How to Develop a Chart of Accounts for a Construction Business

CFO'S TOOLBOX

BY JERRY HENDERSON

How to Develop

a Chart of Accounts

for a Construction Business

As a construction professional, you probably understand the importance of a well-laid foundation. Without a good foundation, the walls won't be flush and will eventually crack, the roof will begin to pull away, rain will leak in around the edges of the floor, and utility costs will be higher. Left unattended, the building will eventually fall apart.

Laying a Good Foundation

A chart of accounts is like a foundation. Without a good chart of accounts, the information will be subject to misclassification, sufficient detail will not exist to interpret the information correctly, and users will not be able to distinguish profitable from unprofitable operations. Eventually, the financial statements will fail to benefit upper management because they will no longer be meaningful.

When thought of in these terms, it's easy to see why a well-formatted chart of accounts is so important. And, while there are many components that go into producing a good system of financial reporting, the chart of accounts is one of the most basic. Therefore, it requires some forethought about its design and layout in order to serve your firm well into the future.

So, whether you are in a seasoned company that is considering some refinements to its current chart of accounts, or in a new company

CFMA BP January-February 2004

defining its first chart of accounts, it's important to begin with the end in mind.

To do that, first discuss with your owners their vision for the business five years down the road. Next, meet with your bonding agent and ask him or her about common mistakes in financial statements; do the same with your banker. Then, design your chart of accounts to both meet the needs of your owners and avoid the common bonding/banking pitfalls.

The Basics

Begin with a basic structure similar to the balance sheet and income statement examples shown on the following pages. While these examples are far from inclusive, they give a general idea of the basic structure. (A very simple account number format has been assumed; more detailed formats are discussed later in this article.)

Notice that the universal rules for assigning account numbers apply to contractors. Assets are given account numbers in the 100s, liabilities in the 200s, and so on. But, contractors also have some unique requirements.

The Unique Needs of the Industry

Receivables for a contractor are typically not as straightforward as they are for most other commercial entities. So, in creating accounts for receivables, determine the level of detail you will need. At a minimum, you should have accounts for amounts currently billed, retainage, and allowance for uncollectible accounts.

The allowance account is a contra account, which means it should always carry a credit balance or be zero. You may want other accounts for billed claims or billings on unsigned change orders. By setting these amounts in separate accounts, management is able to gain a better feel for receivables likely to be collected in the near-term, compared to those that may be a little more difficult to collect.

Additionally, a non-current retainage receivable account should be set up to hold retainage amounts not expected to be collected within the next year.

Costs and earnings in excess of billings represents the total underbilled amounts on contracts at the end of the period. Similarly, billings in excess of costs and earnings represents the total overbilled amounts on contracts. This amount is often determined based on a calculation that compares cost incurred-to-date with total contract costs.

The unbilled receivables account is similar to cost and earnings in excess of billings, except it may be used to track costs that do not fit as well into that category. In particular, pure unit-price work might be better classified as an unbilled receivable.

Pre-contract costs are the costs incurred prior to contract commencement (but after the award of the contract) that are accumulated until work begins. These might include the costs for plans and specifications, bonds, engineering services, etc. Stored materials typically represent uninstalled materials that are maintained at the jobsite.

Your accounting software package will significantly influence how your chart of accounts is formatted. Accordingly, if you are starting from scratch, look for an account format structure that will support your needs.

The Next Step

The relative complexity of your operations will help govern the account structure you choose. For example, a company with multiple divisions will, at a minimum, need a two-part account number. The prefix may identify the division, while the suffix may identify the actual account.

Creating a Divisional Chart of Accounts If you are in the process of making the transition from a simple chart of accounts to one with more than one division, consider the following approach.

First, decide whether you want divisional balance sheets or simply divisional income statements. Probably the most important factor affecting this decision is whether there is one office or multiple locations. For a company with multiple locations, divisional balance sheets may be helpful, particularly if these locations are treated as independent operating units.

Notwithstanding this fact, some items may still need to be allocated somewhat subjectively. Examples of such items include line-of-credit balances, income taxes payable/refundable, and accruals for contingencies. For a company with only one office, a single balance sheet with divisional income statements is probably the best approach.

In creating divisional income statements, all revenue and contract cost accounts will essentially be duplicated for each division. Within the existing accounts, certain accounts may need to be renamed and a few accounts may need to be modified.

January-February 2004 CFMA BP

Chart of Accounts Balance Sheet Example

Current Assets 100 Cash in bank - general 101 Cash in bank - payroll 102 Certificates of deposit 110 Accounts receivable - billed 111 Accounts receivable - unbilled 112 Accounts receivable - claims 113 Accounts receivable - unsigned

change orders 114 Retainage receivable 115 (Allowance for uncollectible

accounts) 116 Notes receivable - current 120 Costs & earnings in excess of billings 125 Inventories 126 Stored materials 130 Pre-contract costs 131 Prepaid insurance 135 Investments - current 140 Deferred tax assets - current 141 Refundable income taxes

Non-Current Assets 150 Investments - non-current 151 Investments in joint ventures 152 Equity investments in affiliates 160 Notes receivable - non-current 161 Cash value of life insurance 162 (Loans-life insurance policies) 163 Restricted cash 164 Non-current retainage 165 Deferred tax assets - non-current 170 Land and improvements 171 Building 172 Leasehold improvements 173 Vehicles 174 Construction equipment 175 Shop equipment 176 Office equipment

177 Furniture and fixtures 178 (Accumulated depreciation) 180 Deposits 181 Goodwill 182 Agreements-not-to-compete 183 Financing fees 184 Organizational costs 185 (Accumulated amortization) 190 Other assets

Current Liabilities 200 Accounts payable 201 Retainage payable 202 Accrued payroll 203 Accrued payroll taxes 204 Accrued vacation 205 Withholdings 210 Notes payable to bank 220 Current maturities of

long-term debt 230 Income taxes payable 240 Insurance contract payable 250 Billings in excess of costs &

earnings 260 Deferred taxes - current

Non-Current Liabilities 270 Long-term debt 280 Deferred taxes - non-current 290 Deferred compensation

Equity 300 Common stock - class A 301 Common stock - class B 310 Preferred stock 320 Additional paid-in capital 330 Appreciation in fair value

of investments 390 (Treasury stock)

expenses from the administrative division to the operating divisions. If your company chooses to follow this practice, management must first decide exactly how the costs will be allocated.

While revenues may be a key factor in determining the allocation of some of these expenses, there are others that are not a function of revenue and, as such, would not logically be allocated on such a measure. In these cases, company management should decide on the most meaningful measure for allocation. (For more information on allocating costs, see "What Is Job Cost?" by Keith R. Fetridge in this issue, and my article, "How to Allocate Overhead," in the November/December 1999 issue of this magazine.)

Once you have decided on a measure for allocating the different components of administrative expense, you will need to develop a template for calculating the allocation each month. The results of these calculations will be recorded using intercompany entries.

New accounts will be set up to record these entries. A credit will be posted by the administrative division to an account named, for example, administrative expense allocation out. This credit will be in an amount equal to the recorded expense total. Likewise, a debit will be posted to each division to an account named, for example, allocated administrative overhead charge.

If there are any expenses originally recorded in one division that should be allocated to other divisions, reclassifying entries can simply be posted to the actual expense accounts affected (for example, rent).

In addition to operating divisions, the company would also need to create an administrative or corporate office division. This division would accumulate all operating expenses that are separate from contract costs, as well as other income and expense components.

How Much Is Too Much?

While it may be obvious to one company how it wants to subdivide its information, it may not be so obvious to others, especially when first implementing divisions. The usual rule is the fewer operating divisions, the better.

Some companies have taken the approach that the divisional income statements will end with the gross profit line, and the SG&A expense items will remain within the administrative division. However, the preferred practice is to allocate all

While you want to build a framework that accommodates growth, you don't necessarily need to maximize its potential in the first year. For that reason, you may want to begin with two or three divisions; you can consider adding others later.

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If you are changing to divisions, consider revising the format of your job numbers in your job cost system to make it easy to identify which jobs belong in which division.

Chart of Accounts Income Statement Example

In deciding how you want to divide the operations, con- Revenues

sider the following:

? Distinct operating units ? Different locations ? Geographic territories ? Substantially different job types (such as

private vs. government contracts) ? The jobs themselves (if the number of jobs

is small)

The practice of establishing divisions for each major contract is reasonable as long as the number of very high-volume jobs is small; when this is not the case, structuring divisions for this purpose will prove to be more of a nuisance than a help.

Contractors with few high-volume jobs that wish to set up divisions for each job will need to create contra accounts to offset the amount of prior-year revenue and expense recorded for the job. It is important to discuss this approach with your software vendor to determine

400 Contract revenues - type 1 401 Contract revenues - type 2 402 Engineering income 403 (Over)/underbillings

Cost of Revenues Earned

500 Materials 501 Labor 502 Payroll taxes 503 Fringe benefits 505 Subcontractors 506 Internal equipment rental expense 507 External equipment rental expense 510 Overhead (various accounts)

Operating Expenses

600 Office salaries 601 Office payroll taxes 602 Office fringe benefits 610 Utilities 615 Advertising 620 Travel & entertainment 625 Dues & subscriptions 630 Bad debts 640 Contributions

650 Profit-sharing contributions 690 Miscellaneous

Equipment Operations 700 (Internal equipment

rental income) 710 Depreciation 720 Repairs & maintenance 730 Tires 740 Insurance 750 Taxes & licenses 760 Fuel & oil

Other Income/Expense 800 Interest income 801 Service charge income 810 Gain on sale of assets 811 Gain on marketable

securities 820 Investment income 830 Interest expense

Income Taxes Payable 900 Federal tax provision 901 State tax provision

how to handle this practice from a systems' standpoint

(for example, traditional year-end closings would have to be modified).

three-part account numbers or some alternative tracking field within the account setup itself. Taking advantage of

Creating an Equipment Cost Center Again, if you are expanding from a simple account format to a

such a structure can prove to be beneficial. Some potential uses of a three-part structure are shown below.

more detailed chart of accounts structure, you will probably want to consider placing equipment in its own division. Do this

PART ONE PART TWO

PART THREE

by setting up an additional divisional income statement to capture all equipment costs (as shown here in the income statement example).

Location Division

Division Crew

Account Identifier Account Identifier

This division's revenue would be called internal equipment

Division

Job Type

(fixed, cost+, etc.)

Account Identifier

rental income and would be offset by accounts within the "Cost of Contract Revenues Earned" section of the income

Division

Job

Account Identifier

(small #/high volume)

statement called internal equipment rental expense. En-

tries to these accounts would be made based on predetermined rental rates set by management and then reported on field reports or timecards.

Some accounting packages may have the capability of sorting and reporting the information in a variety of fashions. For those that do not, a good report-writer program can develop

Three- and Four-Part Account Numbers Up to this point, all of the concepts discussed above could be

reports that sort the information into different formats and consolidate activity based on specific criteria.

accomplished using two-part account numbers. However, Here's another plus: A four-part account number can take the

most mid-range accounting packages now offer at least information one level deeper (for example, a location-division-

CFMA BP January-February 2004

CFO'S TOOLBOX

job/type-account identifier) or it may be used to distinguish between two different entities in the system (for example, to accommodate joint venture accounting).

When to Transition Your Chart of Accounts For an existing business, the transition should take place at year-end to avoid as many potential difficulties as possible. It is vital that you work with your software vendor to accomplish this transition. Your vendor should be able to point out potential pitfalls that could make the transition more troublesome than necessary. (For more information on software considerations, see the "Computers in Construction: Software Selection," by Mark Dexter and "What's New for CFMs in Financial Reporting Software" by Christian R. Burger in the January/February 2003 issue of this magazine.)

Conclusion

Whether your company is just getting started or has been around for several years, it is helpful to sit back and determine whether the present/planned chart of accounts is a benefit or a drawback to providing management with useful information. Likewise, it is important to have a chart of accounts that anticipates the future growth of your company and

allows a structure to accommodate that growth. If either of these elements is lacking, it is a good time to begin planning a transition to a new chart of accounts that will produce significantly greater benefits. BP

This article appeared in the January/February 2003 issue of this magazine and was reviewed and updated for this reprinting.

JERRY HENDERSON is a Partner at BKD, LLP in Bowling Green, KY. He has been providing accounting, consulting, and auditing services to the construction industry for the past 13 years. He received a BS in Accounting from Western Kentucky University, also in Bowling Green. Jerry, a frequent contributor to CFMA Building Profits, is the editorial chair for BKD's newsletter, "Blueprint," and has published in various other trade publications, including the Journal of Construction Accounting and Taxation.

Jerry belongs to CFMA's Kentuckiana Chapter and is a former member of CFMA's Accounting & Reporting Committee. He is a council member for the ABC of Kentucky, and is a member of the AICPA and the Kentucky Society of CPAs.

Phone: 270-781-0111 E-Mail: jhenderson@

Web Site:

January-February 2004 CFMA BP

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