The Basics of Contract Accounting for Businesses

Contract accounting is a branch of accounting that specializes in recording expenses and revenue under contractual agreements. It helps businesses that deal with long-term, project-based, or complex contractual work record financial activity accurately. 

What is Contract Accounting?

Contract accounting focuses on recording and managing financial transactions related to long-term business contracts. This branch addresses the unique complexities of contractual work, including revenue recognition, cost tracking, and compliance with relevant accounting standards.

Industries like construction, engineering, and software development often manage larger, more complex projects than typical businesses. These projects often involve broader scopes, longer timelines, and specialized regulatory requirements. To maintain financial control, accuracy, and compliance in reporting, businesses need to follow a specialized accounting branch known as contract accounting. 

The Key Components of Contract Accounting

Contract accounting involves typical accounting practices, such as record-keeping, financial reporting, and auditing. However, it requires a unique approach to cost tracking, revenue recognition, billing, and project changes. 

Cost Tracking

In long-term contracts, project costs like direct costs, indirect costs, and change orders can quickly accumulate over time. When businesses fail to track these costs, they may encounter cost overruns, budgeting issues, and inaccurate profitability projections. 

That’s why cost tracking is a core component of contract accounting. Cost tracking is the process of monitoring, recording, and managing all expenses related to a specific project or contract. It involves the following steps:

1. The business and its customers first agree on a project budget that outlines all estimated costs.
2. Bookkeepers break the budget into specific cost categories (e.g., labor, materials, administrative fees),  then organize each expense by phase, activity, or department.
3. As the project progresses, bookkeepers record all expenses in real time, saving supporting documents such as invoices, timesheets, and receipts.
4. Periodically, bookkeepers calculate the total costs incurred to date. They use the information to estimate the cost of the remaining work.
5. Bookkeepers compare actual costs to the original budget, analyzing any cost overruns or savings, then advise the business on any necessary corrective actions. 

Revenue Recognition

In standard accounting, there are two methods of recording revenue and expenses: the cash method and the accrual method. The cash method recognizes revenue when two parties exchange cash, while the accrual method recognizes revenue when one party invoices or bills the other. Typically, revenue recognition only occurs upon the sale of a product or delivery of a service.

However, since construction projects are typically larger in scale and slower to complete, customers usually spread payments over multiple accounting periods. This makes it difficult to calculate important financial metrics, such as profitability, cash flow, and annual tax liabilities. 

Contract accounting accommodates these large-scale projects by allowing incremental revenue recognition through a method known as percentage-of-completion. 

Percentage-of-completion is one of two types of contract accounting revenue recognition methods. It recognizes revenue and expenses periodically as a project progresses. This is in contrast to the other type of contract accounting revenue recognition method: completed contract method. The completed contract method, like standard accounting, only recognizes revenue upon the completion of all contract-related work. 

The percentage-of-completion method involves the following steps:

1. The business and its customer(s) agree on a project budget, which estimates the total project cost and the total contract revenue.
2. As the project progresses, bookkeepers track all costs incurred.
3. The accounting team calculates the percentage completion by dividing the total costs incurred to date by the estimated total project cost. For example, if the budget estimated a total cost of $4 million, and the project incurred $2 million in expenses to date, then the business can assume that it has completed 50% of the project. 
4. The accounting team determines the revenue to recognize by multiplying the promised contract revenue by the percentage of completion. For example, if the client promised a payment of $6 million, and the business has completed 50% of the project, they can record a current revenue of $3 million. 
5. The accounting team recognizes income and expenses in books and financial statements. 
6. The team regularly reviews and updates its estimates. 

Progress Billing

The incremental nature of revenue recognition also extends to billing and invoicing. Businesses ensure steady cash flow throughout a long-term project by enforcing progress billing, which refers to the practice of billing clients in stages as a project progresses. Instead of waiting until project completion, the business requests payments that match the percentage of work done. 

Clients might also withhold retention until the project is fully completed. Retention refers to a small amount (usually 5 to 10% of the total contract price) that the client withholds to reduce financial risk and incentivize completion to agreed-upon standards. 

Progress billing involves the following steps:

1. The business and its client set a total budget for their project.
2. The business breaks the project down into phases or establishes a regular billing schedule (such as monthly billing).
3. As the business completes portions of the project, it calculates the percentage of completion.
4. It bills the client the amount owed minus any previously billed amounts and retention. 
5. The client reviews and pays their bill based on the agreed-upon schedule. 

Change Order Management

As contractual projects typically span long timeframes, contract terms often see unexpected changes. This can include:

• Increases or decreases in expected work
• Increases or decreases in contract value
• Budget changes
• Changes in material specifications
• Timeline extensions

Change order management ensures that the business documents, evaluates, approves and integrates changes properly. To achieve this, it follows the steps below:

1. Identification: The business or its customer recognizes a necessary change, such as a design adjustment or a timeline extension.
2. Documentation: Management writes a formal change order to outline the changes in scope, budget, or schedule.
3. Evaluation: Authorized bodies assess the implications of the proposed change on the budget and timeline.
4. Approval: Relevant parties, such as clients, contractors, or managers, formally sign off on the change order
5. Implementation: Management updates project plans, budgets, and contract documents to reflect the approved change.
6. Accounting Integration: The accounting team adjusts cost tracking and revenue recognition to include the impact of the change order.

Change order management keeps project changes organized. It also prevents lost revenue from unbilled work, budget overruns, inaccurate job costing, and client disputes. 

Key Takeaway

Using a specialized accounting approach helps businesses that are involved in long-term or complex contract work track their income and expenses more efficiently. With contract accounting, businesses match their income with effort and project costs, gaining a clearer picture of ongoing cash flow, project profitability, and future tax liabilities. 

Interested in starting your contract accounting journey? Check out our guide to the best bookkeeping software for construction businesses for our tech recommendations.