A contractor's accounts: labour and materials, certified progress, and contracts that cross a year end

Hook

Boss, the sentence a contractor dreads most is: is this job making money? Money goes in and out constantly. Money in the account is not necessarily profit; no money in the account is not necessarily a loss. Two years in, you get to year end and find it is nothing like what you thought. Today, plainly: how should a contractor's accounts actually be kept?

Look at the contract first: what are you actually selling

The first step is not to look at the accounts, it is to look at the contract. Construction contracts come in roughly three kinds, and the accounting for the three is completely different. One: supply only. You deliver to the site and whether it gets installed is not your problem. That is not really contracting, it is selling goods — the same logic as the stock in the ninth lesson: goods in, goods out, gross margin, job by job. Two: labour and materials. What you are selling is not the material, it is a finished stretch of work. The material is only a cost, not the product. So the gross margin cannot be read off the material price alone — labour, site overheads and rework all have to go in. Three: labour and materials with machinery on top. This is where most people go wrong. Hired machinery — the rental goes into that job's cost, simple. Your own machinery? An excavator is not a cost of that job; it is your fixed asset. It works on the site for a number of days, so it gets apportioned in by the hours or days it is used — the apportionment from the forty-seventh lesson: fix a ruler and hold it all year. What happens if you do not apportion? Jobs that used your own machinery look wildly profitable while the depreciation all lands in the company's general overheads — and you will quote the next job off a false gross margin.

Material has reached the site — is it a cost yet?

Now the provision most easily got wrong: material on site. A lorry-load of steel bars arrives, none of it tied, none of it poured — what does it count as in the accounts? Not yet a cost of work done on that job. It is still material; it has only changed where it is stored. The key rule in one line: when you measure progress, materials not yet installed do not count as progress. Why? Because progress is how much has been done, not how much has been bought. Think about it: call in a load of material before the year end, and if it counts as progress, the progress is immediately false and the profit is immediately false — and next year it shows. This is the point at which a contractor's accounts most easily deceive their own owner. Keep two things separate: on a certified valuation, materials not yet installed may well be claimable — but that is the rule for getting money, not the rule for measuring profit. Whether you can collect the money and whether you have earned it are two different things.

Contracts that cross a year end: revenue on progress

A job runs a year and a half, or two years — when is the revenue counted? Not when the money is received, and not when the job is finished. On the progress completed. The most common ruler is called the cost proportion: the costs already incurred, divided by the estimated total cost, is how much has been completed; multiply that by the contract sum and that is how much revenue should be recognised today. Look carefully at what that formula turns on: it does not turn on how much you have spent, it turns on the estimated total cost — get the budget wrong and the profit is wrong with it. The forty-third lesson said it: an estimate is not a guess, it needs a basis and it needs updating regularly. And there is an iron rule many people do not know: if the estimated total cost already exceeds the contract sum, the whole loss has to be recognised at once and cannot be spread. Profit is recognised gradually on progress; a loss is recognised all at once. Sounds unfair? That is accounting's conservatism: good news slowly, bad news today.

Three lines have to tie: budget, time, certification

Whether a job is going well really comes down to whether three lines tie. First line: budget versus actual. Every job gets a cost budget, and every month you set the actual against it (job costing from the tenth lesson). If you are over, you need to know immediately, not at handover. Second line: programme versus actual. A day late is a day's money: the workers are there, the machinery is there, the site rental is there. Time is a cost, not just a matter of face. Third line, and this is where most people get in a muddle: what you claimed, what was certified, and what was received. Those are three different numbers: the claim is what you say; the certification is what the consultant and the quantity surveyor say; received is what the bank says. They will never be the same, so they sit in separate places in the accounts. Claimed more than you have done — you owe work, and that is a liability, not revenue. Done more than you have claimed — they owe you, but it is not a receivable yet because you have not invoiced, so it needs its own place in the accounts. And then retention: the amount held back is not a bad debt, it is a conditional receivable — its own account, its own schedule, with the dates recorded alongside (the fortieth lesson). While we are here: raising a claim now involves e-Invoice as well — but remember, the date you invoice is not the date you recognise revenue.

What about dozens of small jobs a year?

At this point a lot of bosses will say: I do not have two-year projects, I do dozens of jobs a year, one or two months each. So do they all need progress and work in progress? No. There is only one dividing line: whether the job crosses the year end. Started in the year, finished in the year, handed over in the year — count it on completion, clean and simple. But — every job still needs its costs collected separately (the tenth lesson). Not for the year end, but to answer a more valuable question: which kind of work makes you money? Renovation or maintenance? This district or that one? This foreman's crew or that one's? Only the jobs that cross the year end need progress and work in progress — usually two or three out of ten, and the workload is entirely manageable.

Handing over does not close the account

The last stretch, which many people skip: once you have handed over, the accounting is not finished, because there is still the defects liability period. Two things must be done. One: release the retention in stages. Part of it on practical completion, the rest when the defects liability period expires — put the dates in the schedule, or that money will lie in the accounts until you have forgotten about it. Two: the repairs you expect to spend must be provided in the year the revenue is recognised. Not treated as an expense two years later when you actually go and repair it — because that cost belongs to that year's job (the consistency from the forty-second lesson). What happens if you do not provide? The profit in the year of completion is overstated and two years later you make an inexplicable loss — and then you think the market has gone soft. In summary: look first at what the contract is selling; material arriving is not work done; progress rests on the budget and a loss is recognised at once; budget, programme and certification, three lines that tie; small jobs still get costed one by one; and after handover, retention and the defects period still have to be followed. Want to know which of the jobs in hand is genuinely making money? Grab a coffee first and talk about your business. For the accounting, come to LTT. I am LTT, helping SME bosses get their accounts straight. Follow us, and see you next time.