Accounting & Financial Management for Residential Construction
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Accounting is surrounded by a mystique. Many people assume that accounting is understandable only to that special breed called accountants, who speak a special language to protect the secrets of their art. Likewise, few subjects in a business school curriculum are dreaded more by students than accounting. However, accounting is a logical and straightforward discipline. Once the general mechanics are understood, accounting begins to make sense and the mystery fades.

Accounting is the process of collecting, analyzing, classifying, and accumulating historical financial data in categories and formats that will accurately reflect a company's operation and present its financial position. Accounting does more than merely provide the Internal Revenue Service with an audit trail and the necessary records to substantiate the payment of income taxes. The accounting function can help you create a valuable data bank, because the accounting system stores all of a company's financial transactions.

Why should the builder, remodeler, or developer worry about accounting at all? Through the accounting function, you can obtain timely financial information that will make the decision-making process less of a guessing game. Accounting records contain a wealth of historical information that you can use effectively to-

• analyze past performance
• evaluate the feasibility of future projects
• estimate the cost of future jobs
• set goals and objectives
• prepare short- and long-term budgets

Accounting should be viewed as a tool that managers are responsible for using effectively. Accounting provides the core of a firm's control function. Through appropriate control, profits increase. The control function involves using and safeguarding assets, for example, equipment, cash, and inventories. During construction most of a company's resources are used to create inventories or work-in-process inventories such as lots, homes, or additions to homes. Therefore, control of construction costs is paramount to the success of the company.

Designing the System

A successful accounting system starts, like a house or remodeling job, with design. Therefore, the following steps require special attention-

Take a good look at the firm's organizational structure. Is it a sole proprietorship, a partner- ship, a C corporation, or an S corporation? Reporting requirements differ under each structure.

Analyze all functions carried out within the organization and who is responsible for each function. Prepare an organizational chart that shows each function in a hierarchy and names the individual responsible. In a small firm one individual might be responsible for more than one function and use a simple, hands-on system. In large companies you might have sub-functions, each staffed by a different person. A large system usually is more complicated and involves more details because people not involved in the record-keeping activities need to make decisions based on the information. The organization's structure will strongly impact the types of reports the builder, remodeler, or developer will need to generate from the system.

Project the firm's growth and the effects it will have on resources and staff as production increases. Can your present staff handle the additional time demands and increased responsibilities? Will you need to add staff? How much authority and responsibility should you delegate to other employees? All of these factors will have a bearing on the accounting system, specifically on the amount of detail that will be generated from the system and on the points of control that are required within the system. These projections must be carefully done because the projected size of a company greatly influences the design of the accounting system.

Analyze carefully the type and quality of reports to be generated from the system. Design the reports and determine how frequently to prepare them, who is to use them, and how detailed they should be. Determine the output of the accounting system at the design stage to allow for efficient and timely preparation of the reports. Completely revising an established system to generate a different kind of report can be disruptive. You can easily avoid revision with a little planning while designing the system.

Under no circumstances should an accountant or consultant design an accounting system without the active participation of the immediate beneficiaries of the system, the builder, remodeler, or developer and for large firms, the top management team. The only way to ensure the system's effectiveness is for the firm's owner and (if the firm has one) the top management team to take an active role in designing the accounting system so that it meets the firm's needs and requirements. Small to medium-volume firms can buy prepackaged computer systems for data processing, but they need to design the structure of the system. The computer package is only a medium for processing the data versus manually doing it.

Choosing an Accountant

An accounting system is handled at two levels: the professional and the technical. Certified public accountants (CPAS) and accountants are at the professional level; bookkeepers and clerical personnel are at the technical level. The difference between an accountant and a CPA is primarily one of approach. The CPA, a member of an independent accounting firm, is primarily concerned with the validity of financial information as the firm reports to third parties. The accountant is usually a company employee and also may have CPA credentials. The independent CPA provides some form of assurance that the financial statements are not materially mistated. The accountant works with accounting information from the management perspective, maintains internal controls, prepares the traditional financial statements as well as management reports, and helps analyze the reports.

These functions of accounting-reporting to third parties and using accounting information in the decision-making process-do not conflict. In fact, many CPA firms today offer their clients both services on a consultation basis. Caps use universal principles and standards to determine whether the financial statements represent fairly a company's financial position. They require little specialization from industry to industry. However, the evaluation of this information for use as a management tool requires extensive knowledge of the industry. Therefore, not all CPA firms can provide the expertise needed to design and implement a system that will serve both as the source for external reporting and as a management tool in the daily decision-making process.

Job cost system is an important element in the accounting system for a homebuilding, remodeling, or development company. At least 50 percent of the charges against sales revenue are construction costs, thus representing the highest single line item affecting the profitability of a firm. The job cost system is a subsidiary system that accumulates cost not only by unit of production but also by cost code (lumber, plumbing, electric) within each unit. The unit might be a house, a remodeling job, a subdivision, or a commercial establishment. This subsystem establishes the framework for controlling construction cost.

The treatment of land and development costs and indirect construction costs (including capitalization of interest) requires special attention from builders, remodelers, and developers. They must look, not only at the structure to accumulate and control the indirect costs, but also at the procedure to allocate those costs to production units.

You should set up your accounting systems and procedures from a management perspective. However, you should be aware of Internal Revenue regulations so that you can accumulate and classify the information needed for tax purposes in a way that facilitates tax reporting at the end of the year. Otherwise you or your accountant may have to search through the files to find the information. Because regulations change often, both you and your accountant must understand the latest regulations.

The Bookkeeper

Bookkeepers and clerical personnel are generally in charge of collecting, classifying, and accumulating financial information within a framework designed by an accountant. The daily handling of financial information is clerical in nature and can be easily handled in-house by a secretary or bookkeeper or outside by a bookkeeping service or a bookkeeping division of a CPA office. In some small-volume firms the builder, remodeler, or developer, or an office manager may perform the bookkeeping duties.

The bookkeeper's job is to collect data. Bookkeepers are not substitutes for accountants. They perform a necessary and valuable function in the accounting system, but they cannot perform a function for which they have not been trained. The accountant retains the responsibility for performing reviews for accuracy, analyzing the data, preparing reports, and reviewing the data collection process.

If you need to use an outside bookkeeping service, choose a service familiar with the homebuilding or remodeling industry. The bookkeeping service should follow the system and requirements designed by an accountant, rather than some predetermined general requirements set by the service. The accountant should perform a monthly or, at minimum, quarterly review of the bookkeeping function to ensure that the bookkeeping function is being performed accurately to prepare special reports and perform analytical reviews of the accounting data.

If the owner of a homebuilding, remodeling, or development firm does not have enough accounting background to set up the firm's accounting system, the owner will need the design services of an accountant with some experience in homebuilding, remodeling, development, or at least construction accounting.

The Accountant

For firms large enough to afford one, selecting an accountant is a critical task for management, particularly in the building, remodeling, and land development industries, which have special requirements. For example, as stated earlier, job cost is an integral part of the system, as well as the treatment of indirect costs. The accountant must understand the building, remodeling, and development industries and the construction, remodeling, and development processes and also be sensitive to the owner's or manager's needs. Check references from other builders, remodelers, or developers who have used the accountant. Your attorney or supplier also may know about the level of the accountant's skills.

Because specialization in the accounting profession is less likely in small towns, you may need to go to a nearby larger town to find one. At the least you would want to present your accountant with a copy of this manual as a guide to the specific requirements of the homebuilding, remodeling, and land development industries.

The Certified Public Accountant

For many small companies an in-house accountant is not a practical option and in some cases is not necessary. The selection of a Certified Public Accountant (CPA) is then critical. The CPA should not only satisfy all traditional external requirements for reporting but also help management analyze financial information for controlling the business and making business decisions. Under these circumstances the CPA should have an in-depth knowledge of the homebuilding (not construction) industry, the structure and organization of the individual company, its products and/or services, and construction methods.

Builders, remodelers, and developers must educate their CPAs to the internal operations of their companies and should be receptive to recommendations and suggestions made by the CPA. A two-way dialogue is essential to the relationship between the builder, remodeler, or developer and the accountant. Above all, the right accountant can mean the difference between a business that merely functions and one that prospers. Most firms will use the services of a CPA to some extent for taxes or for audits, reviews, or compilations.

CPA Firms and Level of Services Available

Generally, CPA firms offer three levels of end-of-year services to their clients: audits, reviews, and compilations. In addition many CPA firms also provide management consulting services. The scope of the work done by a firm will determine the type of service and the cost of the work performed.

Audits

An audit is by far the most comprehensive and expensive of the services offered by a CPA firm. After an audit, the CPA firm will issue an opinion about a firm's financial statements. The financial statements are representations made by management. The CPA merely offers an opinion as to whether or not the statements represent fairly the financial position of the company in accordance with generally accepted accounting principles (GAAP).

The audit process includes verification of certain accounts by confirming bank balances, out- standing receivables, and payable accounts with the appropriate third parties. The CPA firm also scrutinizes the system of internal control to insure the existence of and compliance with rules and procedures. The review of the financial information must be thorough enough to satisfy the CPA that the information presented in the financial statements accurately represents the financial condition of the company in accordance with GAAP or other consistent recognized systems of accounting. Audits are necessary only if they are required by investors or banks. To save the expense of a detailed audit, builders, remodelers, and developers sometimes negotiate the removal of that requirement from financial documents for their firms.

Reviews

Audits are relatively expensive. Therefore, some firms, not required by their lenders to have an audit, often choose a less involved review.

A review provides a limited analysis or testing of the financial information. Therefore, the opinion expressed after a review is limited in scope. It generally does not include confirmation of account balances by third parties.

Because of the reduced scope of the work, the cost of a review is less than that of an audit but more than a compilation. Many lenders require borrowers to provide annual statements that have been reviewed by a CPA firm. Reviews also provide the firm's owners with a limited assurance that the accounting department is following accepted procedures in the recording and reporting functions.

Compilations

Compilations are by far the least expensive of the three services offered by CPA firms. In a compilation the CPA is under no obligation to review or investigate any account or procedure unless something looks suspicious or appears to be misleading.

In a compilation the CPA issues no opinion as to the accuracy of the data. The CPA simply presents the data supplied by the firm's owner in an accepted financial format for disclosure to lenders, income tax purposes, or any other use intended by the owner.