANSACTIONS AFFECT CONTRACTOR ACCOUNTS • 100: Assets • 200: Liabilities • 300: Contractor Equity (net worth) • 400: Contract and Fee Revenue • 500: Direct Costs of Construction • 600: Indirect Costs of Construction • 700: Operating Expenses • 800: Financing Expenses • 900: Income Taxes and Other Expenses

  12. SETTING UP INDIVIDUAL ACCOUNTS • Class “100”: All assets • Class “150”: All fixed assets • Class “155”: All company vehicles • Class “155.3”: Earth movers

  13. Records are the raw materials of accounts Specific items Basic data Items are limited on a record (7-8 or less) Examples: Time cards Materials receipts Equipm’t maintenance Reports are well- organized sets of information for a period of time Reports are a summary of accounts Examples: Costs for the week Balance sheet Cash flow budget ACCOUNTING RECORDS / REPORTS

  14. EXAMPLE OF RECORD JOB TIME PERIOD RECORD

  15. WHAT ITEMS SHOULD GO INTO THESE RECORDS? • Equipment Control • Purchase Order • Personal Time Card

  16. EQUIPMENT RECORDS EQUIPMENT PLAN JOB RECORD ACQUISITION EQUIPMENT RECORD (IDENTIFICATION) EQUIPMENT USAGE DEPRECIATION FOR EXTERNAL REPORTING

  17. RECORDS AND REPORTS COST AND INPUT DATA MANAGEMENT DECISION MAKING RECORDS REPORTS EXTERNAL ANALYSIS

  18. MODULE 2 CONSTRUCTION ACCOUNTING • ACCOUNTING METHODS • INCOME RECOGNITION • IN CONSTRUCTION

  19. ACCOUNTING RECORDS AND THE BUSINESS CYCLE BANK ACCOUNT ESTIMATES FOR JOBS RECORDS FOR JOBS CHART OF ACCOUNTS CHECK PAYMENTS CASH COLLECTION EQUIPM’T RECORD CREDIT SALES CREDIT COLLECTIONS CASH ON HAND PERCENTAGE OF COMPLETION ADJUSTMENTS (2) Doing the job (3) Completing the job FINANCIAL STATEMENTS (1) Ready to work (4) Later events

  20. HOW FINANCIAL INFORMATION IS REPORTED TO OTHERS TRANSACTIONS JOURNALS INCOME STATEMENT LEDGERS BALANCE SHEET CASH FLOW STATEMENT

  21. THE ACCOUNTING THAT CONSTRUCTION MANAGERS CARE ABOUT They’re calling again! Is there a check inside?

  22. Contractors have their building projects(3 houses completed) 2004 2005 and Accountants have their time periods • 1.75 houses completed in 2004 • 1.25 houses completed in 2005

  23. CASH FLOW IS NOT NET INCOME! Work is done and we bill customers. -Lots of income to report, but how much cash? -Liberal credit: slower collection of cash We borrow money and use our credit line. - Lots of cash inflow, but how much income? - Later: interest expense and cash outflow We pay for insurance and rent in advance. - Cash payments now, expenses reported later We record depreciation on our equipment. - Report of expenses, but no effect on cash We save money by failing to replace equipment on time. - Future breakdowns and inefficiency, cash outflow We save costs by finishing a project ahead of schedule. - Possible overtime costs, contract incentives

  24. When the goods are delivered, the services provided or the contract finished. When a percentage of the project costs is incurred (for a partially completed project). Not when the cash is received! Not just when the project is fully completed. REVENUE RECOGNITION

  25. COMPLETED-CONTRACT METHOD Used mostly by subcontractors For small and quick jobs Recognize revenue, costs and income when the job is completed . PERCENTAGE-OF-COMPLETION METHOD Used mostly by general contractors For jobs that last for 2+ reporting periods Recognize some revenue, cost and income at each billing date and at the end of each year or quarter Recognize revenue gradually as work phases are finished or as project costs are incurred.

  26. EXAMPLE OF PERCENTAGE-OF-COMPLETION Contract price: $1,000,000 Estimated cost of project: $800,000 Assumed a fixed price contract. --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Plan: Year One: Cost $400,000, Revenue $500,000 Year Two: Cost $400,000, Revenue $500,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- What really happened: Year One: Cost $450,000, Revenue = ? Year Two: Cost $400,000, Revenue = ? If more work was really done, then calculate percentage as (450,000/850,000) = 52.9%. Revenue in Year One will be $529,000.

  27. KEY ACCOUNTING EVENTS Work is done Bill the customer (pay req) Collect cash • At what point do we • Recognize revenue • and costs • Recognize profit

  28. YEAR-END ADJUSTMENTSFOR UNFINISHED WORK • ASSET ACCOUNTS: • Contract Receivable (when work is billed) • Retainage (when work is billed and funds retained) • Cost in Excess of Billings (any unbilled work) • LIABILITY ACCOUNTS: • * Billings in Excess of Cost (any overbilled work) Example: Contractor submits invoice of $100,000 for payment on project that has a 10% retainage provision. Because of front-loading, the contractor overbilled $15,000 for work not yet finished. Accounting: Contract Receivable $90,000 and Retainage $10,000 Contract Revenue for $85,000 and Billings in Excess of Cost $15,000.

  29. MODULE 3 CONSTRUCTION ACCOUNTING BALANCE SHEET TOPICS

  30. BALANCE SHEET POINTS • It shows a specific date (December 31, 2004) • Different accounts are measured in different ways (look at • cash compared with inventory and equipment) • Assets are resources available for future business • Liabilities show how much others are financing us • Equity shows how much the contractor finances itself • Assets - Liabilities must = Equity • Accounts are ordered by their liquidity (how quickly can • the account be converted to cash) • Assets and liabilities are separated into current (to be • converted in one year) and non-current • The balance sheet can be converted into a common-size • format (see next slide)

  31. ANY OLD CONTRACTORBALANCE SHEETDECEMBER 31, 2004(with common size conversions) Current Assets: dollars % Cash $ 45 17.3 Accts Receivable 85 32.7 Constr’n in Process 50 19.2 $180 69.2 Fixed Assets: Buildings $ 50 19.2 Equipment 30 11.5 $ 80 30.7 Total Assets $260 100.0 ==== === Current Liabilities: $ % Accts Payable $60 23.1 Long-Term Debt $100 38.5 $160 61.6 Equity: Capital Stock $50 19.2 Retained Earn. 50 19.2 Total Liab+Eq.$260 100.0 ==== ====

  32. COMMON-SIZE BALANCE SHEET (Conversion of Figure 25-1 into common size) February 28, X2 and X1 X2X1 Current liabilities: Accounts payable 1.4 1.1 Payroll taxes payable 1.9 0 Current note payable 28.6 26.0 Total 31.927.1 Long-term liabilities: Long-term note 3.936.3 Net worth: Retained earnings 55.3 33.5 Current net income 8.9 3.1 Total 64.236.6 Total liab. & net worth 100.0 100.0 ==== ==== X2 X1 Current assets: Cash 6.3 11.1 Accts. Receivable 55.4 46.5 Reserve for bad debts (1.5) (0.6) Inventory 8.2 5.9 Total current assets 68.562.8 Fixed assets: Equip. & machinery 46.9 38.3 Accum. Depreciation (15.4) (1.1) Net fixed assets 31.537.2 Total assets 100.0 100.0 ==== ====

  33. BALANCE SHEET Date of Balance Sheet Assets (100) Current assets: Cash Receivables billed Retainage Cost in excess of billings Construction in process Prepaid expenses Long-lived assets: Land Buildings Equipment Less Accum. Depreciation Long-term investments Deposits Liabilities (200) Current liabilities: Accounts payable Accrued wages, interest, taxes Current maturities on LTD Billings in excess of cost Long-term liabilities Long term debt (e.g. mortgage) Deferred income tax Shareholder loan Owners’ equity / Net worth (300) Capital stock Additional paid-in capital Retained earnings

  34. TRIAL BALANCE (Date) ACCOUNTSDEBITCREDIT Current assets Long-lived assets Accumulated depreciation Other assets Current liabilities Long-term debt Owners’ equity Retained earnings Fee and contract revenues Direct costs of construction Operating expenses Provision for income tax TOTALS

  35. TYPES OF CURRENT ASSETS CASH SECURITY INVESTMENTS ACCOUNTS RECEIVABLE

  36. BUSINESS DECISIONS • Purchase or rent our equipment? • (Purchase = Asset and Liability, Rent = Expense only) • “Keep off the balance sheet at any cost!” Then rent it, • or form another company to hold the equipment. • 2. Make an investment in real estate assets? • (Again, there will be an asset and a liability, and some • financial ratios will suffer) • Should the contractor’s property be owned by the • contractor itself? By the shareholders? By another company? • (Someone still has a debt! Will the contractor look better?) • If shareholders pay some of the contractor’s bills, should • they do this as a loan to the company or as a contribution? • (Making a loan may save some taxes, but it will not impress • a bank unless the loan is converted into equity. Anyway, • the bank will force the shareholder loan to be subordinated.

  37. BALANCE SHEET RATIOS Current ratio: (Ability to meet obligations) Current Assets / Current Liabilities (example: $180,000 / $60,000 = 3.00) - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Leverage ratio: (How much does the contractor borrow?) Total Liabilities / Total Equity (example: $160,000 / $100,000 = 1.60)

  38. MODULE 4 CONSTRUCTION ACCOUNTING INCOME STATEMENT TOPICS

  39. INCOME STATEMENT POINTS • Stated for a period of time (3 months, 1 year) • Recognizes the revenue and related costs for work that • has been completed • Shows a series of “bottom line” company performance • (gross profit, operating profit, net profit) • Net income becomes part of the company’s retained • earnings (it belongs to the company’s owners) • Net income is not cash flow (invoices are paid later) • The “income tax provision” is not the tax that is paid • This statement can be prepared at any level of activity • (project, region, contractor as a whole) • Some results are subject to judgment calls (how much • work was done, how big will our losses be) • Will the owners pay themselves via salaries (expenses) • or via distributions (taxed twice)?

  40. INCOME (EARNINGS) STATEMENT For year/quarter ended (date) Gross revenue (sales, fees) Less Returns & allowances = Net sales Less Direct costs of construction = Gross profit Less Operating expenses (administrative, selling) = Operating profit Less Interest and other non-operating expenses = Profit before income taxes Less Income tax provision (not the actual tax payment) = Net profit / Net earnings See how many kinds of profit we have to study!

  41. ANY OLD CONTRACTORINCOME STATEMENTFOR YEAR ENDED DEC 31, 2004(with common-size conversions) dollars % Contract revenue $5,200 100.0 Cost of construction 4,200 80.8 Gross profit $1,000 19.2 Operating expenses 800 15.4 Operating profit $ 200 3.8 Income tax provision 75 1.4 Net profit after taxes $ 125 2.4

  42. CALCULATING PROFITABILITY

  43. Experience can be a useful predictor. But-- CASH (PROFIT) PLANNING * The demand for new buildings may rise or fall. * Interest rates may rise or fall. * Approvals of new construction may be delayed or frozen. Estimate the timing of cash flows on company’s projects. * What is the desired minimum balance? * What are the routine inflows and outflows? * Are there any special events affecting cash flow? Estimate the profitability of company’s projects. * More profitable: higher cash inflow. * Review both the amount and per cent of profit.

  44. HOW PROFITABLE ARE OUR JOBS? Not all jobs are equally profitable. - high end: commercial, pricey condos, homes - low end: government, low income apartments Make sure we know how our costs and expenses arise: - Direct costs: related to the building process - Selling & Operational expenses: support activities - Which support activities are done on which jobs? Example: half our contract work is in commercial buildings, half in apartments. Are our selling expenses split 50:50 between these two kinds of jobs? What about staff time at headquarters?

  45. DO “FIXED COSTS” STAY FIXED? Next Year Right Now Sky box End zone seats Fly coach Fly Gulfstream

  46. THE COST AND PROFIT OF DOWNSIZING One thing for sure: company revenues will fall. What about costs and expenses? - Building costs will also fall. - Operating expenses? Office salaries, maybe. Office rent and property tax, maybe not. So: don’t expect to improve profit margin by downsizing! • HOW TO ASSIGN OPERATING EXPENSES • TO THE COMPANY’S LINES OF BUSINESS: • It’s better not to do it at all. “But we put them in our bids!” • Look at the revenue each line generates? “Want enemies?” • Study the way each line affects our operating expenses? • - Some office staff may be dedicated to one work area. • - Some expenses are based on number of workers on jobs. • - We’ll discuss other approaches later in the course.

  47. INCOME STATEMENT RATIOS Receivables turnover: (How quickly do we collect from customers?) Total Invoices / Receivables Balance (example: $5,200,000 / $85,000 = 61.2) (Note: This contractor collects about every 6 days) - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Return on total assets: (Rate of return for the amount of money invested) Net Profit after Taxes / Total Assets (example: $25,000 / $260,000 = 0.096 or 9.6%) (Note: This is a high rate of return for a contractor. Usually it is in the 3-5% range.)

  48. MORE INCOME STATEMENT RATIOS • Operating expenses to sales: • (Is our front office out of control?) • Total Operating Expenses / Total Contractor Revenue • (example: $50,000 / $500,000 = 0.10 or 10%) • (Note: This is at the high end. Contractors should stay below 10%.) • - - - - - - - - - - - - - - - - - - - - - - - - - - - - • Gross margin on contract work: • (Rate of return on work finished) • Gross Profit / Total Contractor Revenue • (example: $60,000 / $500,000 = 0.12 or 12%) • (Note: This is a desirable rate of return for a contractor. • The largest contractors have gross margins around 10%.)

  49. OTHER IMPORTANT RATIOS Quick (Acid-test) ratio: (Ability to pay obligations due very soon) Current Assets minus Inventory / Current Liabilities (example: $130 / $60 = 2.17) (Note: This is a very strong result. Usually it is closer to 1.00. And the acid-test working capital is equal to $70.) - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Investment in fixed assets: (Amount invested by the contractor itself) Buildings and Equipment / Total Equity (example: $80,000 / $100,000 = 0.8) (Note: The higher the result, the better for the contractor)

  50. OPERATING EXPENSES TO TOTAL SALES CAN YOU SPOT A TREND? 25.0 * * * 20.0 15.0 * 10.0 Dec ‘04 Jan ‘05 Feb ‘05 Mar ‘05

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