A is for accounting: what grade does your accounting system merit?

Custom Home, July-August, 2004 by Steve Maltzman

You probably rely on report cards to find out how your kids are doing in school. But have you ever subjected your own business to the grading system? It could tell you where you are succeeding and where you need to improve. So I've devised a series of tests to help you rank your company's performance. These tests will help you evaluate the six key areas of financial management for a custom builder: accounting system, budgeting, job cost reporting, financial reporting, cash management, and tax planning.

In this column, we'll tackle accounting systems and what it takes to earn an A. We'll look into the other areas of the financial management report card in future columns.

There are four major areas of your accounting system that you should evaluate: chart of accounts, accounting method, internal controls, and system documentation. Within each of these categories are up to 10 items you should rate. For each of the items on this checklist, give your system a score of 0, 1, or 2 as follows:

0 System not in existence

1 System in existence but not consistently adhered to

2 System consistently adhered to

Chart of Accounts. The key to developing a successful accounting system begins with a chart of accounts that successfully addresses all aspects of your business. If the chart is not set up properly, your accounting system will not easily provide you with accurate and timely financial information. It is important to establish a chart of accounts that is specifically tailored to the custom building business so that your transactions will be posted into the proper category.

Grade the following five areas of your chart of accounts. (For a sample custom builder chart of accounts, visit my Web site at www.smaconsulting.net.)

0 1 2 My chart of accounts provides a systematic numbering structure for assets, liabilities, equity, income, cost of construction, and operating expenses.

0 1 2 It includes accounts for under billing (an asset account commonly known as costs in excess of earnings) and over billing (a liability account commonly known as billing in excess of costs).

0 1 2 It includes separate sales and cost of sales accounts for different types of work being performed (i.e., custom homes with land, custom homes on the customer's land, remodeling, spec homes).

0 1 2 Operating expenses are grouped into four main categories: sales and marketing, indirect construction costs (building-related costs that are not charged to specific jobs), financing expenses (for those custom builders who finance home construction), and general and administrative expenses.

0 1 2 Labor burden in the accounting system includes the same components that are used in your estimating system to develop your estimated labor rate.

Accounting Method. In my column on percentage-of completion accounting in the May/June 2004 issue of CUSTOM HOME ("Cash Flow," page 28) I discussed four different methods that are frequently used to recognize income, costs, and profits on construction contracts--cash, accrual, completed contract, and percentage of completion--and highlighted why the percentage-of-completion accounting method provides a custom builder with the best information to analyze the financial results of pre-sold homes.

Grade your accounting method:

0 1 2 Day-to-day accounting uses the accrual method of accounting.

0 1 2 Revenue and costs from pre-sold homes are accounted for using the percentage-of-completion method. Spec homes are accounted for using the completed contract method of accounting.

0 1 2 The monthly percentage-of-completion report includes current job cost estimates that are updated for both change orders and budget changes.

0 1 2 Revenue is 'adjusted monthly for over-or under-billings.

0 1 2 Information is captured that helps your tax preparer easily adjust the accounting records from percentage of completion to the method he uses to prepare tax returns.

Internal Controls. Maintaining a strong system of internal control procedures is a key ingredient of a strong accounting system. Internal controls should be designed to give you confidence that your company is producing reliable financial reports, encouraging effective and efficient operations, protecting assets, and ensuring compliance with laws and regulations. The accounting system must be set up in a way to deter employees from intentionally or unintentionally misappropriating company assets.

Grade your accounting system's internal control procedures:

0 1 2 Someone other than the accounting personnel who enters accounting data and writes checks signs each check and reviews the supporting detail to determine if the expense is appropriate and classified properly.

0 1 2 Bank statements and enclosures are reviewed by someone other than the person writing checks before accounting personnel receive it. This allows management to review enclosures for any unusual items. Managers also review the bank reconciliations after they are prepared.

0 1 2 Invoices for material purchases are compared against purchase orders and receiving tickets before being processed for payment. (If a committed cost system is not being used you can still earn one point if all invoices are compared to budget prior to processing.)