Tag: Construction Accounting

Indirect Contract Costs

Posted on by dsp64

The Invisible Load Every Contractor Carries

In the construction industry, managing costs effectively is critical to profitability, compliance, and financial and tax reporting. Correctly identifying and allocating indirect contract costs is essential to this cost management. This blog will explore indirect contract costs, provide examples, explain their importance, discuss the benefits of proper allocation and risks of improper allocation, and outline some of the acceptable allocation methods under U.S. GAAP.

What Are Indirect Contract Costs?

Indirect contract costs are expenses that cannot be directly traced to a specific construction project but are necessary for overall project execution. Unlike direct costs—such as materials and labor directly tied to a particular job—indirect costs support multiple projects or the business as a whole.

Examples of Indirect Contract Costs

  • Indirect Contract Labor: Salaries for supervisors, project managers, and contract-related administrative staff who provide services across multiple contracts during an accounting period
  • Employee Benefits: Health insurance, retirement contributions, and other fringe benefits related to indirect contract labor (indirect labor burden)
  • Equipment Costs: Depreciation, maintenance, fuel, and repairs for machinery used across multiple projects
  • Utilities: Electricity, water, and gas for facilities supporting construction activities
  • Insurance: General liability and workers’ compensation insurance covering all projects
  • Office Overhead: Rent, supplies, and IT infrastructure directly supporting construction activities

These costs are often grouped into overhead pools and allocated to individual contracts based on an appropriate method, as described below.

Why Proper Allocation of Indirect Contract Costs Matters

Accurate allocation of indirect contract costs is vital for compliance with accounting standards under U.S. GAAP and, by extension, sound financial reporting. Additionally, it is necessary for meaningful project profitability analysis.

Key Benefits

The following are a few key benefits of a carefully designed system for allocating indirect contract costs.

  • Accurate Financial Reporting: Proper allocation ensures that financial statements reflect the actual cost of each contract, which is critical for stakeholders like investors and lenders.
  • Improved Decision-Making: By understanding the full cost of each contract (including indirect costs), contractors can make better pricing and bidding decisions.
  • Regulatory Compliance: Misallocation can violate tax laws or contractual agreements, especially in government-funded projects where cost breakdowns are scrutinized.
  • Enhanced Competitiveness: Allocating costs accurately allows contractors to identify inefficiencies and improve cost management strategies.

The Risks of Improper Allocation

Failing to allocate indirect job costs correctly can have significant consequences affecting profitability, decision-making, and overall business health. Below are some primary financial impacts:

  • Distorted Profitability: Under-allocated or over-allocated costs can misrepresent the profitability of individual contracts. For example, when performing a post-completion review of contracts, the under-allocation of indirect costs creates a false sense of profitability and can lead to overconfidence in bidding on future projects. Conversely, allocating too many indirect costs to a project can make it appear less profitable, potentially leading to unwarranted decisions such as discontinuing certain services or focusing on less profitable contracts.
  • Regulatory Issues: Non-compliance with U.S. GAAP or contractual requirements may result in penalties or disqualification from future bids.
  • Cash Flow Problems: Misallocation can lead to inaccurate billing or cost recovery issues, straining cash flow.
  • Fraud Risk: In the case of uncompleted contracts on the cost-to-cost percentage of completion method, improper allocation methods might be perceived as fraudulent if they result in an overstatement of contract profit.
  • Lost Opportunities for Operational Efficiency: Accurate allocation helps identify inefficiencies by revealing which projects consume disproportionate resources. Without this insight:

    • Contractors miss opportunities to streamline operations or renegotiate terms with subcontractors and suppliers.
    • Indirect cost drivers (e.g., equipment usage or labor hours) cannot be optimized effectively.

Acceptable Allocation Methods Under U.S. GAAP

U.S. GAAP provides flexibility in allocating indirect contract costs but requires systematic, rational, and consistently applied methods. Below are examples of commonly accepted methods:

  • Direct Labor Hours: The allocation of indirect costs is based on the number of hours worked on each project. For example, if a supervisor spends 75% of their time on Project A and 25% on Project B, their salary and burden would be allocated accordingly.
  • Direct Labor Costs: Allocate based on the proportion of direct labor expenses incurred by each project. For example, if Project A incurs 10% of total direct labor costs, it would absorb 10% of indirect labor costs.
  • Machine Hours: Allocate equipment-related indirect costs based on the number of machine hours used per project. For example, if a specific piece of heavy equipment is used for 75 hours on Project A and 25 hours on Project B, Project A would bear 75% of the equipment-related indirect costs.
  • Internal Rental Rate: A related acceptable and commonly used method to allocate equipment cost to jobs is that of an “internal rental rate.” The hourly internal rate is developed by estimating the annual equipment cost divided by the estimated yearly machine hours.
  • Square Footage: For projects involving physical spaces used both for manufacturing related to the contract and for administrative purposes, costs such as depreciation, rent, utilities, etc., can be allocated based on a ratio of square footage.

Conclusion

Indirect job costs play a crucial role in determining the true profitability of construction projects. Proper allocation ensures compliance with U.S. GAAP and provides valuable insights into operational efficiency and financial performance. CPA firms specializing in construction accounting can add significant value by guiding clients through this complex but essential process.

How About Another Accounting Quiz? (Along with a Few More Answers)

Posted on by dsp64

Part II

Last month we presented some questions (along with suggested answers) related to the Paycheck Protection Program. Part II of this Q&A blog will focus on construction accounting. Specifically, the spotlight will be on accounting for long-term construction contracts.

Construction accounting can be somewhat counter-intuitive. For example, billings and revenue generally are not the same thing. Also, an asset nicknamed underbillings may cause considerable concern to end-users of the financial statements, such as the company’s surety. At the same time, a liability referred to as overbillings may be construed in a favorable light. So, without further ado, here we go.

  1. Did the relatively new revenue recognition standard (ASC Topic 606) eliminate the percentage of completion accounting for long-term construction contracts?
    • a. No. Percentage-of-completion revenue recognition method was incorporated into ASC 606 without any variances from the prior approach under ASC 605.
    • b. No. ASC 606 did not eliminate percentage-of-completion accounting for construction contracts in premise. While ASC 606 does not refer to “percentage-of-completion” by name, the over-time input method in ASC 606 can be very similar, though not precisely the same as the former percentage-of-completion under ASC 605.
    • c. Yes. ASC 606 specifically eliminated the percentage-of-completion approach to revenue recognition for long-term contracts.
    • d. Yes. All construction contracts are accounted for on either the cash or accrual method, whichever best approximates the transfer of goods and services to the customer.

  2. In job cost accounting for a construction company, unsubstantiated reclassification of cost from one contract to another (aka cost-shifting) may be done to:
    • a. Fraudulently increase construction revenue and gross profit for financial statement presentation.
    • b. Conceal a loss contract.
    • c. Increase project manager bonuses based on contact performance.
    • d. All of the above.

  3. 3. Under ASC Topic 606 for a construction contractor, wasted cost, such as the purchase and installation cost of materials that do not meet specifications, and therefore must be replaced:
    • a. Are charged to job cost but excluded from the percentage-of-completion calculation since they do not contribute to contract progress.
    • b. Are charged to job cost and included in the percentage-of-completion calculation with both the percentage-of-completion numerator and denominator adjusted accordingly.
    • c. Are captured as inventoriable job cost and subject to write-off at the end of the job, based on contract evaluation.
    • d. Are charged to indirect job cost not subject to allocation to work-in-progress contracts. It is presented as a mezzanine classification on the statement of income between gross profit from operations and general and administrative expenses.

  4. 4. A general contractor negotiates a new revolving-line-of-credit secured by accounts receivable and the personal guarantees of the company’s members. The bank promissory note specifies a maturity date of three years. How should the LOC be classified on the balance sheet at the end of the first year?
    • a. As a current liability, since the company assets securing the obligation are presented as current assets.
    • b. As a current liability, if the company expects to repay the outstanding balance during the next subsequent year.
    • c. As a long-term liability, but only if the company is contractually permitted and intends to delay repayments until maturity.
    • d. As a long-term liability, since the term of the promissory note has a long-term maturity date.
    • e. It depends.

  5. Our construction company obtained a contract in a specialty that is new to us. Therefore, we experienced a reasonably steep learning curve during the first half of the contract. How should we account for the learning curve cost?
    • a. The learning curve cost should be capitalized and amortized straight-line over the entire term of the contract. Otherwise, you bunch up the revenue during the first half of the job and may end up showing a loss in the second half.
    • b. Since learning curve costs generally contribute to the contract’s performance and lead to greater efficiencies and cost savings in the latter part of the contract, they should be included in the percentage-of-completion calculation as incurred.
    • c. Learning curve costs should be presented as general and administrative expenses. If charged to job cost, the contract would earn more revenue during the inefficient learning curve stage.
    • d. Since learning curve costs do not contribute to the contract’s performance, those costs should be excluded from the percentage-of-completion calculation.

Here are the answers:

1b. No. ASC 606 did not eliminate percentage-of-completion accounting for construction contracts in premise. While ASC 606 does not refer to “percentage-of-completion” by name, the over-time input method in ASC 606 can be very similar, though not precisely the same as the former percentage-of-completion under ASC 605.

The percentage-of-completion method survived under ASC 606 as a type of input method, but it’s not front and center. What are front and center is the new five-step method of determining revenue recognition from customers. The basic premise of ASC 606 is that “…an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” This premise is embodied in the five-step method of recognizing revenue from customers:

  1. Identify the contract with the customer
  2. Identify the performance obligation in the contract
  3. Determine the transaction price.
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue as performance obligations are satisfied.

2d. All of the above.

Cost shifting is deceptively dangerous. On the face of it, it looks like reclassifying costs from one contract to another will not affect the overall gross profit. Not exactly correct. It can have a considerable effect if, for example, $1 million of cost is improperly reclassified (shifted) from a completed contract showing a loss to a very profitable uncompleted contract at 50% complete. Consider the following example where a company performs two contracts for the year:

  • Completed contract with the following at year-end:
    • Revenue of $5 million
    • Cost of $6 million
    • Gross loss of $1 million
  • Uncompleted contract 50% complete with the following at year-end:
    • Projected revenue of $10 million
    • Projected cost of $8 million
    • Revenue-to-date of $5 million (50% of $10 million projected revenue)
    • Cost-to-date of $4 million
    • Gross profit to date of $1 million

The project manager is responsible for both contracts and has system rights to reclassify costs between jobs. The PM is very unhappy with his combined gross profit of zero because his annual bonus is paid on contract profitability. Therefore, he quietly moves $1 million from the completed loss job to the profitable uncompleted job. Here is the effect:

  • Completed contract with the following at year-end:
    • Revenue of $5 million
    • Cost of $5 million
    • The job breaks even with a gross profit of $0.
  • Uncompleted contract (now 62.5% complete with the following at year-end):
    • Projected revenue of $10 million
    • Projected cost of $8 million
    • Revenue-to-date of $6.25 million (62.5% of $10 million projected revenue)
    • Cost-to-date of $5 million
    • Gross profit to date of $1.25 million

So, at year-end, the PM picked up $1.25 million with a sleight of hand. However, this will come back to haunt him the following year. His uncompleted contract will finish with only $1 million job-to-date gross profit instead of the original projected $2 million. Additionally, the current year’s gross profit will be a loss of $250,000.

3a. Are charged to job cost but excluded from the percentage-of-completion calculation since they do not contribute to contract progress.

For some contractors, this is a change from legacy ASC 605. Before the effective date of ASC 606, many contractors who measured revenue using cost-to-cost percentage-of-completion would include wasted cost in both the numerator and denomination. However, under ASC 606, wasted cost is not included in the cost-to-cost revenue measurement if it does not contribute to satisfying the performance obligation. Instead, such wasted cost is included in job cost but excluded from the percentage-of-completion revenue measurement. Accordingly, this generally will have the effect of accelerating the reduction of the contract’s gross profit at the end of the accounting period compared to gross profit recognition under legacy ASC 605.

4e. It depends.

Not enough information is provided in the question.

Answer “a” is incorrect. The balance sheet classification of the assets securing the debt has no bearing on the debt classification. However, suppose the debt is an asset-based financing arrangement. In that case, the asset securing the debt could have a bearing if the estimated amount of the borrowing base (accounts receivable) at any point during the next year is less than the debt amount at the balance sheet date. In that case, the gap between the debt balance at year-end and the estimated low point of the borrowing base the next year should be classified as current debt. However, this distinction relates to the estimated future amount of the security, not the security’s classification as current.

As for answers b, c, and d, it depends on whether you give greater weight to the company’s intent or the debt’s contractual provisions. If the company anticipates repaying part or the total amount of the line-of-credit the following year, many practitioners suggest that amount should be presented as current. Other practitioners look more to the date the debt is contractually due to be settled because of the uncertainty of future repayment and that contractual stipulations should carry greater weight than mere intent. Those practitioners would classify the debt as long-term in our example.

The Financial Accounting Standards Board has issued Proposed Accounting Standards Update No. 2019-780 (revised September 12, 2019). If the exposure draft is issued in its present form, it will simplify some of the complexities highlighted in question #4. Proposed ASU No. 2019-780 would establish a principle for classifying debt as noncurrent if it meets either of the following criteria as of the balance sheet date:

  • The liability is contractually due to be settled more than one year after the balance sheet date.
  • The entity has a contractual right to defer settlement of the liability for a period greater than one year after the balance sheet date.

5b. Since learning curve costs generally contribute to the contract’s performance and lead to greater efficiencies and cost savings in the latter part of the contract, they should be included in the percentage-of-completion calculation as incurred.

The cost associated with a learning curve is generally anticipated between the contractor and the customer during contract negotiations. Therefore, they are not considered wasted costs which are excluded from the cost-to-cost percentage of completion calculations. Nor are they capitalized. Instead, they should be charged directly to job cost as incurred and drive revenue recognition. In theory, they will lead to greater efficiencies and cost savings in the latter part of the contract.

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