By Ara Grigorian, CPA, CCIFP

Don’t let the label “supplemental information” fool you. Accurate contract schedules are just as crucial as the balance sheet and income statement for a construction contractor. By contract schedules, I mean the schedule of completed contracts and contracts in progress. These schedules provide a glimpse of where the company is and where it’s likely headed. This is why it’s important to take extra care in preparing accurate schedules. My goal with this lesson is to offer some insights into preparing accurate schedules, with an emphasis on the schedule of contracts in progress. I will provide some best practices and why they’re so important and ways to improve the reporting process.

First, I want to lay some of the groundwork. The examples discussed involve simplistic interpretations of the revenue recognition standard. We are to assume that the percent complete method is appropriate in each scenario presented, which obviously isn’t always the case. Finally, by work in progress (WIP), I mean over/underbillings. Now, let’s get to it!

Reconcile, Reconcile, Reconcile

This may seem obvious, but I’ve seen this step overlooked many times: reconcile contract activity to the trial balance. By that I mean, obtain the project subledger that lists every project with billing or cost activity during the year and reconcile the total from each activity to their respective accounts on the trial balance. The way you go about this varies depending on the accounting software you’re using but the goal remains the same; to obtain an accurate number for billings to date and cost to date by project through the end of the reporting period. This step is crucial in ensuring that you are working with complete information. Not doing so can result in inaccurate over/underbillings, which can then lead to unfavorable outcomes on the balance sheet and income statement. Before you prepare any schedules and calculate WIP, make sure the activity reconciles to the trial balance.

Large Underbillings

Estimates work like everything else, if they look too good to be true, they probably are. Pay close attention to projects that have large underbillings. They may be great for the company’s bottom line, but they’re extremely risky. Through my experience, projects with large underbillings have outdated estimates that require adjustments. What qualifies as a high underbilling requires professional judgement. Consider percent complete, contract size, estimated gross profit percentage, actual gross profit (without WIP), and project owner (governmental or private) when evaluating reasonabless of underbillings.

Let’s look at Example 1 below which is based on a scenario I came across during a financial statement review. Based on billings and costs to date, gross profit was at 21%, which is reasonable for a contract of that size. However, based on the estimate and percent complete, the project was underbilled by $1M. This scenario is essentially saying that the client should have billed an additional $1M to meet their estimate. After several inquiries, I learned that the client was not factoring in unbudgeted costs that were incurred into the estimated total cost. As a result, the underbilling was inflated. Through more inquiries and analysis, the client determined that estimated cost should increase by approximately $700K, which decreased the underbilling by approximately $400K.

Example 1:

When you encounter such scenarios, ask yourself “according to our estimate, cost to complete the project is $X, what are our remaining costs by phase?” Compare the two amounts. It’s possible that no adjustments need to be made to the estimate. However, based on my experience, these questions have led to increases in total estimated costs which ultimately reduced the underbilling.

Large Overbillings

Large overbillings should be investigated just as you would investigate large underbillings. There are numerous ways to troubleshoot overbillings, but I wanted to share the two most common scenarios I’ve encountered.

1. Overly conservative costs: Look over your latest job cost estimates to see if anything has changed on the project. There may be cost savings that you currently aren’t recognizing as profit, which is driving up overbillings. As a result, you may need to decrease total estimated cost because your current WIP report is suggesting that you are recognizing too much gross profit from your billings and cost to date. Decreasing your total estimated cost would increase your estimated gross profit percentage which would in turn would decrease the overbilling. See illustration in Example 2 below.

Example 2:

1. Improper cost cutoff: Scan the cost detail from the subsequent period for the project in question. There may be a large invoice(s) recorded in the subsequent month/period that should move back to the period covered in the WIP report. For example, costs for material were incurred and billed to the general contractor in December, but the invoice for the material was recorded in January. Technically, that cost should move back to December with an accrual. Increasing cost to date on your WIP would decrease the gross profit percentage from billings and cost to date to an amount closer to your estimated gross profit percentage, which would lower the overbilling. See illustration in Example 3 below.

Example 3: 

Subsequent Activity

As discussed, review subsequent billing and cost activity after the reporting period. Depending on what time of year you’re preparing your WIP schedule, the projects that were open at year or period end may have already been completed. This is an ideal scenario because you know what the total contract amount is and total estimated cost since you’re dealing with hard numbers. There’s no more estimating. What I’ve noticed when talking with clients is that the original estimates provided were not updated to reflect subsequent activity. If the original estimate calculates $50,000 in costs to complete at 12/31, but cost incurred through March of the following year was $150,000, the total estimated cost should increase by $100,000 if the project was completed by then or more if it’s still in progress.

Subsequent activity is also helpful for evaluating your estimates at year end for projects still in progress through the date of the report. If a project’s margins are decreasing through each passing month, you have a strong case for increasing the total estimated cost at year or period end.

 About the Author: 

Ara Grigorian, CPA, CCIFP is the founder of Percent Complete CPA, PLLC. He is a member of the Oklahoma Chapter of the American Subcontractors Association. Ara has over 10 years of experience in accounting with a specialization in construction. He works primarily on construction financial statement reviews and compilations.

 For additional lessons on construction accounting, please visit www.thewipreport.com