Does your CPA sound like the parents of Charlie Brown every time Work-In-Progress is discussed? And are you tired of how Work-In-Progress changes your financial statements and tax returns each year? This necessary evil, as you know, is a vital part of accounting for your business. Understanding the process of how this schedule works will provide immeasurable value to your business and stop the accounting insanity that occurs each year.
Understanding how job costing and your work-in-progress (WIP) schedule affect your Company’s financial statements and tax return is imperative. If a material part of your revenue cycle is generated from long-term contracts, you cannot afford to ignore job cost accounting. Every successful contractor I know can tell me where they are at on all of their major projects and what their estimated profitability is on those jobs on any given day during the year. Where almost all of them have difficulty is understanding how the financial reporting of where each job is actually at affects the bottom line at the cutoff date for the financials and/or tax return. To complicate things even more, the method of accounting for WIP can vary dramatically from book accounting to tax accounting in the same year.
There are numerous methods of accounting for long-term contracts, but the primary two methods used are percentage of completion and completed contract. Both methods of accounting compare actual costs incurred at cutoff to total estimated costs to determine how much revenues and expenses should be recognized.
Percentage of completion method
Under the percentage of completion method, the company recognizes earned revenue based on the percentage of cost incurred as of cutoff to total estimated necessary for the contract. For example, if your Company had a $200,000 job with estimated costs to complete the job of $140,000 and $70, 000 of actual job costs at cutoff, the Company would recognize $100,000 of earned revenue because on a cost-to-cost basis the job is 50% complete and $30,000 of actual profit. This method takes out the guessing game on whether you have billed your customer in advance or received any money in advance for the job. Instead, it matches up your revenue when the expenses actually occur. This adjustment can be done by your bookkeeper and does not affect when or how much your customer owes you.
Completed contract method
The completed contract method, on the other hand, states that as long as the job is open, total costs to-date do not equal estimated costs, then no revenue or expenses are recognized until the job is complete. Thus under the above scenario, no profit would be recognized on the open job. Instead, the profit will be recognized upon completion of the job. This could greatly affect your taxes by moving profit to future years, however, those future years could be taxed heavily if many jobs are completed in the same year.
I have clients who review their respective WIP schedules with project managers and foreman to see if the Company is on target to meet profit expectations, plan for labor allocations, and to ensure materials are in line with expectations.
So how can you tell if your WIP schedule is being accounted for correctly and your books reflect accurately the financial and tax earned income? First off, the estimated amounts have to accurately reflect the profitability of each job. As an owner, the way you can test this is look at the estimated profitability reported on the WIP schedule and compare it to the profit and loss gross profit for the same period. They should be relatively comparable. If they are not then WIP schedule will not accurately reflect profitability.
Actual costs to date need to be accurately allocate to each job monthly. The old adage applies here, “Crap in, Crap out”. The costs that should be allocated to each job can be found in the cost of completed contract section of your Company’s profit and loss. We recommend sitting down with your bookkeeper and make sure they have a good understanding of all direct costs included in your contract bids and controls are in place to accurately allocate those costs to each job. The most basic software issued by QuickBooks® will assist you with these steps.
Lastly, look at your Company’s balance sheet. The balance sheet is where you will see the deferred revenue and expenses the Company is carrying. Underbillings for percentage of completion method and work-in-progress for completed contract method are the asset accounts that show how much the Company has in deferred expenses. Overbillings for percentage of completion method and progress billings for completed contract method are the liability accounts that show how much revenue is being deferred. If these accounts are not changing on a monthly basis, your WIP schedule is not being reconciled. Also, if your deferred liability accounts exceed your deferred asset accounts, then the Company has deferred revenue that will eventually need to be recognized. This deferral often hits in years where the Company has financial losses and not a lot of jobs open at the end of the year. The deferral would go to zero or near zero and all the associated revenue would be recognized.
As you can see, accounting for long-term contracts can be complicated and greatly affect your financials or tax return if not reconciled regularly. Ultimately, I find the owner and bookkeeper benefit most by having several training sessions with their CPA. As with anything in business, the more time and consideration you spend on this area, the greater value it will provide to you.
If you have any questions, concerns or need assistance with setting up a job cost system, please do not hesitate to contact our offices.