Managing Estimated Cost on Uncompleted Contracts

When preparing a work-in-process (WIP) schedule, it is essential to ensure that estimated costs to complete on uncompleted contracts are accurate.

These estimates provide users of the financial statements, such as banks, bonding companies and other business partners, with insight into the status of the contract based on the percentage completed and whether the specific project is anticipated to be profitable using the cost-to-cost input method from ASC 606 (costs incurred to date / total estimated costs). Inaccuracies with estimated costs to complete can mislead financial statements users and create significant operational and financial risks.

Consequences of Inaccurate Estimated Costs to Complete

Inaccurate estimates can result in:

• • Non-compliance with loan covenants and bonding capacity
  • Misallocation of resources, project delays and disputes with contract owners and subcontractors
  • Misguided project manager expectations due to incorrect percentage-of-completion calculation
  • Cash flow and budgeting challenges
  • Damage to the company reputation, growth and business relationships
  • Misleading financial statements user
  • Erosion of trust with investors and stakeholders
  • Increased audit scrutiny due to inconsistent estimates affecting revenue year over year

Effects of Overestimating Estimated Costs to Complete

• • Understating the job completion percentage prematurely (higher total cost drives down the percent completed)
  • Understating current-year revenue, showing a weaker income statement and deferring revenue to future periods due to a lower percent completed than what it should be
  • Understating costs relative to billings, deflating contract-related assets
  • Overstating billings relative to costs, inflating contract-related liabilities

Effects of Understating Estimated Costs to Complete

• • Overstating the job completion percentage prematurely (lower total costs will drive up the percent completed)
  • Overstating current-year revenue and creating potential future losses due to inflated percentage completed
  • Overstating costs relative to billings, inflating contract-related assets
  • Understating billings relative to costs, deflating contract-related liabilities

Accurate estimated costs to complete on uncompleted contracts will alleviate the potential issues listed above and eliminate potential future risks. By implementing an effective cost-to-cost input method and regularly updating estimates based on current progress and actual costs incurred, estimated costs to complete will consistently be up-to-date and accurate for each closing period. This can be achieved in various ways.

Best Practices for Estimated Costs to Complete

• • Use reliable project management software and detailed job costing records
  • Maintain consistent communication with project managers throughout the duration of the contract to track status, potential issues, changes in scope and expected completion timing
  • Review contract costs, such as subcontractor, materials, and labor, timely and routinely
  • Assess potential risks of litigation
  • Perform month-to-month analytical comparisons of actual vs. estimated costs (i.e. gross profit fade and gain analysis)
  • Consider if materials and labor costs align with the actual status of the contract

Benefits of Accurate Estimated Costs to Complete

• • Clear understanding of contract status
  • Improved use of resources (labor, materials, etc.)
  • Accurate budgeting and forecasting
  • Reliable financial statements
  • Increased trust with investors, stakeholders and financial statement users
  • Enhanced company reputation and stronger business relationships
  • Ability to support sustainable company growth

Overall, accuracy in estimating costs to complete on uncompleted contracts is essential for any company seeking to grow and maintain positive working relationships with the users of the financial statements. Maintaining reliable financial statements ensures that banks, bonding companies, stakeholders and other third parties can make informed decisions based on accurate information. Regularly updating estimates and adhering to best practices not only protects your company from financial and operational risks but also strengthens trust and confidence in your organization.

Contributing author: Joseph Chemotti, CPA, CCIFP, is an audit partner and a chief financial officer (CFO) with 34 years of experience providing auditing, accounting and consulting services to a wide range of privately-held companies. He has deep expertise in the construction industry, assisting clients with complex accounting issues, financial reporting, and operational guidance to maximize banking and bonding capacity and improve overall profitability. For more information on this topic, you may contact Joe at jchemotti@dmcpas.com or (315) 472-9127.