Accounting in Construction Companies

Nigerian construction firms typically manage and report contingent liabilities related to project risks in line with local and international accounting standards, as well as industry best practices. An overview of how they handle these liabilities are as follows:

1. Risk Identification and Assessment

Construction firms first identify potential project risks, which may include cost overruns, legal disputes, environmental issues, or delays. Once identified, they assess the likelihood and impact of these risks materializing into actual liabilities.

2. Risk Management Strategies

To manage contingent liabilities, Nigerian construction firms implement several risk mitigation measures, including:

1. Insurance: Many firms take out construction-specific insurance policies (e.g., public liability, professional indemnity, contractor’s all-risk insurance) to cover potential financial impacts.
2. Risk Sharing: Contracts often include clauses that shift or share the burden of certain risks with clients, subcontractors, or suppliers through indemnity or performance bond agreements.
3. Project Management Systems: Using sophisticated project management tools, firms closely monitor project progress and manage risks through early intervention and resource allocation.
4. Diversification: Firms may spread their risks by diversifying their project portfolios geographically or by sector.

3. Accounting for Contingent Liabilities

According to International Financial Reporting Standards (IFRS), which Nigeria has adopted, contingent liabilities are recognized and disclosed based on their likelihood:

1. Probable Liabilities: If the probability of an unfavourable outcome is high and the amount can be reasonably estimated, the company records the liability in its financial statements.
2. Possible Liabilities: If the likelihood is lower but still possible, the firm discloses it as a note to the financial statements without recording it on the balance sheet.
3. Remote Liabilities: If the likelihood of the liability occurring is remote, no reporting or disclosure is required.

4. Reporting in Financial Statements

Contingent liabilities are reported in line with IAS 37 (Provisions, Contingent Liabilities, and Contingent Assets). Nigerian construction firms:

1. Disclose the nature of the contingent liability.
2. Estimate the potential financial impact of thematerial.
3. Explain any mitigating factors, such as insurance or contractual risk-sharing mechanisms.
4. Update these disclosures periodically based on new information or changes in project status.

5. Compliance with Local Regulations

Construction firms in Nigeria must also comply with regulations set by the Financial Reporting Council of Nigeria (FRCN). This includes adhering to local standards and practices for corporate governance and financial disclosures andensuring transparency in risk reporting.

6. Use of External Auditors

Firms may engage external auditors to review and validate the accuracy of reported contingent liabilities. Auditors assess the company’s risk management framework and how it reflects on the financial statements.

7. Communication with Stakeholders

Construction firms frequently communicate contingent liabilities to key stakeholders, such as investors, lenders, and regulatory bodies, through annual reports, project updates, and disclosures. Effective communication ensures that all stakeholders are aware of potential risks.

By employing these methods, Nigerian construction firms can manage and report contingent liabilities in a way that reduces financial exposure while maintaining compliance with regulatory and accounting standards.

In construction projects, accounting practices for tracking project budgets and actual costs are crucial for maintaining financial control and ensuring profitability. The following are common accounting practices used by construction firms to manage project budgets and actual costs:

1. Job Costing System

1. A job costing system tracks expenses for individual projects or jobs. This method allocates direct costs (e.g., labor, materials) and indirect costs (e.g., overhead) to specific projects.
2. Usage: Each project is treated as a separate “job,” and costs are tracked under that job number. This enables construction firms to monitor project-specific expenses and compare them with the allocated budget.
3. Benefits: It helps firms accurately calculate project profitability and identify cost overruns early.

2. Cost Codes

1. Cost codes are a system of categorizing costs by type (e.g., labor, materials, equipment, subcontractor fees).
2. Usage: Construction firms use cost codes to track actual costs against budgeted amounts for each type of expense within a project. For example, labor costs may have one code, while material costs have another.
3. Benefits: This system allows for detailed tracking of different cost categories, making it easier to identify areas where budgets may be exceeded.

3. Progress Billing

1. Progress billing involves invoicing clients incrementally based on the percentage of work completed.
2. Usage: Firms bill customers at various stages of a project, typically aligning with project milestones or completion percentages. This approach helps maintain cash flow and ensures payments align with project costs.
3. Benefits: It provides real-time financial tracking and ensures that firms receive payments in line with project progress, reducing the risk of cash flow problems.

4. Percentage of Completion Method (PCM)

1. This accounting method recognizes revenue and expenses in proportion to the work completed during a specific period.
2. Usage: Firms estimate the total cost of a project and recognize income and expenses over time based on how much of the project is completed. This approach allows for more accurate financial reporting in long-term contracts.
3. Benefits: PCM provides a clear picture of profitability and helps match revenue with project progress, reducing the risk of financial surprises.

5. Earned Value Management (EVM)

1. EVM is a project management technique that integrates scope, cost, and schedule to assess project performance.
2. Usage: EVM calculates performance metrics like the Cost Performance Index (CPI) and Schedule Performance Index (SPI) to compare budgeted costs to actual costs at specific points in a project.
3. Benefits: It helps firms assess whether a project is on track or if corrective actions are needed, offering a proactive approach to managing costs and timelines.

6. Variance Analysis

1. Variance analysis involves comparing actual project costs to the budgeted costs to identify discrepancies.
2. Usage: Construction firms regularly conduct variance analyses, comparing actual spending against the project budget to identify cost overruns or savings. They analyze these variances to understand the reasons and take corrective action if necessary.
3. Benefits: This method allows close monitoring of cost trends and helps firms maintain control over project finances.

7. Work-in-Progress (WIP) Reporting

1. WIP reports track the costs of ongoing construction projects, including the percentage of completion, billed amounts, and recognized revenues.
2. Usage: Construction firms use WIP reports to track ongoing project expenses and revenues over time. It’s crucial for aligning costs with revenue recognition in long-term contracts.
3. Benefits: WIP reporting provides real-time insights into project profitability and financial health, enabling better forecasting and financial decision-making.

8. Change Order Tracking

1. Change orders are modifications to the original scope of work, which result in changes to the project budget and timeline.
2. Usage: Construction firms track all approved change orders to adjust project budgets and schedules accordingly. This ensures that any additional costs are captured and billed to the client.
3. Benefits: Accurate tracking of change orders ensures that all extra work is compensated, preventing budget shortfalls.

9. Budget Forecasting and reforecasting

1. Budget forecasting involves estimating future project costs based on current progress while re-forecasting updates these estimates as the project progresses.
2. Usage: Firms create initial project budgets and periodically update them based on actual costs and expected future expenses. Reforecasting is especially important for long-term projects that may face changes in scope or market conditions.
3. Benefits: Ongoing forecasting helps prevent surprises, ensuring that project managers can adjust financial strategies to stay within the budget.

10. Retention Accounting

1. Retention refers to a portion of the payment withheld by the client until the project is completed or meets specific milestones.
2. Usage: Construction firms track retention amounts and recognize revenue only when the retention is released after completing the project or meeting specific conditions.
3. Benefits: This ensures that firms don’t prematurely recognize revenue, helping align cash flow and financial reporting with project performance.

11. Indirect Cost Allocation

1. Indirect costs (e.g., overhead, administrative expenses) are those not directly attributable to a single project but are spread across multiple projects.
2. Usage: Firms allocate indirect costs using various methods, such as dividing them based on labor hours, project size, or a flat percentage. Accurate allocation ensures that no project is disproportionately burdened with indirect costs.
3. Benefits: Proper allocation of overhead and other indirect costs improves the accuracy of project cost tracking and financial statements.

12. Time and Material (T&M) Accounting

1. T&M contracts involve billing clients based on the actual time spent and materials used.
2. Usage: Construction firms track the actual hours worked and materials used on a project and bill the client accordingly. T&M contracts are common in smaller projects or when the scope of work is uncertain.
3. Benefits: This method provides transparency and flexibility in project billing, ensuring that clients pay for the actual work performed.

The impairment of construction-related assets is assessed and reported under IAS 36 (Impairment of Assets), which provides guidelines on how to ensure that assets are not carried at more than their recoverable amount. In a volatile economic environment, where market conditions can fluctuate significantly, construction firms must be particularly vigilant about monitoring and reporting asset impairments. The process involves the following:

1. Identification of Construction-Related Assets Subject to Impairment

Construction firms hold a variety of assets that may be subject to impairment, such as:

1. Property, Plant, and Equipment (PPE): Heavy machinery, tools, and equipment.
2. Intangible Assets: Goodwill, licenses, permits, or construction-related technology.
3. Inventory and Work in Progress (WIP): Unfinished projects, raw materials, and components.
4. Receivables: Outstanding payments from clients.

Firms must regularly assess whether there are indications that these assets may be impaired, particularly in a volatile economic environment where:

• Project cancellations or delays are more frequent.
• Client defaults increase, leading to potential bad debts.
• Market values of assets fluctuate due to changes in demand or economic instability.

2. Indicators of Impairment

Under IAS 36, firms need to assess for external and internal indicators that could signal impairment. These indicators might be more common in a volatile economic environment:

1. External Indicators: Decline in market prices of construction assets, increases in interest rates that affect the discount rate, or unfavorable changes in regulatory or economic conditions (e.g., inflation, currency devaluation).
2. Internal Indicators: Physical damage to equipment, reduced utilization of assets due to project cancellations or reduced demand, or declining cash flows from construction contracts.

3. Measuring the Recoverable Amount

When there is an indication of impairment, IAS 36 requires construction firms to estimate the recoverable amount of the asset. The recoverable amount is the higher of:

1. Fair Value Less Costs of Disposal (FVLCD): The price the asset would fetch in an arm's length transaction, minus any costs associated with selling the asset.
2. Value in Use (VIU): The present value of future cash flows expected to arise from the asset's continued use and eventual disposal.

In a volatile economic environment, the estimation of these values can become challenging:

1. Fair Value: May fluctuate significantly due to market instability. Firms may rely on market comparables, independent valuations, or adjusted historical prices.
2. Value in Use: This is based on future cash flow projections, which are often difficult to predict in unstable markets. The discount rates used may also be higher due to increased economic risks, reducing the value of future cash flows.

4. Impairment Testing for Cash-Generating Units (CGUs)

Construction-related assets that do not generate independent cash flows are grouped into Cash-Generating Units (CGUs). For example, a piece of construction equipment may be used in multiple projects, making it difficult to assess impairment at the individual asset level. CGUs are tested for impairment when there are indicators of a decline in performance or profitability.

In a volatile economy, CGUs such as entire project teams or segments of a construction firm might face impairment due to:

• Declining contract values.
• Project cancellations or reduced bidding opportunities.
• Increasing material or labor costs that reduce profitability.

5. Impairment Loss Recognition

If the carrying amount of an asset or CGU exceeds its recoverable amount, an impairment loss is recognized. This is recorded as an expense in the firm’s profit or loss statement, reducing the carrying amount of the asset or CGU on the balance sheet.

For construction firms, this means:

1. Property, Plant, and Equipment (PPE): If a piece of machinery’s market value drops below its book value due to reduced demand in construction services, the firm must recognize the impairment.
2. Work in Progress (WIP): If an ongoing project’s expected revenues fall short of covering costs due to economic downturns, the WIP may need to be impaired.
3. Goodwill or Intangible Assets: In an environment where construction firms face increased competition or project delays, the value of acquired intangibles (such as construction permits or goodwill from past acquisitions) may need to be written down.

6. Reversal of Impairment

IAS 36 allows for the reversal of impairment losses if the recoverable amount of an asset increases after an impairment has been recognized. For example, if market conditions improve or the value of a construction asset appreciates due to a surge in demand, the impairment loss may be reversed, except in the case of goodwill.

However, the reversal should not increase the carrying amount of an asset beyond what it would have been if the impairment had not occurred.

7. Disclosure Requirements

IAS 36 mandates detailed disclosures when impairment losses are recognized or reversed, particularly in volatile conditions. Construction firms must disclose:

• The events and circumstances leading to the impairment.
• The amount of the impairment loss and the assets affected.
• The method used to determine the recoverable amount (fair value or value in use).
• Key assumptions used in cash flow projections, particularly in volatile economies (e.g., discount rates, growth assumptions).

8. Challenges in a Volatile Economic Environment

In volatile economies, the following challenges make impairment assessment more difficult

1. Uncertainty in Cash Flows: Economic instability leads to uncertainty in forecasting project revenues, completion timelines, and overall cash inflows from contracts.
2. Increased Risk in Estimations: The discount rate used in value-in-use calculations may rise to reflect greater risk, resulting in lower recoverable amounts.
3. Market Volatility: The market value of construction assets may fluctuate unpredictably, making fair value less reliable as a benchmark for asset valuation.

Conclusion

In accordance with IAS 36, construction firms operating in volatile economic environments must be proactive in assessing the impairment of their assets. This involves a thorough review of external and internal factors affecting asset values, careful calculation of recoverable amounts, and adherence to detailed disclosure requirements. The dynamic nature of the construction industry, coupled with economic fluctuations, necessitates regular and precise impairment testing to ensure financial statements accurately reflect the true value of assets.