software consulting, custom reporting, financial resources

Articles:

Credit Card Transactions

Entering Fixed Assets as Journal Entries

Estimating

Estimating-At-A-Glance

Estimating, Project Management Overview

Paying Liabilities and Transfers Between Accounts

Payroll Overview

Profitability

Proposals

Profits - Strategies to Improve

Responsibility As A Motivator

Risk Management

Schedule Variance

Take Your Business to the Next Level

Teamwork As A Motivator

Time Management

Time Management Matrix

Timetable of Procedures

The Balance Sheet, Part 1

The Balance Sheet, Part 2

The Balance Sheet, Part 3

The Balance Sheet, Part 4

Training Saves Money

Value As A Motivator

Year-end Close

The Balance Sheet, Part 3

The Matching Principle

This principle mainly occurs in construction and may not be applicable to other industries. The value of this principle has been debated, and is mainly applicable when a bonding company or bank requires calculations based on this principle.

In order to measure the company’s true profitability, the company must match the company’s income earned with the company’s expenses incurred during the same period. Therefore, if the company shows revenue during an accounting period, the company should show all expenses incurred to earn that revenue in the same time period.

To accomplish this, the company not only needs to keep the company’s books on an accrual basis, but the company also will need to adjust accounts to reflect when costs are incurred. The matching principle allows the company to show prepaid expense accounts, depreciation of fixed assets, and other adjustments to reflect the expenses as they are actually used (but not necessarily as they are paid).

The matching principle also allows the company to adjust the company’s income based on the company’s earnings, not the company’s billings, and to utilize the WIP accounts to do this.

WIP stands for “Work In Progress”. This is a way to recognize income earned, not necessarily income billed to the client. The advantage of performing a WIP adjustment is that it makes the company’s Income Statement more truly reflect actual work done to date. At the same time, it makes the company’s Balance Sheet show the company’s real Assets (Underbillings) and Liabilities (Overbillings). It also removes the large monthly profit swings on the company’s financial statements that result from the unpredictability of when an invoice was or wasn’t mailed. This allows the company to better analyze the company’s profitability throughout the year and make better financial decisions based on these more accurate financial statements.

Over and Underbillings (Invoicing does not necessarily equal earnings):

The expenses one incurs as a contractor happen throughout the month. One
receives small and large bills from suppliers and subcontractors, and prepares weekly or bi-weekly payroll. But one typically sends out invoices only once or a few times per month. Therefore, when one prints the Income Statement, the profit may vary based on whether or not the company just sent out an invoice:

The day before the company prepares the invoice, the company may show a loss.

The day after the company created the invoice, the company may show a profit.

Because of this, the company will need to adjust the company’s income on the Income Statement to reflect the amount of money the company has earned on a job, not just the amount of money the company has invoiced the client. The other half of this adjustment will sit on the company’s Balance Sheet as Underbillings or Overbillings.

As a contractor, the company should invoice the company’s clients as early as possible. Early and more frequent billing has several advantages:

Faster invoicing generally means faster payments, helping the company’s cash flow.

The company will more quickly discover which clients are slow payers or have trouble paying their bills.

More frequent invoices usually mean smaller invoice amounts, making it
easier for clients to pay.

The company also may be able to collect a prepayment or job deposit.

Regardless of what form this prepayment takes, if the company has not performed the work, the company should not classify these payments as income.

To compensate for this, at the end of each month the company will need to create a WIP schedule. WIP stands for “Work in Progress”. When accounting for long-term projects, the company can only recognize income that the company has earned, not necessarily income that the company has billed. For example, if the company has spent 50 percent of all the expected costs on a job, the company can be assured that the jobs are 50 percent complete.

If the company has billed 60 percent of the total contract, then the company is showing too much income on the company’s Income Statement. The company should to take the extra 10 percent billed out of the Income Statement and hold it as a liability on the company’s Balance Sheet in the Overbillings Account (sometimes called Billings in Excess of Costs).

On the other hand, the company may have additional job costs that have not been included on the client’s invoices. If the company has costs that the company has not billed to the client, the company may have Underbillings. To correct this, the company will increase the amount of the company’s income shown on the Income Statement and recognize an increase in the company’s assets on the Balance Sheet in the Underbillings account (sometimes called
Earnings in Excess of Billings).

Determining Over and Underbilling Amounts:

Determining the amount of Over and Underbillings has three steps.

Step One: Determine the percentage of the job that has been completed:
Total Costs to Date on a Job / Total Expected Costs = Percent of Job Completed.

Notice that this is based on total costs incurred (i.e. all the costs that have been incurred to get the job to its current percentage of completion).

Step Two: Determine the amount of income the company has actually earned:
Percent Complete / Total Revised Contract Amount = Amount of Earned Income.

Step Three: Calculate any over or underbillings:
Total Amount Invoiced Client minus Amount of Earned Income = Over/Underbillings.

The “Amount of Earned Income” represents the dollars the company can recognize as income on the company’s financial statements. Any difference between that amount and the total amount the company has invoiced for the job will be the amount for the Over or Underbillings account on the Balance Sheet.

Here is an example:

Total Costs to Date on Job: $84,000
Original Budget: $120,000
Budgeted Costs of Change Orders: $20,000
Total Revised Budget $140,000
Original Contract $145,000
Approved Change Orders $25,000
Total Revised Contract $170,000
Total Amount Invoiced Client to Date: $110,000

Step One - Calculate the Percentage of the Job Completed:
Total Costs / Total Expected Costs
$84,000 / $140,000 (original budget of $120,000 plus $20,000 in
Change Orders = Percent of Job Completed: $84,000 / $140,000, or 60%.

Step Two - Calculate the Amount of Income the company has actually earned:
The company can recognize 60% of the revised contract amount
Revised Contract Amount = $170,000 (original contract of $145,000 plus $25,000 in Change Orders).
Amount of Income The company Can Recognize: $170,000 * 60%, or $102,000.

Step Three - Calculate Any Over or Underbillings:
Total Amount Invoiced Client ($110,000) less amount of Income the company can recognize ($102,000) equals a negative $8,000 (overbilled).
The company will now need to reduce the company’s income and recognize an overbilling amount of $8,000; therefore the company’s Balance Sheet will show a WIP liability of $8,000.

Please contact me if you would like to learn more about instituting a comprehensive training process. Thank you.

Andy King
T: 805-771-8400
service@missiondevelopment.com