Accounting basics for contractors

A project manager does not need to be an accountant, but needs to read what the accountant produces and to understand how site decisions turn into entries in the books. This lesson reviews the accounting ideas that the rest of the course relies on: the accounting equation, double entry, accrual accounting, the chart of accounts, the general ledger and the job cost ledger, and the month-end close. It focuses on what is specific to contractors. A fuller treatment of financial accounting belongs to ACCT-101; here we take only what is needed to read and question a contractor's books.

The accounting equation

Every set of accounts rests on one identity: what a business owns equals what it owes to others plus what belongs to its owners.

Assets are resources the firm controls that will bring future benefit: cash, amounts owed by customers, equipment, prepaid insurance. Liabilities are obligations to others: amounts owed to suppliers and subcontractors, wages payable, loans, taxes owed. Equity is the residual, the owners' claim after all liabilities are paid. Profit increases equity and losses or dividends reduce it. Every transaction changes at least two items in a way that keeps the equation in balance, which is why bookkeeping is called double entry.

Billing the owner and receiving a subcontractor invoice both affect profit immediately, even though no cash moves. Collection and payment move cash but do not change profit. That distinction is the heart of accrual accounting.

Debits and credits

In double-entry bookkeeping, each transaction is recorded with equal debits and credits. By convention, debits increase assets and expenses, and credits increase liabilities, equity and revenue. The words come from Latin and have nothing to do with good or bad. A project manager rarely needs to post an entry, but reading a journal entry is useful when checking how a change order, a holdback release or a back-charge has been recorded.

Accrual accounting and the matching principle

Under accrual accounting, revenue is recognized when it is earned and costs are recognized when they are incurred, whether or not cash has been received or paid. The matching principle says that costs should be reported in the same period as the revenue they helped to earn. For a contractor, that means the cost of concrete placed in March belongs in March, even if the supplier's invoice arrives in April and is paid in May; and the revenue for the work done in March belongs in March, even if the owner pays in May.

Some very small contractors keep their books on a cash basis, recording revenue when received and costs when paid. Cash-basis records are simple but can badly mislead: a firm that bills a large claim on the last day of the year and pays its suppliers early looks very different from one that does the opposite, with the same work done. The accounting standards used for general-purpose financial statements require the accrual basis, and sureties and lenders expect it. Tax rules sometimes allow other methods, which Lesson 10 discusses.

Accruals at month-end

Because invoices lag the work, the books at month-end always miss some costs. The accountant adds accruals for costs incurred but not yet invoiced: subcontract work done but not yet billed, materials received without an invoice, unpaid payroll for the last days of the month, equipment rental for the month. CON-310 showed how project teams provide the information for accruals on each job. From the company's point of view, accruals matter because the WIP schedule calculates revenue from cost incurred; missing costs understate both cost and, under the cost-to-cost method, revenue, and distort the job's apparent margin.

The chart of accounts

The chart of accounts is the list of all accounts in the general ledger, numbered so that similar accounts are grouped. A contractor's chart looks much like any company's for its balance sheet and overhead, but it has extra accounts for the features of contracting: holdback or retainage receivable and payable, contract assets and contract liabilities (underbillings and overbillings), costs on uncompleted contracts, equipment clearing accounts, and separate revenue and cost accounts for contract work.

The general ledger records totals by account. It does not tell management which job a cost belongs to. That is the job of the job cost ledger.

The general ledger and the job cost ledger

Every direct cost a contractor incurs is recorded twice in effect: once in the general ledger, in an account such as subcontract costs, and once in the job cost ledger, under a job number and cost code. The job cost ledger is a subsidiary ledger. Its total for all jobs must equal the direct cost accounts in the general ledger, and reconciling the two each month is a basic control. CON-310 described the job cost ledger from the project's point of view, with cost codes and cost types. From the company's point of view, the job cost ledger is the source of the cost-to-date figures on the WIP schedule, and errors in coding move cost and profit from one job to another.

# Reconcile the job cost ledger to the general ledger at month-end
gl_direct_cost = {"5100 field wages": 612_400, "5200 materials": 948_100,
                  "5300 subcontracts": 3_216_750, "5400 equipment": 141_900,
                  "5500 other direct": 66_300}
job_ledger = {"J-2407": 2_884_150, "J-2411": 1_452_600, "J-2415": 424_550,
              "J-2502": 77_500}
gl_total = sum(gl_direct_cost.values())
jobs_total = sum(job_ledger.values())
print(f"General ledger direct cost: {gl_total:,}")
print(f"Job cost ledger total:      {jobs_total:,}")
print(f"Difference to investigate:  {gl_total - jobs_total:,}")

General ledger direct cost: 4,985,450
Job cost ledger total:      4,838,800
Difference to investigate:  146,650

A difference means that something was posted to a direct cost account without a job number, or to a job without the matching account. Common culprits are invoices coded to a closed job, equipment charges posted to the clearing account but not to jobs, and manual journal entries. In this example, $146,650 of direct cost, about one dollar in every thirty-four this month, is not on any job, which would understate costs and overstate margins on the WIP schedule if it belongs to active jobs.

Subsidiary ledgers for receivables and payables

Contractors also keep subsidiary ledgers for receivables, by owner and job, and for payables, by vendor and subcontract. These show not only how much is owed but how old it is and how much is held back. An aged receivables report that separates current billings from holdback, and that flags amounts in dispute, is one of the first schedules a lender or surety asks for. On the payables side, a report by subcontract that shows the contract value, approved changes, billings to date, holdback withheld and amount paid ties directly to the commitment reports used in CON-310.

The month-end close

The close is the routine that turns a month of transactions into reliable figures. A good contractor runs a fast, consistent close, typically finishing within ten to fifteen working days of month-end, because a WIP schedule that arrives in the last week of the following month is too late to act on.

The step that most often slows the close is the project managers' updates. A WIP schedule is only as good as the estimates of cost to complete, and those require the project manager to think about what is left to do, not simply to subtract cost to date from the budget. CON-310 covered how a project team builds a defensible forecast; this course shows how that forecast flows into the company's revenue.

Internal controls in a contracting firm

Internal controls are the policies that protect a firm's assets and make its records reliable. Contractors face particular risks: payments to fictitious vendors, payroll for workers who do not exist, materials delivered to the wrong place, unapproved change orders paid to subcontractors, and costs moved between jobs to hide losses. Basic controls are inexpensive and expected by lenders and sureties.