CC AA OONNSSTTRRUUCCTTIIOONN CCCCOOUUNNTTIINNGG FF MM AANNDD IINNAANNCCIIAALL AANNAAGGEEMMEENNTT SECOND EDITION Steven J. Peterson, MBA, PE Weber State University Prentice Hall Upper Saddle River, New Jersey Columbus, Ohio Library of Congress Cataloging-in-Publication Data Peterson, Steven J. Construction accounting and financial management / Steven J. Peterson. 2nd ed. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-13-501711-1 ISBN-10: 0-13-501711-4 1. Construction industry—Accounting. 2. Construction industry—Finance. 3. Managerial accounting. I. Title. HF5686.B7P48 2009 624(cid:2).0681—dc22 2008019396 Vice President and Executive Publisher: Cover Designer:Bruce Kenselaar Vernon R. Anthony Cover Image: Getty Images, Inc. Acquisitions Editor:Eric Krassow Director of Marketing:David Gesell Editorial Assistant:Sonya Kottcamp Marketing Manager:Derril Trakalo Production Manager:Wanda Rockwell Marketing Coordinator:Alicia Dysert Creative Designer:Jayne Conte This book was set in 10/12 ITC Mendoza Roman Book by Aptara®, Inc. It was printed and bound by Hamilton Printing Company. The cover was printed by Phoenix Color Corp. Microsoft® Excel is a trademark of the Microsoft Corporation. Microsoft product screen shot(s) reprinted with permis- sion from Microsoft Corporation. DISCLAIMER:The sample Excel spreadsheets in this book are to provide the reader with examples of how Excel may be used in accounting and finance, and as such, are designed for a limited number of accounting and finance situations. Before using the spreadsheets in this book, the reader should understand the limits of the spreadsheet and carefully verify that the spreadsheets (1) are applicable to their situation and (2) produce an acceptable answer. The reader assumes all risks from the use and/or performance of these spreadsheets. Copyright © 2009, 2005 by Pearson Education, Inc., Upper Saddle River, New Jersey 07458. Pearson Prentice Hall. All rights reserved. Printed in the United States of America. This publication is protected by Copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission(s), write to: Rights and Permissions Department. Pearson Prentice Hall™is a trademark of Pearson Education, Inc. Pearson®is a registered trademark of Pearson plc. Prentice Hall®is a registered trademark of Pearson Education, Inc. Pearson Education Ltd., London Pearson Education Australia PTY, Limited Pearson Education Singapore. Pte. Ltd Pearson Education North Asia Ltd., Hong Kong Pearson Education Canada, Inc. Pearson Educación de Mexico, S.A. de C.V. Pearson Education—Japan Pearson Education Malaysia, Pte. Ltd. Pearson Education Upper Saddle River, New Jersey 10 9 8 7 6 5 4 3 2 1 ISBN-13: 978-0-13-501711-1 ISBN-10: 0-13-501711-4 This book is dedicated to John Peterson, a good friend who encouraged me to study business. This page intentionally left blank Preface Several years ago I was asked to teach a course on construction accounting and fi- nance. The course was to cover the fundamental principles needed by construc- tion managers to successfully manage the finances of construction companies. In preparing to teach this course I found that these principles were scattered among many disciplines, including business management, engineering economics, ac- counting, estimating, project management, and scheduling. After I reviewed the available textbooks, two things were apparent. First, the material was often pre- sented in a generic fashion and failed to address how the principles applied to the construction industry. For example, in most accounting textbooks only a few pages were devoted to the accounting procedures for long-term contracts, which comprise a bulk of the projects for general construction companies. Second, with the topics scattered among many disciplines and textbooks, the topic of how the different components of construction financial management were interrelated and interacted was being ignored. Financial management may be defined as the use of a company’s financial resources and encompasses all decisions that affect a company’s financial health. Many everyday decisions affect a company’s financial health. The difference be- tween a marginally profitable and a very profitable company is good financial management. Business schools teach the fundamental principles of financial management; however, because of the many unique characteristics of the con- struction industry, the usefulness of these financial principles as taught by busi- ness schools is limited. To be useful, these principles must be adapted specifically to the construction industry. For example, in the construction industry equip- ment is mobile and may be needed for multiple jobs during a single month. Tra- ditional accounting methods and financial statements do not allow a company to properly manage and account for its equipment. This book was written to help construction professionals—both those who are working in the construction industry and those seeking a degree in construction management—learn how the principles of financial management can be adapted to and used in the management of construction companies. This book will be most useful for general managers and owners of companies who are responsible for managing the finances of the entire company; however, many of these principles are useful to project managers and superintendents. For the project manager or v vi PREFACE superintendent who desires to stand out in a company, there is no better way than to improve the profitability of their project through the principles of sound finan- cial management. The book also discusses how owners and general managers can manage construction projects by sound management of their project managers, superintendents, and crew foreperson. This book explains common financial principles, demonstrating how these principles may be applied to a construction situation and how these principles af- fect the financial performance of a company. Many of the examples included in this book are based on actual situations encountered by the author. This book is organized in five parts: introduction to construction financial management, accounting for financial resources, managing costs and profits, managing cash flows, and making financial decisions. The first part—comprising Chapter 1—introduces the reader to construction financial management, explains why construction financial management is different than financial management in other industries, and defines the role of a construction financial manager. The second part—comprising Chapters 2 through 6—describes how to account for a company’s financial resources. Accounting for these resources is built around a company’s accounting system. The third part—comprising Chapters 7 through 11—examines how to manage the costs and profits of a construction company. This must be done at the project level as well as at the company level. The fourth part—comprising Chapters 12 through 16—looks at how to manage a company’s cash flows and how to evaluate different sources of funding cash needs. The fifth part—comprising Chapters 17 and 18—explores ways to quantita- tively analyze financial decisions. After reading this book, you should have a better understanding of the following: ❑ The basic financial principles that are widely used in the business world and how to modify them so that they work for the construction industry. Application of these principles will help you better manage your business. ❑ Construction accounting systems, which will help you manage the accounting systems and use accounting information to manage a company. ❑ Financial and accounting principles, so that you may interact with accountants and bankers at a professional level. To access supplementary materials online, instructors need to request an instruc- tor access code. Go to www.pearsonhighered.com/irc, where you can register PREFACE vii for an instructor access code. Within 48 hours after registering, you will receive a confirming e-mail, including an instructor access code. Once you have received your code, go to the site and log on for full instructions on downloading the ma- terials you wish to use. This textbook brings all of the key financial management principles needed by construction managers under one cover, addressing how they are applied in the construction industry and how they interact. Many of the examples in this book are based on my fourteen years of experience in construction financial management. Join me on a journey of discovery as we discuss the fundamental principles of financial management that are needed to make a construction com- pany a financial success. Particular thanks are due to Richard J. Gebken (Missouri State University), Ahmad Hadavi (Northwestern University), Kelly Strong (Iowa State University), Syed M. Ahmed (Florida International University), Laura Lucas (Indiana Univer- sity–Purdue University, Indianapolis), Jonathan Shi (Illinois Institute of Technol- ogy), and Brent H. Weidman (Brigham Young University) for their assistance with the text review. Best Wishes, Steven J. Peterson, MBA, PE This page intentionally left blank Contents P I I C F ART NTRODUCTION TO ONSTRUCTION INANCIAL M 1 ANAGEMENT 1 C HAPTER CONSTRUCTION FINANCIAL MANAGEMENT 3 What Is Financial Management? 5 Why Is Construction Financial Management Different? 5 Project Oriented 6 Decentralized Production 7 Payment Terms 7 Heavy Use of Subcontractors 7 Who Is Responsible for Construction Management? 8 What Does a Financial Manager Do? 8 Accounting for Financial Resources 8 Managing Costs and Profits 10 Managing Cash Flows 11 Choosing among Financial Alternatives 13 Conclusion 13 Problems 13 ix