The Contract Schedule: Inputs, Calculations and Why They Matter

The contract schedule is the heart and soul of any construction company. The calculations contained within the schedule can determine bonding capacity, dictate the ability to obtain financing, and even impact whether a company will be selected for a job. This article seeks to explore a few of the most important elements of the contract schedule, including the impact of project estimates, identification of the four key inputs used in the calculation of revenue, and discussion of three fundamental metrics and what they can tell a company about its ongoing projects.

Under the accounting standards generally accepted in the United States of America (“GAAP”), construction projects that are long-term in nature recognize revenue using the percentage of completion method. This means that the amount of revenue recognized over the course of a long-term construction project is highly dependent on the contract estimates, which is one of the most unique and high-risk elements of construction industry accounting. As such, it is crucial that companies have processes in place to ensure that the original estimates are as accurate as possible and reviewed and updated on a regular basis.

There are four key inputs that are necessary to calculate the percentage of project completion and the related revenue to be recognized in the current period. These inputs include total contract value, total estimated direct costs, total costs to date, and total billings to date.

The contract value should primarily include the original contract amount, plus or minus any changes in scope that increase or reduce the original value (i.e., change orders). It can be tricky to determine whether a change order should be fully or partially included, or completely omitted from the contract value, under GAAP. Is the change order signed by both parties? If so, the value and total estimated costs to complete the additional work should be fully included.

Unapproved change orders require careful evaluation. If approval is considered probable, the estimated value should be included in the transaction price, fully or partially, only to the extent significant reversals are unlikely, using either the Expected Value Method or Most Likely Amount Method. If approval is not probable, the costs are added to total project costs, reducing gross margin, without changing contract value.

Total estimated costs to complete is the key estimate used to calculate project percentage of completion and revenue recognition. Owners should monitor their ongoing construction projects and have frequent discussions with project managers to determine whether changes to the estimate are necessary. Project delays due to unforeseen circumstances or price escalations with respect to materials are just a couple of the more common circumstances that result in cost overruns that need to be incorporated into the schedule. Price escalations continue to be of great concern in the post-COVID era, particularly due to the uncertainties surrounding tariffs. Companies may want to consider adding price escalation clauses to contracts if not already incorporated.

Total costs to date, divided by total estimated costs to complete, determines the project percentage of completion. For example, let’s analyze a project with a contract value of $150k, total estimated costs of $100k, total costs to date of $50k, and total revenue recognized in prior years of $20k. These inputs would indicate that the project is estimated to be 50% complete ($50k/$100k), with total revenue recognized to date of $75k (.5 x $150k), resulting in current period revenue of $55k ($75k – $20k).

Typically, as project billings are released to the customer, the company records a debit to accounts receivable and/or retainage, and a credit to contract revenue. The billings to date input is the key to calculating a project’s over/under billings, which is necessary in determining the journal entry required to adjust revenue recognition to be consistent with the percentage of completion method.

There are several crucial insights that the contract schedule can provide if analyzed on a regular basis. Contract gross margin, gross profit gain/fade analysis, and over/under billings analysis are not only important metrics to third party users of the financial statements but can also be used to provide keen insights to owners. Additionally, if used correctly, analysis of these metrics will likely improve the financial results of a company’s operations going forward.

While overall projected gross margin on contracts in progress is subject to estimation uncertainty, gross margin on completed contracts is not. For this reason, it is a good idea to periodically compare estimated margins to actual margins on completed contracts that are comparable in size and scope. If a contract in progress has a projected margin that is much lower than the margins realized on similar completed contracts, this indicates a conservative estimate and may result in a higher amount of revenue recognized as the project nears completion. Although conservative estimates are considered favorable with respect to financial statement presentation, it is important to note that the tax implications can be significant, particularly in the year of project completion.

Alternatively, contracts in progress with much higher margins than those realized on similar completed contracts may indicate that the total estimated cost value is inaccurate or incomplete. Ultimately, this will result in higher revenue recognition in the year of inception and profit fade as the project nears completion. If the contract ends up in an overall loss position, GAAP dictates that the entirety of the expected loss, along with the reversal of all revenue previously recognized on the project, must be recognized in the period the loss was identified. Large losses on contracts may reflect negatively on the company with respect to bonding, financing arrangements, and potentially winning bids on new contracts.

Gross profit gain/fade analysis is another way to evaluate the accuracy of contract estimates. It involves comparing the prior period’s estimated gross profit related to contracts in progress to the current period estimates (or final gross profit, depending on the job’s status). Profit fade may be an indication that the original bid was inaccurate, or cost overruns need to be addressed. If a customer frequently changes or decreases the scope of a project, resulting in profit fade, companies may want to evaluate the extent of the impact to determine whether it would be prudent to limit acceptance of jobs with the customer in the future.

Gross profit gain is often a result of conservative estimates or change orders. Change orders can often be billed at a higher margin than the original contract due to a positive relationship with the customer and/or the convenience of maintaining consistency with respect to who is performing the work. If change orders result in favorable gross margin outcomes, companies should evaluate ways in which this can be capitalized upon going forward.

When analyzing the contract schedule, it is important for companies to identify significant over/under billings balances and have a good understanding of the underlying facts and circumstances related to the balances. In construction, cash is king, and over billings on contracts in progress can be indicative of a company ensuring that the project is being financed by the customer, mitigating the risk that a company’s operating cash flow becomes constrained. However, over billings that are greater than overall projected gross profit could be a sign of “job borrow,” which involves borrowing cash from one job to cover the costs of completing another. In other words, the company is “borrowing from Peter to pay Paul.” Use of this practice results in negative cash flows. If used consistently, it can create a snowball effect, requiring new jobs to be over billed to cover the costs of jobs that are fully billed, ultimately leading to a cash crunch.

Under billings are often a result of timing differences, particularly when the timing of monthly project billings is dictated by the terms of the contract. However, significant under billings can also be indicative of inaccuracies with respect to the total contract value and should be analyzed accordingly.

The contract schedule is one of the most important resources for a construction company. Understanding the key inputs and calculations will highlight issues within the job bidding and estimation process, improving contract estimations going forward, resulting in more favorable margins overall. Regular analysis of the estimates and metrics helps ensure that decisions are being made based on the most accurate information available. There will always be unforeseen circumstances that arise outside of a company’s control. However, having the insights that come from consistent contract schedule analysis all but ensures that companies will not overlook those factors which are within their control.

Author: Julie Christensen, CPA, CCIFP | [email protected]