Welcome back to Part 2 of our Project Accounting series!
In our first article, we introduced you to the concept of Project Accounting and discussed what makes it different from generic Financial Accounting.
And today, we are going to dwell deep into the principles and methods used for Project Accounting. So sit tight!
Principles Of Project Accounting
As with all project management methods, Project Accounting also follows some principles to initiate, strategize and set up metrics for all the accounting that goes into any project.
These principles are put into place to better understand how to execute legal contracts, avoid creep in the scope of work, and close out projects timely with profits. There are 8 main principles used for Project Accounting, which are:
1. Cost Principle
Used during recording project costs, here you will use original costs instead of forecasted market costs. The idea is to record the actual cost your company has spent, not the potential cost the project might incur.
2. Matching Principle
This principle is used to match appropriate costs of revenue and expenses during the lifecycle of the project. This means you assign actual expenses incurred by your team during the execution of the project to match the given stage and period of the project.
3. Consolidation Principle
This principle allows you to group costs for all related tasks in a project. This helps keep the overall cost of the project consistent. To do this, you need to use a systematic process to identify revenue and cost with all team members as well as outside vendors to consolidate all financial activities for the project and document them under a single account.
4. Full Disclosure Principle
Anything of significance in project financial statements that may occur during the lifecycle of a project must be carefully recorded for transparent documentation. This keeps your project finances clean and truly helps with accountability when discussing project finances with CXOs, clients or stakeholders.
5. Prudence Principle
This principle comes into play so you can showcase the revenue and expenses best represented to estimate the actual revenue and costs that might occur during the lifecycle of the project.
6. Liability Principle
This principle allows you to define costs related to any future tasks/situations that may arise during a project. This can include but is not limited to contract penalties or liquidation damages that could be associated with any breach of contract. In simple words – these are costs you are liable for should they be incurred by your company.
7. Resource Allocation Principle
This principle is really helpful for allocating your resources more wisely. Using this, you can allocate your resources (i.e., your people) to more than one project. Managers get the freedom to allocate resources to various projects for financial benefit instead of allocating more money to save time.
8. Control Principle
These controls are put into place to monitor financial activity within a project so that it always follows stipulated regulations. Using this principle, managers can easily monitor and track the actual costs of a project to adjust or correct any non-recurring events, which helps keep tighter control over the budget.
Some Project Accounting Procedures That Work Best
As seen above, project accounting does share similar concepts to standard financial accounting. However, the intent and often the scale differs. With Project Accounting, tracking costs incurred during a project becomes just as important as tracking billing and revenue recognition for the project.
Unlike general financial accounting that tallies expenses, budgets and revenues across the company, Project Accounting goes a step further to maintain the budget within the project and reallocate finances or people to ensure profitability as well as delivery timeline.
Below, we discuss some project accounting methods that help keep your finances in better shape.
· Have a Separate System of Accounting
It is best to use a granular accounting method as this process is far more detailed and thorough than generic company finance tracking. It’s a good idea to use one program or software to complete all accounting processes for a project.
· Pay Attention to Reporting Frequency
Unlike generic accounting, projects require more frequent and detailed reporting to ensure that they are within budget, maintain the scope of work and will deliver the project on time. It’s a good idea to increase report frequency, particularly as a project comes to an end and the team is scrambling to meet all deliverables.
· Keep Reporting Simplified but Specific
The best way to create project-based financial reports is to determine KPIs (Key Performance Indicators) that are specific to that particular project. This allows managers to instantly notice which KPIs are not being met and address the issue immediately. For example, if a team member isn’t meeting a particular KPI, the manager can either allocate more resources or change the budget to fix the problem.
· Identify Project-Specific Transactions
This transaction identification process is very important to focus on project-specific transactions so they can be allocated to the appropriate cost centres.
· Forecasting Project Budget
Budgets change, and variances are common in the world of projects. Managers need to be able to forecast these changes in the budget to document financial progress as well as completed cost estimates.
· Focus on Resource Management
Making sure your resources are being used to the best of their ability is the key to success for any project-driven business. Keeping a closer eye on all internal and external resources, along with third-party materials, helps avoid spiralling costs that can throw off your budget.
What Are The Revenue Recognition Methods Used In Project Accounting?
Now that we understand what are some of the principles and procedures used for Project Accounting, let’s discuss the all-important Revenue Recognition Methods.
In project accounting, revenue recognition is based on what a client will pay for the project – either upfront, in parts, or when the final project has been delivered. The important thing to note is that Revenue Recognition only takes revenues into account when they have been earned.
The common revenue recognition methods used in project accounting are:
1. Sales Basis
The easiest method, this one recognises revenue as soon as the sale is made. This is the point of purchase for your revenue recognition. It may also be referred to as Billed revenue and can be in the form of both cash and credit for the goods/services to be delivered.
However, if the client has pre-paid for the service, your company will record the payment once the project has been delivered.
2. Instalment Basis
As the name suggests, the client will pay for the project in parts – or instalments. These instalments can be decided at the time of signing the contract and could be time-based or dependent on milestone deliverables.
This means that revenue is recognized as a percentage of total revenue as and when you earn it. There is some risk involved, as a client could default on an instalment at the due date.
3. Percentage of Completion
Very popular with long-term or large-scale projects, here the client pays your company based on the percentage of work completed. Essentially, that means your company will recognise revenue when you have delivered key milestones that showcase the project is progressing smoothly as planned.
This method has very clear and detailed contracts to state when revenue will be recognized, and also reduces some risk as you get paid for each deliverable when it occurs. This method is rather common in construction and engineering firms.
4. Completed Contract
The riskier option, here your company will only recognise revenue after the entire project is completed and delivered. Your payment is also based on how satisfied the client/stakeholders are with your delivered work.
This kind of method is only common for very small, short-term projects or when extended warranty comes into play. Sometimes, companies might use this method when they’re unable to meet the requirements of the percentage of completion method to be able to deliver quality work.
5. Cost Recoverability
This method is used when a company is unable to estimate or identify the cost of goods/services to be delivered.
This is a rather conservative approach for revenue recognition as you wait to be paid until your accountants have been able to tally all costs and bill the client.
Often, the cost recoverability method is used when you have understated revenue early on in the project and overstated it for your company’s future years.
We hope you enjoyed reading about the Principles, Procedures and Revenue Recognition Methods in Project Accounting. For our next article, we will be discussing the benefits of Project Accounting, some best practices, as well as the role a project accountant plays in ensuring that your project finances are always on track. Stay tuned!
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