9.3 Financial Reporting: Statements, Accounting Methods, and Key Ratios
Key Takeaways
- The balance sheet is a snapshot at a point in time built on assets equals liabilities plus owner's equity; the income statement covers a period and ends in net profit; the cash flow statement reconciles the two by showing where money actually moved.
- Percentage-of-completion accounting recognizes revenue as the work is performed, usually by the cost-to-cost method, and is the standard for contractors with contracts spanning reporting periods.
- Underbillings, shown as costs and estimated earnings in excess of billings, mean the contractor has performed work it has not yet invoiced and is financing the customer.
- Overbillings, shown as billings in excess of costs and estimated earnings, are a liability, not profit, because the contractor has been paid for work it still owes.
- Depreciation spreads the cost of equipment over its useful life; straight-line divides cost less salvage by the years of life, while accelerated methods and the Section 179 election move the deduction forward.
Financial Reporting: Statements, Accounting Methods, and Key Ratios
Quick Answer: Three statements answer three different questions. The balance sheet is a snapshot — $\text{Assets} = \text{Liabilities} + \text{Owner's Equity}$. The income statement covers a period and ends in net profit. The cash flow statement reconciles them by tracking where money actually moved. For a contractor, add a fourth: the work-in-progress (WIP) schedule, which exposes underbillings (you performed work you have not billed — you are financing the customer) and overbillings (you were paid for work you still owe — a liability, not profit). Contracts spanning reporting periods are normally reported on percentage of completion, usually measured cost-to-cost.
1. The Balance Sheet
| Assets | Liabilities and Equity |
|---|---|
| Current: cash, accounts receivable, retention receivable, inventory, costs in excess of billings, prepaid insurance | Current: accounts payable, accrued payroll and payroll taxes, billings in excess of costs, current portion of notes |
| Fixed: trucks, trailers, compressors, lifts, tools, less accumulated depreciation | Long-term: equipment notes, vehicle loans, long-term debt |
| Other: deposits, goodwill | Equity: paid-in capital plus retained earnings |
Retention receivable deserves its own line. It is an asset you cannot spend and often will not see for months.
2. The Income Statement
| Line | Meaning |
|---|---|
| Revenue (contract income) | Recognized under the chosen accounting method |
| − Direct job costs | Labor burdened, material, subcontracts, equipment, other direct |
| = Gross profit | The number that must cover overhead |
| − General and administrative expense | Office, admin salaries, marketing, insurance not charged to jobs, depreciation on general-use assets, licenses |
| = Operating profit | |
| ± Other income and expense | Interest, gain or loss on equipment sales |
| = Net profit before tax |
The classification rule that gets tested: a cost traceable to a specific project is a direct job cost; a cost of being in business generally is G&A. Depreciation on a crane used on jobs is a direct or equipment cost; depreciation on a car used generally by the sales staff is general and administrative.
3. The Cash Flow Statement
Three sections, and the first one is where contractors learn something:
- Operating activities — net profit adjusted for non-cash items (depreciation) and for changes in receivables, payables, and billings. A profitable company with exploding receivables shows negative operating cash flow, which is the early warning of the cash crunch described in Section 9.1.
- Investing activities — equipment and vehicle purchases and sales.
- Financing activities — borrowing, repayment, owner contributions, and distributions.
4. Accounting Methods
| Method | Revenue recognized | Typical use |
|---|---|---|
| Cash | When cash is received; expenses when paid | Very small contractors; simple but distorts any period with heavy receivables |
| Accrual | When earned; expenses when incurred | The general business standard |
| Completed contract | Entirely at completion | Short-duration contracts; defers both revenue and cost |
| Percentage of completion | Progressively as work is performed | The contractor standard for contracts spanning reporting periods |
Cost-to-Cost Percentage of Completion
Worked example. A $400,000 commercial reroof with a total estimated cost of $320,000 has incurred $208,000 of cost to date.
If the contractor has billed $235,000, it has an underbilling of $25,000: work performed but not invoiced, reported as costs and estimated earnings in excess of billings, an asset — and a sign the billing process is lagging production.
If instead it had billed $290,000, it would have an overbilling of $30,000: billings in excess of costs and estimated earnings, a liability. Overbillings feel like cash in the bank and are not — the contractor still owes the work. Spending overbillings on overhead is a classic route to a failed job and a failed company.
5. Depreciation
Depreciation allocates the cost of a long-lived asset across the periods it serves, matching cost to the revenue it helps produce.
Straight line:
A $54,000 roofing truck with a $9,000 salvage value and a 5-year life depreciates $(54{,}000 - 9{,}000) \div 5 = $9{,}000$ per year.
Accelerated methods (declining balance, sum-of-the-years'-digits) take more depreciation early, matching the heavier early productivity and repair profile of construction equipment. The federal Section 179 election and bonus depreciation let a contractor expense qualifying equipment in the year placed in service rather than spreading it — a tax timing decision, not an accounting-principle decision, and one to make with a CPA.
Depreciation is a non-cash expense. It reduces reported profit without reducing cash, which is why the cash flow statement adds it back.
6. The Ratios a Lender or Surety Reads
| Ratio | Formula | What it tells them |
|---|---|---|
| Current ratio | Current assets ÷ current liabilities | Short-term solvency; below 1.0 is a red flag |
| Quick ratio | (Cash + receivables) ÷ current liabilities | Solvency without relying on inventory or unbilled cost |
| Debt to equity | Total liabilities ÷ owner's equity | Leverage; high ratios limit bonding capacity |
| Gross margin % | Gross profit ÷ revenue | Pricing and production performance |
| Net margin % | Net profit ÷ revenue | Whether overhead is sized to the volume |
| Working capital turnover | Revenue ÷ working capital | Whether volume has outrun the capital supporting it |
| Return on equity | Net profit ÷ owner's equity | Whether the owner's capital is earning its keep |
A surety underwriting a payment and performance bond for a public works roofing project will look hardest at working capital, the debt-to-equity ratio, the WIP schedule, and whether the contractor's overbillings are funding operations.
7. Keeping Books a Third Party Can Read
Use a construction chart of accounts that separates direct job cost from G&A. Reconcile bank and credit card accounts monthly. Close the month within about two weeks and produce a WIP schedule with it. Have a CPA familiar with construction prepare at least an annual compiled or reviewed statement — CSLB, sureties, and lenders all want statements someone outside the company stands behind. And retain records: injury records five years, payroll records three years, and tax records generally at least four years after the return is filed.
A contractor has a $400,000 contract with total estimated costs of $320,000 and has incurred $208,000 of cost to date. Using cost-to-cost percentage of completion, how much revenue has been earned?
On the same contract, the contractor has billed the owner $290,000 while $260,000 of revenue has been earned. How is the $30,000 difference reported and what does it mean?
A roofing contractor buys a $54,000 service truck with an estimated salvage value of $9,000 and a five-year useful life. What is the annual straight-line depreciation?