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December 11, 2018

Using the Accrual Concept to Improve Financial Reporting

When analyzing a construction company’s Gross Margin or Net Income by month, it is not unusualaccounting-3 to see significant fluctuations from month to month.  One of the primary reasons for this is a mismatch between Contract Revenues (i.e., job billings) and Cost of Contract Revenues (i.e., job cost) for the reporting period.  For example, the month may encompass 5 weeks of labor expense (which occurs once per calendar quarter) and only four weeks of billed labor.  

Conversely, aggressive billing may include subcontract and material cost, the invoices for which have not yet been received from vendors (or they are stuck on a Project Manager’s desk awaiting approval) and, consequently, not yet vouchered as Job Cost and Accounts Payable items.

One of the tenets of GAAP accounting is the recording of transactions on an accrual (rather than cash) basis.  Specifically, revenues need to be recognized when they are earned (and not when they are received in cash), and expenses need to be recognized when they are incurred (and not when they are paid in cash).  At the end of each reporting period, adjusting journal entries (AJEs) may be recorded to recognize (ACCRUE FOR) aforementioned transactions to achieve a better match between revenues and expenses for that reporting period, which in turn smooths out the peaks and valleys that appear in unadjusted Trial Balances.

Accounting Departments incorporating Best Practices will perform a detailed review of job cost activity for the month, identifying instances where there is significant revenue billed to the customer without corresponding job cost.  If this is the case, the following AJE (adjusting journal entry) will be recorded on the last day of the reporting period in the Job Cost subsidiary ledger:

Debit:  Cost of Contract Revenues     xxxxx

Credit: Accrued Job Cost Liabilities     xxxxx

In anticipation of receipt of the actual invoice and its processing as an Accounts Payable item, make sure you reverse the above entry on the first day of the next reporting period, to prevent the double count of the expense.

In the rare instance where there may be more cost recorded than billed, the following entry should be recorded to achieve the desired match:

Debit:  Prepaid Job Cost Expenses     xxxxx

Credit: Cost of Contract Revenues     xxxxx

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