Two methods are generally used to recognise revenue for a construction business, the completed contract method and the percentage of sales method. In both cases, the revenue is recognised vem before the delivery of the product, if it is reasonably assured that the payment and its schedule by a buyer is reasonably assured.
Inventory for construction business
In both methods, an inventory account called construction in process CIP, similar to the work in process account is used. This account is similar to COGS account used in a merchandise company when using the perpetual inventory method. Some major difference are elucidated below.
1. In the construction industry, as the revenue is recognised before delivery, whenever a construction cost is incurred, it is debited to the CIP account, and credit goes to all the accounts utilised in the construction like cash, accounts payable, raw material inventory etc.
As the construction progresses, the total cost of construction gets accumulated in the CIP account. Whereas, when the cost of the goods sold gets debited to the COGS account, the credit goes only to the merchandise inventory. This is because, the cost of sales in a merchandise company consists of only the procured goods, while that of the construction industry consists of raw materials, labour and various other products and service costs.
Construction in progress xxx
Various acc xxx
2. The construction in progress account is debited whenever a construction cost incurs, billing may or may not happen simultaniously. The billing is mostly done according to a schedule. COGS account (in the perpetual inventory system) is debited whenever a sale happens. The billing for construction which is treated as a contra account to CIPS is recorded as follows
accounts receivable xxx
billing on construction xxx
3. In completed contract method, the CIP is closed into the billing on construction and a gross income is derived same as the COGS, which is closed into the sales account to derive a gross income at the end of the construction, before delivery. But, if it is found out that the construction will end up in a loss ie of CIPS will be greater than the billings, then the loss is immediately booked and placed into the CIPS as follows.
If the CIPS acc balance is $50000, and billings total comes to $60000 then
billing on construction 60000
Construction in progress 50000
income on construction 10000
If the CIPS acc balance is $50000 and billings comes to $40000 then
Loss on construction 10000
construction in progress 10000
Now the balance on CIPS is $40000. At the end of the construction,
billing on construction 40000
Construction in progress 40000
4. In percentage of completion method, all the costs and billings are done exactly as for the completed contract method. But the gross income is not recognised in bulk at the end of the construction, but accrued each year, according to an estimate. This estimated income becomes a part of the income statement each year, out of which various other expenses are subtracted to arrive at a net income. The estimated income is based on costs incurred thus far, total estimated cost of construction, estimated gross profit, previous year's income.
The estimated income each year is again placed onto the CIP account by debiting the CIP account and crediting the income from construction account which forms the part of income statement. The estimated income each year adds up to the total income. Thus the estimated income gets accumulated in the CIP account, making the CIP account equal to the accumulated billing on construction account. At the end of construction, both the CIP and the billing on construction account is closed into each other.
When a loss is calculated, it is placed into the CIP along with the deletion of previous accumulated estimated incomes.
Suppose the estimated income for the final year of construction is $10000, CIP account balance at the beginning of the final year is $40000 and the billing on construction balance is $50000 then
income from construction 10000
At the end of construction
billing on construction 50000
Construction in progress 50000
Suppose if the construction took 4 years to complete, the estimated income recognised for the first 2 years is $10000 and $25000. The total accumulated CIP at the beginning of the 3rd year is $50000. Therefore the actual construction cost till the end of 2 years is only $15000. Suppose a total loss of $5000 is calculated instead of a profit, ie the billing can be done only for $10000, then
loss from construction $40000
billing from construction $10000
This means, since the actual loss is only $5000, the previous incomes recognised in the first two years of total $35000 has to be reversed.
Hence the $40000 loss from construction.