@ WILEY FINANCIAL MANAGEMENT AND ACCOUNTING FUNDAMENTALS FOR CONSTRUCTION

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1 FINANCIAL MANAGEMENT AND ACCOUNTING FUNDAMENTALS FOR CONSTRUCTION DANIEL W. HALPIN, PURDUE UNIVERSITY BOLIVAR A. SENIOR, COLORADO STATE WILEY JOHN WILEY & SONS, INe.

2 CONTENTS PREFACE 1 INTRODUCTION The Big Paradox / 1 What Is Financia1 Management? / 2 First Stop: Financia1 Accounting / 2 Why Construction Accounting Is Different from Accounting in Other Business Sectors / 4 Who Is at Risk? / 5 Projects: The Output of the Construction Process / 6 Project-Leve1 Contro1s / 7 Time Va1ue of Money / 8 Entrepreneurial Issues / 8 Review Questions and Exercises / 9 ix 1 2 linderstanding FINANCIAL STATEMENTS Introduction / 11 Why Shou1d You Care about Accounting? / 12 Generally Accepted Accounting Principles / 12 Cash and Accrua1 Bases: Two Ways to Look at Accounting / 13 Cash Basis of Accounting / 14 Accrua1 Basis of Accounting / 15 11

Accounts / 16 Account Hierarchy / 16 Financial Reports / 17 Bookkeeping / 19 The Balance Sheet / 20 Balance Sheet Layout / 21 Balance Sheet Account Categories in Detail / 21 The Fundamental

3 Accounts / 16 Account Hierarchy / 16 Financial Reports / 17 Bookkeeping / 19 The Balance Sheet / 20 Balance Sheet Layout / 21 Balance Sheet Account Categories in Detail / 21 The Fundamental Accounting Equation / 22 Asset Values / 23 The Fundamental Equation and Owners' Risk / 24 Balance Sheet for Fudd Associates, Inc. / 24 Key Accounts / 26 The Income Statement / 29 Components of an Income Statement - More Details / 32 The Statement of Cash Flows / 35 Contract Backlog / 37 Public Corporations / 38 Review Questions and Exercises / 39 3 ANAlYZING COMPANY FINANCIAl DATA 43 Introduction / 43 Vertical and Horizontal Analyses / 44 Vertical Analysis: Financial Ratios / 44 Liquidity Indicators: Can This Company Get Cash in a Hurry? / 45 Current Ratio / 45 Quick Ratio / 46 Working Capital / 47 Profitability Indicators: Is This Company Making Enough Profit? / 48 Return on Equity / 48 Return on Revenue / 50 Return on Assets / 51 Earnings Per Share / 51 Efficiency Indicators: How Long Does It Take a Company to Turn over Its Money? / 52 Average Age of Inventory / 53 Average Age of Accounts Receivable (Collection Period) / 55 Average Age of Accounts Payable / 56 Other Average Ages / 57 Operating Cycle / 57

4 Turnover Ratios / 58 Revenue to Assets Turnover / 58 Capital Structure Indicators: How Committed Are the Owners? / 59 Debt to Equity / 60 Assets to Equity (Leverage) / 60 Other Indicators / 60 Horizontal Analysis: Tracking Financial Trends / 62 Time Series Graphs / 62 Index-Number Trend Series / 63 Conclusion / 63 Review Questions and Exercises / 64 4 ACCOUNTING BASICS 71 Introduction / 71 Transaction Processing / 71 Journalizing the Transaction / 73 A Transaction to Enter Initializing Capital / 74 A Vendor Billing Transaction / 74 A Billing to the Client / 76 Posting Entries to the Ledger / 78 Relationship ofwork-in-pragress and RevenuelExpense Accounts / 80 Closing the Accounting Cycle / 82 Recognition of lncome / 83 Percentage-of-Completion Method of Income Recognition / 83 Completed-Contract Method of Income Recognition / 85 Transactions during aperiod / 86 Posting to the General Ledger during the Accounting Period / 88 Closing Actions at the End of the Period / 91 Review Questions and Exercises / 93 5 PROJECT LEVEL COST CONTROL Objectives of Praject-Level Cost Contral in Construction / 97 Unique Aspects of Construction Cost ContraI / 98 Types of Costs / 99 The Construction Estimate / 99 Cost Control System / 101 Building a Cost Contral System / 101 Cost Accounts / 103 Cost Account Structure /

5 Project Cost Code Structure / 106 Cost Accounts for Integrated Project Management / 110 Earned Value Analysis / 113 Labor Data Cost Collection / 122 Review Questions and Exercises / FORECASTING FINANCIAL NEEDS 129 Importance of Cash Management / 129 Understanding Cash Flow / 129 Retainage / 131 Project Cost, Value, and Cash Profiles / 131 Cash Flow Calculation-A Simple Example / 133 Peak Financial Requirements / 136 Getting Help from the Owner / 137 Optimizing Cash Flow / 138 Project Cash Flow Estimates / 141 Using Software for Cash Flow Computations / 144 Company-Level Cash Flow Planning / 145 Strategic Cash Flow Management: "Cash Farming" / 145 Project and General Overhead / 146 Fixed Overhead / 148 Considerations in Establishing Fixed Overhead / 149 Breakeven Analysis / 151 Basic Relationships Governing the Breakeven Point / 154 Review Questions and Exercises / TIME VALUE OF MONEY AND EVALUATING INVESTMENTS 161 Introduction / 161 Time Value of Money / 162 Interest / 162 Simple and Compound Interest / 163 Nominal and Effective Rate / 165 Equivalence and MARR / 166 Discount Rate / 167 Importance of Equivalence / 167 Inflation / 168 Sunk Costs / 169 Cash Flow Diagrams / 169 Annuities / 171

6 Conditions for Annuity Calcu1ations / 173 Calcu1ating the Future Va1ue of ascries of Payments / 174 Summary of Equivalence Formulas / 175 Worth Analysis Techniques: An Overview / 176 Present Worth Analysis / 179 Investments with Different Life Spans / 180 Equivalent Annual Worth (EAW) / 181 Internal Rate of Return / 183 Limitations of the IRR Method / 185 An Example Invo1ving Cost Recovery / 186 Comparison Using EAW / 188 An IRR Example-Owner Financing Using Bonds / 191 Review Questions and Exercises / CONSTRUCTION LOANS AND CREDIT Introduction / 199 The Construction Financing Process / 200 A Sampie Developmenta1 Project / 202 The Amount of the Loan / 204 How Is the Cap Rate Determined? / 205 Mortgage Loan Commitment / 206 Construction Loan / 206 Commercial Lenders / 208 Lines of Credit / 209 Interest Paid on Outstanding Balance / 210 Commitment Fees / 211 Compensating Balances / 211 Clean-Up Requirement / 212 Collaterals / 212 Accounts Receivab1e Financing / 213 Trade Credits / 213 Long Term Financing / 215 Loans with End-of-Term Balloon Payments / 216 Review Questions and Exercises / THE IMPACT OF TAXES Introduction / 219 Types of Taxes /

Jncome Tax Systems / 221 Alternatives for Company Legal Organization / 221 Sole Proprietorships / 222 Partnerships / 222 Corporations / 222 Limited Liability Partnerships and Companies / 223 Other

7 Jncome Tax Systems / 221 Alternatives for Company Legal Organization / 221 Sole Proprietorships / 222 Partnerships / 222 Corporations / 222 Limited Liability Partnerships and Companies / 223 Other Options / 224 Taxation of Business / 224 Business Deductions in General / 227 Taxable Income: Individuals / 227 Itemized Deductions, Standard Deductions, and Personal Exemptions / 228 The Tax Significance of Depreciation / 229 Calculating Depreciation / 230 Straight Line Method / 231 The Production Method / 232 Depreciation Based on Current Law / 233 Marginal Tax Rates / 235 Tax Credits / 238 Tax Payroll Withholding / 239 Tax Payment Schedules / 239 Marginal, Average, and Effective Tax Rates / 239 Net Operating Losses / 240 Taxes on Dividends and Long-Term Capital Gains / 242 Alternative Minimum Tax / 242 Summary / 243 Review Questions and Exercises / 243 APPENDIX A TYPICAL CHART OF ACCOUNTS 247 APPENDIX B FURTHER ILLUSTRATIONS OF TRANSACTIONS 251 APPENDIX C COMPOUND INTEREST TABLES 275 REFERENCES 301 INDEX 305

DANIEL W. HALPIN, PURDUE UNIVERSITY BOLIVAR A. SENIOR, COLORADO STATE UNIVERSITY JOHN WILEY & SONS, INC.

FINANCIAL MANAGEMENT AND ACCOUNTING FUNDAMENTALS FOR CONSTRUCTION DANIEL W. HALPIN, PURDUE UNIVERSITY BOLIVAR A. SENIOR, COLORADO STATE UNIVERSITY JOHN WILEY & SONS, INC. This book is printed on acid-free