A construction company might come to your mind by reading the phrase “Construction In Progress.” Indeed, construction in progress accounting is mostly used by construction firms. Besides business dealing in building huge fixed assets, also use construction in progress accounting.
However, any other business not falling under the categories mentioned above might also be dealing with the construction in progress account. Think of a company building its new warehouse or extending the plant facility. Or just think of a company building new office space for employees. All of these accounts will be recorded under ‘construction in progress.’
In this blog, we will discuss the instances when construction in progress is used by the business. The international financial reporting standards dictate the recording of percentage completion in financial statements. It will also be part of the blog. Let’s start with the construction contracts.
What is IAS 11 Construction Contract?
Under the IAS 11.3,
A construction contract is a specific contract negotiated to build a fixed asset or group of interrelated assets.
Under the IAS 11.8, if a construction contract relates to building two or more assets, each asset will be treated as a separate contract if specific conditions are fulfilled. The IAS 11.9 regulates the treatment of two or more assets’ construction as a single contract if they are negotiated as one contract.
IAS 11 regulates the accounting treatment of construction contracts. The appropriation of revenues and expenses should be made in the relevant accounting period according to the work’s percentage completion. It also dictates which revenues and costs related to a construction contract should be recorded and when to record.
The IAS 11 construction contract is a comprehensive document dictating the complete accounting for construction in progress.
What is Construction In Progress?
Construction in progress, or most commonly known as CIP, is a fixed asset account with a natural debit balance.
We can define Construction in Progress as,
It is an accounting term used to represent all the costs incurred in building a fixed asset.
The CIP procedures dictate the proper recording of construction costs in financial statements. In the company’s balance sheet, construction in progress is most commonly found under the head of PP & E( Plant, Property & Equipment).
All the costs of assets under construction are recorded in the ‘Construction In Progress Ledger Account.’ They are shifted to the asset side of the balance sheet from the ledger.
One thing to understand is that only capital costs related to an asset under construction are to be kept in the CIP account. The operating costs related to a specific period must be charged to the same accounting period.
The most common capital costs include material, labor, FOH, Freight expenses, interest on construction loans, etc.
According to the matching principle of accounting of accrual accounting, the expenses related to certain revenues must be recorded in the same period when they were incurred.
The fixed assets like building space, warehouse, plant manufacturing, etc., can take years. A company can leave the financial statements blank for all times when work was in progress. It will violate the accrual principle to record some million revenues at the end of the construction.
Therefore, the construction in progress is a non-current asset account that keeps a record of all the costs incurred until completion.
For a construction firm that makes a contract to sell fixed assets, the objective is the same. Although accounting treatment might differ.
Another objective of recording construction in progress is scrutiny and audit of accounts. The construction in progress can be the largest fixed asset account due to the possibility of time it can stay open.
The balance sheet must show the true picture of the company’s financial health. When the construction under progress is recorded proportionally in every accounting period, it maintains the financial position’s transparency.
Progress Vs. Process
In most cases, the term of process or progress can be used interchangeably. However, there are chances that the term process written in a financial statement instead of progress indicates the business nature.
In some accounting conventions, the term ‘progress’ refers to a fixed asset under construction for business use. For instance, the extension of its warehouse by a company is ‘construction under progress.’
However, the term ‘ construction under process’ is used when the company is making construction contracts. It can be a selling contract of building a ship, airplane, building, or other fixed assets.
If the financial statements have ‘construction in progress or process’ under the head of PP&E, it is a ‘build to use’ asset. Whereas, if the account appears under the heading of ‘Inventory and assets,’ it is probably a ‘build to sell’ asset.
Build For Use
Build to use can be an extension in an existing office facility, building a new plant, warehouse, or any business asset. The accounting treatment for the ‘build to use’ CIP is not much complicated.
All the costs being incurred over time will be debited to the CIP account. In most cases, the credit will be account payable or cash if paid immediately. However, in some cases, the inventory assets can also be credited. It relates to using that raw material in building the asset which is sold by the business as its normal operation.
For instance, if a cement manufacturing company is expanding the manufacturing unit. It will use cement from its own inventory, therefore, debiting the inventory account.
After the construction has been completed, the relevant building, plant, or equipment account is debited with the same amount as construction in progress. CIP is credited as a result. After the completion of construction, the company will record depreciation on the asset.
Build To Sell
Build to sell relates to the construction firms or companies that make build-to-sell contracts. These businesses mostly involve ship-manufacturing companies, space vehicle manufacturing, airplane manufacturing companies, construction firms, etc.
The accounting for construction in progress for such businesses is a little bit complicated. According to Generally Accepted Accounting Principles, the businesses should use the ‘percentage of completion method’ for recording the revenues and expenses in the same accounting period when they were incurred. This provision is made under the matching principle of accounting.
Let’s look at the accounting treatment under the “Percentage Of Completion Method.’
Accounting Treatment Percentage Of Completion Method
When it comes to accounting under the percentage of completion method, the company can decide which basis to use. There are three completion-percentage appropriation methods:
- Cost-to-cost method
- Efforts Expended method
- Units-to-deliver method
In cost to cost method, all the cost incurred to the date is divided by the project’s total expected cost. It gives the estimation of work completed to the date.
Efforts Expended Method
The appropriation is done similarly to the cost-to-cost method. The effort expended to the date is divided by total expected efforts. The basis for the effort expended can be labor hours, the material used, or machine hours.
This percentage completion appropriation method is most common when a contract of delivering a large number of similar assets is made. For instance, it can be a contract to manufacture tires for a car manufacturing company. In this method, the number of units manufactured is divided by the total number of units to be manufactured.
Journal Entries For Construction In Progress
The journal entries for the recording of construction in progress in a general project will be as follows:
- For the recording of construction costs, the construction in progress account will be debited. On the other hand, cash will be credited if the payments are made immediately. If the amount is due, the account payable will be credited.
|Jan 1, 2020
|Construction In Progress Account
|Cash Account/Account Payable
- You will have to bill your customer for the construction account. The construction receivables will be debited, which is an asset account. On the credit side, progress billings, a contra-asset account to offset the construction in progress will be credited.
|Jan 1, 2020
|Construction Receivables Account
- The completion percentage will be multiplied by the project’s total value to record the construction contract’s revenues. After the calculation of revenues, the construction in progress account will be debited by that amount. The construction revenues account will be credited.
|Jan 1, 2020
|Construction In Progress
Benefits Of Construction In Progress
- The company can have a better idea if a certain project is profitable or not. By appropriating the construction in progress, a firm can take timely actions to respond to any changes. For instance, the revision of cost estimations is possible by the CIP accounting.
- The management can have a better risk management plan if they know what is coming their way. For instance, a major economic event might impact work completion. By the figures about completion of work, the company will be better positioned to manage risk.
- The matching principle of accounting is followed in CIP accounting; therefore, the true picture of financial position is depicted.
We have tried to help you understand the concept of construction in progress. However, you must know that the nature of costs and revenues in every construction contract varies. There might be a wide range of expenses in one construction contract.
The article is to help you have a clear understanding of how to do accounting treatment of construction in progress in financial statements of a business.