I love working with specialty contractors of all kinds. Most use the percentage of completion method for financial reporting. In some cases, using the completed contract method makes sense, especially for projects lasting just a few months with contract amounts typically less than $100,000.
The Quick Primer
I find the completed contract method simple to implement and easy to explain. Unfortunately, the biggest barrier to this reporting methodology is the business owner’s requirement for new habits, disciplines, and processes. In 100% of the cases that I’ve worked with since 2001, the following has always been true for each contractor:
- They are using spreadsheets to manage projects
- They are not using any daily or weekly WIP reporting, and
- More than likely, they are not forecasting future cash flow for projects in process
In these cases, the office manager is booking a customer invoice to revenue. Direct payments against the contract are reported as COGs. In some months, there will be negative gross profit. In other months, there will be revenue and very few direct costs. Professional finance professionals call this an unbankable mess that needs to be cleaned up. The completed contract method is the least path to resistance in this cleanup.
However, the move to the completed contract method is far more than an academic accounting exercise. In the video below, we’ll see how the completed contract method works, how it’s revealed in cash flow reporting, and its underlying LOC requirements.
As a recap, client billings and payments for direct charges on each contract are not reported on the P&L until the project is 100% completed. In the interim, such activity is reported on the balance sheet under two different WIP accounts.
In the video, I purposely did not discuss the WIP reporting underpinnings that drive the P&L and balance sheet numbers. However, you will need a simple schedule to track these WIP buckets by contract, as I show below in a tool that I like using:
Earlier, I stated that moving to the completed contract method (from doing nothing) is more than an accounting exercise.
Once you implement this costing approach, you can start playing the what-if game on a contract-by-contract basis. The schedule above is for actual numbers. There are other matrixes where we can move around billings and sub-contractor invoices, impacting the actual cash received and paid 30 to 60 days later.
In short, this simple accounting construct will become a powerful cash flow forecasting tool once your finance director has it set up. Before that can happen, let me offer some advice.
Tools and Actions Needed for the Completed Contract Method
Nate’s business in the video above is fictitious. His name is real, along with his family-owned business that manufactures custom cabinets. Nate gives his approval on these suggestions:
- No more spreadsheets in managing projects. Use real project management software. I always recommend UDA, the online version, as a starting point to learn about these systems. Sure, it’s pricey, but not if you are serious about scaling your business. Peter Diamondis talks frequently about the abundance mindset. That’s the thinking needed when obtaining your first job costing system. (Note: I’m indifferent to UDA. Find three other systems to review, but use UDA as the benchmark for features).
- Implement a weekly cash flow update for all projects in progress. I recommend forecasting the cash flow for all contracts in progress going out 8 to 13 weeks. Don’t worry about perfection. We need a rough idea of the peaks and valleys of our weekly cash balances.
- Related to the point above, every year, about six months before your line of credit is up for renewal, project your LOC need for the following 12 months and be prepared to present this to your lender. Your Director of Finance is an expert in such matters. Determining the need and acquiring the increase should be easy, assuming you have a strong business model with a strong management team.
The last two points are important. Moving from spreadsheets to a ‘real’ system is critical for scaling your business.
Completed Contract Method FAQs
The Benefits of Proper Revenue Recognition for Specialty Contractors
I’ve been a consultant for more than 20 years, and I’ve never had an entrepreneur or a CEO ask me about the benefits of the completed contract method or the percentage of completion method, which most of my clients use.
Earlier, I stated that picking a revenue recognition policy (in this case, the completed contract method) is far more than an academic accounting exercise.
Every contractor serious about growing the firm should have a solid WIP management tool. If not, WIP cash flow projections are not impossible but nightmarish to compile, an exercise that should only take a few minutes to complete every Friday night before leaving the office. And good luck with LOC financing talked about in the video.
While you may not have noticed, the 5-project WIP report I showed in the video has all the pertinent information to complete the monthly WIP entries in the accounting system. Care to guess how long that takes to complete each month-end? About five minutes. Let that sink in for a moment–about five minutes.
We don’t do the completed contract method or the percentage of completion method (my preference) to appease the accounting gods (unless you are required to get an audit by your bank or insurance carrier). We do it because you are already doing WIP management and forecasting (or you will be soon). Since you already have the data, a scale-up CFO will have the accounting team book these monthly entries.
Ignoring one of these revenue recognition practices means you probably want to remain a very small business where you constantly deal with cash flow headaches and frustrations with customers and vendors. That’s fine, but you must ask, “Am I happy with my past and current progress? Is running this business getting easier or harder?”
Better administrative practices do not make your biggest problems go away. Instead, they are the symptom of a much more serious problem. It’s your job to find out the root cause of any resistance you might have to these changes I’m describing.
Again, accounting and professional reporting is not the main thing. The front stage is. An organized and well-oiled backstage gives you a crystal-clear picture of where you’ve been, where you are now, and where you are headed.