Construction billing can cause a lot of headaches if you don’t stay on top of it. As a contractor, having accurate numbers on a regular basis can make all the difference in whether or not your business succeeds or fails.
If you are planning to make it in the construction industry, you and your accountant need to be on the same page when it comes to understanding over and under billing. We’ll guide you through it in this post, so you’ll hopefully be able to grow your company without all the stress that messy financials can bring.
Over and Under Construction Billing Explained
What is the difference in over and under billing? Overbilling and underbilling are terms used in construction accounting that help explain why invoices and actual costs don’t always match up.
Accounting in construction businesses isn’t handled the exact same way as a typical retail or service-based company. In those businesses, money and the product/service usually change hands at the same time. So keeping accurate financial records is fairly straightforward.
In the construction industry, however, projects usually stretch out over long periods of time. It is not uncommon to have multiple invoices across several different billing periods for a single project. Also, most construction companies are working on more than one project at a time (in as many different locations), so each project has to be managed independently…even though the money all flows into and out of the same company’s bank account.
When a contract is bid on and awarded, the construction company and the client settle on a total price for the project. It is the contractor’s goal to invoice the percentage of that price back to the client at the same rate that the job is being completed.
For example, if you have a $1,000,000 contract, at the point the job is 50% finished you would expect to have billed $500,000. When those percentages don’t line up accurately one way or another, overbilling or underbilling is what happens.
Overbillings and underbillings basically work like this:
Overbilling=Billing In Excess of Costs
In our example above, if you have the customer pay 50% in advance you are starting the job overbilled since no work has been done yet. The first half of the project is spent catching up to what you have already been paid. This is the most common form of overbilling as it happens at the beginning of pretty much every job.
Overbilling makes your Profit & Loss Statement (P&L) look like you have a lot of profit. If you aren’t careful, you can take that to mean that you’re flush with cash and spend that money elsewhere too soon, leaving yourself in a bind later.
Underbilling=Costs in Excess of Billing
Let’s imagine that unexpected supply costs or last-minute change orders occur during the build (not uncommon at all in the construction industry). If you’ve been paid for 50% of the job but have already gone through that money with only 30% of the project completed, that’s underbilling.
Underbilling can make your P&L appear to show that you aren’t profitable, which can be misleading to lenders or other outside parties. It doesn’t account for future invoices that should make up the difference as the job moves forward.
Construction in Progress Accounting
As we’ve said, construction billing is not like accounting for any other industry. Because of the fluctuations in when contractors get paid, the variations in expenses, and the multiple job sites they’re working on at any given time, construction accountants have a difficult time using the traditional “cash basis” form of bookkeeping.
(Cash basis accounting, as defined by Investopedia, “recognizes revenues and expenses at the time cash is received or paid out.”)
Instead, construction industry professionals use a method of “accrual basis accounting” called “Percentage of Completion” (POC) accounting.
As work is done, invoices are sent out and the client pays for the portion of the project that is completed. Normally, a percentage is paid in advance to cover initial costs and materials and another percentage (usually 20%) is held in reserve by the client until they are fully satisfied that the work has been finished to their satisfaction.
How to Record Construction in Progress
When a large future asset like a building is being constructed, companies need to know what to do with the costs associated with it before it begins making money for them. Construction In Progress (CIP) accounting allows them to keep track of everything and record it all in the right places on their balance sheet.
Indeed.com has a good article that explains “How to Use Construction In Progress Accounts.” It lays out the basic steps pretty clearly:
- Decide which expenses are CIP related
- Accurately record all invoices and receipts
- Log the expenses:
- Project costs get recorded as a debit on a line titled “Construction In Progress.”
- Associated payments are recorded as a credit to “Accounts Payable.”
- Once the project is completed, expenses from the CIP line get moved to the line on your balance sheet associated with that asset.
Work In Progress Report for Construction
From the construction company’s point of view, they need to keep better ongoing records throughout the project that show exactly how much has been completed and how actual income expenses are lining up compared to estimated costs and revenue. They simply can’t afford to guess when it comes to their finances.
A “Work In Progress” report (or WIP Accounting) is the tool that allows contractors to see at a glance exactly where they are financially on each individual job they are involved in. When accurate numbers are readily available, fewer mistakes are made and they immediately become more profitable.
A typical WIP adjustment journal entry might look something like this:
To arrive at a simple chart like this, there are 3 formulas we use:
- Percentage of Completion (POC) = Costs / Estimated Costs
- Revenue = POC x Estimated Revenue
- Over/Under Billing = Total Billings – Earned Revenue
There is no standard way to report WIP. It is an internal document used to help construction project managers and accountants stay on the same page, so each company may choose to set theirs up differently depending on its needs. The main thing is to know your numbers in order to run your business well.
Over Under Accounting Shouldn’t Be Overly Complicated
We get it. As a contractor, you’re focused on building great things and doing work that earns you a solid reputation. That’s why we are here…to partner with you as your construction accountants and help make sure you have accurate and timely information about the costs and revenue for each and every job you do.
We’ve been at this for over 40 years, and we’d love to see how we can help you too!
Schedule a call today to get started.
