The cost accounts described in the previous sections provide only one of the various components in a financial accounting system. Before further discussing the use of cost accounts in project control, the relationship of project and financial accounting deserves mention. Accounting information is generally used for three distinct purposes:

• Internal reporting to project managers for day-to-day planning, monitoring and control.
• Internal reporting to managers for aiding strategic planning.
• External reporting to owners, government, regulators and other outside parties.

External reports are constrained to particular forms and procedures by contractual reporting requirements or by generally accepted accounting practices. Preparation of such external reports is referred to as financial accounting. In contrast, cost or managerial accounting is intended to aid internal managers in their responsibilities of planning, monitoring and control.

Project costs are always included in the system of financial accounts associated with an organization. At the heart of this system, all expense transactions are recorded in a general ledger. The general ledger of accounts forms the basis for management reports on particular projects as well as the financial accounts for an entire organization. Other components of a financial accounting system include:

• The accounts payable journal is intended to provide records of bills received from vendors, material suppliers, subcontractors and other outside parties. Invoices of charges are recorded in this system as are checks issued in payment. Charges to individual cost accounts are relayed or posted to the General Ledger.
• Accounts receivable journals provide the opposite function to that of accounts payable. In this journal, billings to clients are recorded as well as receipts. Revenues received are relayed to the general ledger.
• Job cost ledgers summarize the charges associated with particular projects, arranged in the various cost accounts used for the project budget.
• Inventory records are maintained to identify the amount of materials available at any time.

In traditional bookkeeping systems, day to day transactions are first recorded in journals. With double-entry bookkeeping, each transaction is recorded as both a debit and a credit to particular accounts in the ledger. For example, payment of a supplier's bill represents a debit or increase to a project cost account and a credit or reduction to the company's cash account. Periodically, the transaction information is summarized and transferred to ledger accounts. This process is called posting, and may be done instantaneously or daily in computerized systems.

In reviewing accounting information, the concepts of flows and stocks should be kept in mind. Daily transactions typically reflect flows of dollar amounts entering or leaving the organization. Similarly, use or receipt of particular materials represent flows from or to inventory. An account balance represents the stock or cumulative amount of funds resulting from these daily flows. Information on both flows and stocks are needed to give an accurate view of an organization's state. In addition, forecasts of future changes are needed for effective management.

Information from the general ledger is assembled for the organization's financial reports, including balance sheets and income statements for each period. These reports are the basic products of the financial accounting process and are often used to assess the performance of an organization. Table12-5 shows a typical income statement for a small construction firm, indicating a net profit of $ 330,000 after taxes. This statement summarizes the flows of transactions within a year. Table 12-6 shows the comparable balance sheet, indicated a net increase in retained earnings equal to the net profit. The balance sheet reflects the effects of income flows during the year on the overall worth of the organization.

In the context of private construction firms, particular problems arise in the treatment of uncompleted contracts in financial reports. Under the "completed-contract" method, income is only reported for completed projects. Work on projects underway is only reported on the balance sheet, representing an asset if contract billings exceed costs or a liability if costs exceed billings. When a project is completed, the total net profit (or loss) is reported in the final period as income. Under the "percentage-of-completion" method, actual costs are reported on the income statement plus a proportion of all project revenues (or billings) equal to the proportion of work completed during the period. The proportion of work completed is computed as the ratio of costs incurred to date and the total estimated cost of the project. Thus, if twenty percent of a project was completed in a particular period at a direct cost of $180,000 and on a project with expected revenues of $1,000,000, then the contract revenues earned would be calculated as $1,000,000(0.2) = $200,000. This figure represents a profit and contribution to overhead of $200,000 - $180,000 = $20,000 for the period. Note that billings and actual receipts might be in excess or less than the calculated revenues of $200,000. On the balance sheet of an organization using the percentage-of-completion method, an asset is usually reported to reflect billings and the estimated or calculated earnings in excess of actual billings.

As another example of the difference in the "percentage-of-completion" and the "completed-contract" methods, consider a three year project to construct a plant with the following cash flow for a contractor:

The supervising architect determines that 60% of the facility is complete in year 1 and 75% in year 2. Under the "percentage-of-completion" method, the net income in year 1 is $780,000 (60% of $1,300,000) less the $700,000 in expenses or $80,000. Under the "completed-contract" method, the entire profit of $100,000 would be reported in year 3.

The "percentage-of-completion" method of reporting period earnings has the advantage of representing the actual estimated earnings in each period. As a result, the income stream and resulting profits are less susceptible to precipitate swings on the completion of a project as can occur with the "completed contract method" of calculating income. However, the "percentage-of-completion" has the disadvantage of relying upon estimates which can be manipulated to obscure the actual position of a company or which are difficult to reproduce by outside observers. There are also subtleties such as the deferral of all calculated income from a project until a minimum threshold of the project is completed. As a result, interpretation of the income statement and balance sheet of a private organization is not always straightforward. Finally, there are tax disadvantages from using the "percentage-of-completion" method since corporate taxes on expected profits may become due during the project rather than being deferred until the project completion. As an example of tax implications of the two reporting methods, a study of forty-seven construction firms conducted by the General Accounting Office found that $280 million in taxes were deferred from 1980 to 1984 through use of the "completed-contract" method.

It should be apparent that the "percentage-of-completion" accounting provides only a rough estimate of the actual profit or status of a project. Also, the "completed contract" method of accounting is entirely retrospective and provides no guidance for management. This is only one example of the types of allocations that are introduced to correspond to generally accepted accounting practices, yet may not further the cause of good project management. Another common example is the use of equipment depreciation schedules to allocate equipment purchase costs. Allocations of costs or revenues to particular periods within a project may cause severe changes in particular indicators, but have no real meaning for good management or profit over the entire course of a project. As Johnson and Kaplan argue:

Today's management accounting information, driven by the procedures and cycle of the organization's financial reporting system, is too late, too aggregated and too distorted to be relevant for managers' planning and control decisions....

Management accounting reports are of little help to operating managers as they attempt to reduce costs and improve productivity. Frequently, the reports decrease productivity because they require operating managers to spend time attempting to understand and explain reported variances that have little to do with the economic and technological reality of their operations...

The managagement accounting system also fails to provide accurate product costs. Cost are distributed to products by simplistic and arbitrary measures, usually direct labor based, that do not represent the demands made by each product on the firm's resources.

As a result, complementary procedures to those used in traditional financial accounting are required to accomplish effective project control, as described in the preceding and following sections. While financial statements provide consistent and essential information on the condition of an entire organization, they need considerable interpretation and supplementation to be useful for project management.

Example 12-5: Calculating net profit

As an example of the calculation of net profit, suppose that a company began six jobs in a year, completing three jobs and having three jobs still underway at the end of the year. Details of the six jobs are shown in Table 12-7. What would be the company's net profit under, first, the "percentage-of-completion" and, second, the "completed contract method" accounting conventions?

TABLE 12-7  Example of Financial Records of Projects

Net Profit on Completed Contracts (Amounts in thousands of dollars)
Job 1 Job 2 Job 3     Total Net Profit on Completed Jobs	$1,436 356      - 738 $1,054
Status of Jobs Underway	Job 4	Job 5	Job 6
Original Contract Price Contract Changes (Change Orders, etc.) Total Cost to Date Payments Received or Due to Date Estimated Cost to Complete	$4,200 400 3,600 3,520 500	$3,800 600 1,710 1,830 2,300	$5,630 - 300 620 340 5,000

As shown in Table 12-7, a net profit of $1,054,000 was earned on the three completed jobs. Under the "completed contract" method, this total would be total profit. Under the percentage-of completion method, the year's expected profit on the projects underway would be added to this amount. For job 4, the expected profits are calculated as follows:

Current contract price	= Original contract price + Contract Changes = 4,200 + 400 + 4,600
Credit or debit to date	= Total costs to date - Payments received or due to date = 3,600 - 3,520 = - 80
Contract value of uncompleted work	= Current contract price - Payments received or due = 4,600 - 3,520 = 1,080
Credit or debit to come	= Contract value of uncompleted work - Estimated Cost to Complete = 1,080 - 500 = 580
Estimated final gross profit	= Credit or debit to date + Credit or debit to come = - 80. + 580. = 500
Estimated total project costs	= Contract price - Gross profit = 4,600 - 500 = 4,100
Estimated Profit to date	= Estimated final gross profit x Proportion of work complete = 500. (3600/4100)) = 439

Similar calculations for the other jobs underway indicate estimated profits to date of $166,000 for Job 5 and -$32,000 for Job 6. As a result, the net profit using the "percentage-of-completion" method would be $1,627,000 for the year. Note that this figure would be altered in the event of multi-year projects in which net profits on projects completed or underway in this year were claimed in earlier periods.