Contracts in Progress: A Deeper Dive on Over- and Under-Billings
by Justus Wesloh, CPA/CFE
The independent accountant’s review report included in the financial statements for many contractors and construction companies states that, “The accompanying supplementary information…is presented for purposes of additional analysis and is not a required part of the basic financial statements.” So, what exactly is this supplementary information and why is it an important, but not required, part of the financial statements?
While we will be focusing on the schedule of contracts in progress, below is a list of commonly included supplementary schedules:
- Earnings from Contracts
- Contracts in Progress
- Completed Contracts
- Accounts Receivables
- Aged Payables
- Key Financial Ratios
What is the Schedule of Contracts in Progress?
The schedule of contracts in progress presents detailed information about the revenues, costs, and billings on individual performance obligations as of the financial statement period-end date. This information is presented in four groups (example assumes a year end date of December 31, 2020):
- Total Contract: includes total revenues per the contract’s agreement plus any change orders and total estimated costs to complete the contract, as well as a calculation of estimated gross profit or loss.
- From Inception to December 31, 2020: includes total costs incurred through 12/31/2020, loss accrual (if applicable; beyond the scope of this article), a calculation of revenues and gross profit recognized, as well as billings through 12/31/2020.
- At December 31, 2020: The focus of this article; costs and estimated earnings in excess of billings (under-billings) and billings in excess of costs and estimated earnings (over-billings).
- For the Year Ended December 31, 2020: includes calculations of revenues and costs that were recognized in the year ended 12/31/2020.
Under-billings represent revenues recognized in excess of the amount billed to date. This results in a receivable for the unbilled portion and is reported on the balance sheet as a component of contract assets in current assets. However, on the statement of cash flows, increases in under-billings are a reduction to cash flows from operating activities. Significant under-billings may result in cash flow problems for the company and typically concern lenders and other external financial statement users regarding management’s operation of the business.
Under-billings can also be overstated by improperly estimating total costs on a contract. If a contract’s total costs are estimated at less than the total costs to be incurred on the job at completion, it will cause additional revenue to be recognized earlier than expected. This can have adverse tax implications, such as increasing the tax liability in the current period, further stressing the company’s cash flows and ability to meet operating obligations.
On the other hand, over-billings represent the amount billed to date in excess of revenues recognized. This results in a payable for the over-billed portion and is reported on the balance sheet as a component of contract liabilities in current liabilities. On the statement of cash flows, increases in over-billings are an increase to cash flows from operating activities. Strong over-billings allow the company to finance projects without borrowing from financial institutions. However, management must be diligent about managing these funds. Spending over-billings on fixed assets and other non-project costs may result in future cash flow issues on jobs that have already been over-billed.
Overestimating the total costs to complete a contract will result in lower revenues being recognized in the current period. As a result, over-billings are likely to be overstated. This can have adverse tax implications in subsequent periods, such as increasing the future tax liability, when cash may not be available to cover these additional operating obligations. Further implications include the impact on certain requirements of profitability in bank covenants or key performance indicators that could affect a company’s internal decision-making process.
Understanding and maintaining current contract schedules provides valuable information to owners and management while navigating the financial aspects of project management. Under-billings might look good as assets are increased on the balance sheet but can lead to cash flow issues if the balance gets too high. Conversely, over-billings increase liabilities reported on the balance sheet but provide advance cash flows that may be used to finance the costs of construction without obtaining bank loans and lines of credit.
If you’re seeking assistance or support in creating or understanding your contract schedules, reach out to one of our construction team members today.
Call us at (360) 734-4280 or fill out the form below and we'll contact you to discuss your specific situation.
Justus Wesloh, CPA/CFE
Justus Wesloh joined Larson Gross in 2021 after starting his public accounting career at a large National firm. He serves on the firm’s construction team and specializes in preparing and reviewing compiled, reviewed and audited financial statements.