Construction in progress is an asset to a business. If the business uses the asset, it will be a fixed asset. If the business is building assets under contract to sell, they are inventory assets. CIP accounting is important because it can easily be used to manipulate financial statements. As a result, auditors will scrutinize this account. Generally accepted accounting principles (GAAP) requires the percentage of completion in journal entries whenever possible to account for construction in progress.
CIP accounting describes the methods used to properly show construction in progress on the financial statements. Some of the costs of constructing additional PP&E (property, plant and equipment) are capitalized to depreciate over time, and some are expensed in the current accounting period. The capital costs are held in the construction in progress account. This is a fixed asset account and is shown on the balance sheet as a subaccount of property, plant and equipment. The capital costs include construction costs such as materials, labor and benefits, freight costs, interest incurred on construction loans, costs to prepare the site and professional fees related to the project. Expenses that are not specifically tied to the asset should be expensed in the accounting period they occur. This includes expenses that occur after construction is completed, but the asset isn't put in service yet.
Progress Versus Process
Rather than construction in progress, you might see construction in process on financial statements. They might be used interchangeably, or they might mean something else entirely to the two businesses. Some accounting advice points to using the word "progress" when the asset is being built for the business to put into use for itself, while "process" means an asset being built to sell to a customer. If the account shows up as a subaccount of PP&E, it is for the business to use itself. If it shows up as a subaccount of inventory assets, it is to be sold. The accounting for each is a little different.
Built for Business Use
CIP accounting for assets the business will use is fairly straightforward. The capital costs are debited to construction in progress and in most cases credited to accounts payable. The credit side of this entry might be to cash if paid for immediately or to the business's inventory if it used the inventory assets in the construction. This could occur, for example, if a building supply company determines that its cheapest route for drywall is to use its supply that it would normally sell in its normal business operations.
When the asset is completed, you will debit the appropriate PP&E account and credit the total amount held in CIP that relates to that specific asset. For example, Auto Parts Store builds an extra storage facility for its inventory. When the building is ready to move into, they will debit Buildings and credit Construction in Progress.
Built to Sell
Accounting for construction in progress when it is for an asset to be sold is slightly more complicated. GAAP dictate the use of the percentage-of-completion method. This is a method that attempts to match revenues to the expenses required to generate them. Construction of certain assets – naval ships, for example – can take several years. It would be unrealistic for the business to record no revenue for the years they are working on the ship and then record a few million dollars in the year the ship is finished. This would not give an accurate picture of the business's operations. Instead, they recognize revenue and expense by allocating it to accounting periods over the life of the project, based on how much of the project is finished.
Percentage of Completion Journal Entries
The business should decide on a method of allocating costs and remain consistent. Appropriate methods are the cost-to-cost method, the efforts-expended method and the units-of-delivery method. Cost-to-cost compares costs incurred to total expected costs. Efforts-expended is based on labor hours, machine hours or materials used compared to use expected. The units-of-deliver method is used when the contract is for several of the same assets. The percentage is multiplied by the expected gross profit of the project and recorded as revenue in that period. The percentage of completion journal entries would be as follows:
- To record construction costs, debit construction in process and credit A/P or cash.
- To record billings to the customer, debit contracts receivable, an accounts receivable asset and credit progress billings, a contra-asset account that offsets construction in process.
- To record the revenue earned, multiply percent complete by total contract price. Then debit construction in process and credit construction revenue.