Construction counters

[mrEngineer]

I never managed to figure out how construction companies recognise their revenue due to the messy multiple streams on income on different timing. If the property is fully sold, do they immediately recognise the 10% deposit? Or do they fully recognise the revenue after completion of project? Or they recognise as percentage of completion? If partially sold, how the revenue is recognised?

Other than revenue recognition, when would the cashflow be? When would banks that loans buyers pay the construction companies? After the entire project is completed?

As for the capitialising of developmental cost and expenses, what are the impacts on the financial statemetns? How they are reduced or convert to cash eventually?

[Musicwhiz]

I never managed to figure out how construction companies recognise their revenue due to the messy multiple streams on income on different timing. If the property is fully sold, do they immediately recognise the 10% deposit? Or do they fully recognise the revenue after completion of project? Or they recognise as percentage of completion? If partially sold, how the revenue is recognised?

Other than revenue recognition, when would the cashflow be? When would banks that loans buyers pay the construction companies? After the entire project is completed?

As for the capitialising of developmental cost and expenses, what are the impacts on the financial statemetns? How they are reduced or convert to cash eventually?

There are basically two methods for accounting for construction contracts, as stipulated by the Financial Reporting Standards (FRS) of Singapore. One is % of completion method, while the other is the completed contracts method. I think the name of the method is rather self-explanatory, but I will discuss each briefly for the sake of forumers (though I will omit details otherwise it will sound like an accounting lecture!).

If you use % of completion, then companies will recognize the revenue and costs up to the point of construction, based on the % of completion as determined by the quantity surveyor. This is recognized in P&L and the related COGS is also recognized based on progress billings. For completed contracts, only when the entire project is finished, then the costs and revenues will be accounted for fully. As for deposits (e.g. 10%), they are booked as a current liability in the books first before project completion (as it is a liability to deliver on an obligation), and this will reverse out to revenues once the project is completed and sold.

Cashflow is usually a mixture of internal cash flows, equity and debt. The debt will be drawn down progressively based on the T&C of the Term Loans granted to the Company, so the cash can be tapped as and when needed. The collateral for the loan is usually the completed property or it could be some other form of security. Cash flows will be lumpy until the project is fully sold as cash outflows will be consistent but there will be hardly any cash inflows. Thus, a company has to manage cash flows well or risk running out of cash before a building is completed. This has happened before in previous building booms where many properties sit around uncompleted as the companies that were building them went bust!

The costs are capitalized onto the Balance Sheet as "Development in Progress" or Construction in Progress, and are NOT depreciated until the property is completed. Those costs which do not form part of building costs are expensed off (e.g. admin staff costs relating to the property). Revenues are only recognized once a sale is made, but depends on the method of accounting. Basically the conversion to cash occurs once the sales proceeds are collected, whether via bank loans extended to customers, or through upfront deposit collections and progress payments from customers.

Hope this explains.

[mrEngineer]

Thanks MW for your reply.

I guess I am more or less clear about the Construction in Progress (CIP) or Development item in the Current Asset as long I treat them like Inventory and eventually disposed off into the COGS for construction projects that are developed for sale.

As for the cashflow and revenue, maybe I do a scenario analysis to sort my thoughts out clearly. Assuming all properties are fully sold,

% of completion recognition
Deposit is paid to developer. Credit Prepay Liabilities / Debit Cash
Developer uses cash deposit and some bank loans to start construction. Credit Cash / Debit CIP
Half of the construction completed. Credit CIP / Debit COGS, Credit Revenue / Debit Cash or Receivables, Credit Revenue/ Debit Prepay
Construction completed. Credit CIP / Debit COGS, Credit Revenue / Debit Cash , Credit Receivables / Debit Cash

Completed works recognition
Deposit is paid to developer. Credit Prepay Liabilities / Debit Cash
Developer uses cash deposit and some bank loans to start construction. Credit Cash / Debit CIP
Construction completed. Credit CIP / Debit COGS, Credit Revenue / Debit Cash or Receivables , Credit Receivables / Debit Cash, Credit Revnue/ Debit Prepay

So if the properties are partially sold, the same accounting treatment holds except developer has to determine whether they have enough internal funds or willing loans from bank to finance on with constructing. It seems like managing cash flow will be the most difficult aspect in the construction business as cash would only be available when deposit are collected and when the projects are completed. Loans from banks will really depend on interest costs and convenants drawn up.

Thus I may conclude that current market is underpricing Chip Eng Seng is due to its high risk in managing its cash flows with the number of projects they are handling. They might be surviving well now with the low interest financing but if interest rates increase or building cost increases, they may not be able to cope.

Do correct me if any of my simple assumption above went wrong.

[yeokiwi]

Nice explanations

A simple way to valuate a construction company is to calculate the projected NAV. I think the method is similar to valuating a property developer.
For a pure construction contract, I think the after tax profit margin is around 5-10% of the contract value.
Assuming 7% profit margin, a construction company with a $1 billion contract order will be expected to earn around $70 million if they fulfill the contract order.

By taking account of the current NAV and the projected earning for the next few years, the investor should be able to derive a projected NAV for valuation.
Take Tiong Seng as an example, the current NAV is around 22cts and it has a $1 billion contract orders on hand.
Assuming 7% profit margin, the expected future profit will be around S$70 million or 9.1cts per share.
Therefore, the projected NAV is around 31cts.

The current share price is around 25cts and looking at it, there isn't much margin of safety.

[Musicwhiz]

As for the cashflow and revenue, maybe I do a scenario analysis to sort my thoughts out clearly. Assuming all properties are fully sold,

% of completion recognition
Deposit is paid to developer. Credit Prepay Liabilities / Debit Cash
Developer uses cash deposit and some bank loans to start construction. Credit Cash / Debit CIP
Half of the construction completed. Credit CIP / Debit COGS, Credit Revenue / Debit Cash or Receivables, Credit Revenue/ Debit Prepay
Construction completed. Credit CIP / Debit COGS, Credit Revenue / Debit Cash , Credit Receivables / Debit Cash

Completed works recognition
Deposit is paid to developer. Credit Prepay Liabilities / Debit Cash
Developer uses cash deposit and some bank loans to start construction. Credit Cash / Debit CIP
Construction completed. Credit CIP / Debit COGS, Credit Revenue / Debit Cash or Receivables , Credit Receivables / Debit Cash, Credit Revnue/ Debit Prepay

So if the properties are partially sold, the same accounting treatment holds except developer has to determine whether they have enough internal funds or willing loans from bank to finance on with constructing. It seems like managing cash flow will be the most difficult aspect in the construction business as cash would only be available when deposit are collected and when the projects are completed. Loans from banks will really depend on interest costs and convenants drawn up.

Thus I may conclude that current market is underpricing Chip Eng Seng is due to its high risk in managing its cash flows with the number of projects they are handling. They might be surviving well now with the low interest financing but if interest rates increase or building cost increases, they may not be able to cope.

Do correct me if any of my simple assumption above went wrong.

Hi! Wow that's a pretty detailed Dr and Cr scenario you put out.....this is becoming an accounting lesson hahaha.

For payment of deposit to developer, normally entry is as follows:-

Dr Cash At Bank
Cr Deposit Received in Advance

For usage of funds and drawdown of loan:-

Dr CIP/Expenses
Cr Cash At Bank
Cr Bank Loan

The entry to reverse out CIP to COGS is correct, but for selling the property receivables needs to be recognized depending on method of payment:-

Dr Trade Receivables
Dr Cash
Dr Deposit Received in Advance
Cr Revenue

Don't forget the entry for depreciation too (since we are onto accounting haha):-

Dr Depreciation Expense (Property)
Cr Accumulated Depreciation (Property)

The COGS portion will be more of the contractor costs, architects cost and quantity surveyor costs, while the cost of materials, overheads and legal fees will most likely be capitalized into the building itself. However, as I do not work in a construction company, I do not know what exactly goes into ASSET and what is considered an EXPENSE, so don't quote me on this!

Most construction loans are structured as term loans which are pegged to either 1, 3, 6 or 12-month SIBOR rates (depending on your preference) + a spread (say about 1.25% to 1.5%), so since SIBOR is at 0.44% thereabouts, you get a "cheap" loan of about 1.75% to 2.0%. But since rates are floating, the loan does get progressively more expensive in a rising interest rate environment. Since most construction takes about 18 to 24 months, this could have severe impact on cash flows; thus a budget and projection is usually drawn up to mitigate the risks of insufficient funds to service the interest costs, and later on to repay the loan.

[mrEngineer]

Don't forget the entry for depreciation too (since we are onto accounting haha):-

Dr Depreciation Expense (Property)
Cr Accumulated Depreciation (Property)

The COGS portion will be more of the contractor costs, architects cost and quantity surveyor costs, while the cost of materials, overheads and legal fees will most likely be capitalized into the building itself. However, as I do not work in a construction company, I do not know what exactly goes into ASSET and what is considered an EXPENSE, so don't quote me on this!

Dear MW, thanks for your feedback. Actually I do not really fully understand why depreciation is required in this case. As the development or construction in progress for properties to sell is still on-going, it can be treated as an inventory in your current assets. To my knowledge, current assets do not depreciate and only long live assets do. Even if there is an impairment of the inventory or CIP, it should be included as an impairement and not depreciation. Therefore I largely assume that most of the CIP will go into COGS. Could you explain more? Thanks!

Anyway, the reason I detailed out the accounting entries as I wanted to visualise the actual cashflow timings easier.

[Musicwhiz]

Yeah sorry you have a point on that. I was more assuming we are dealing with properties for either sale or rental. If for rental then it's accounted for as a fixed asset; if for sale then as inventory.

So you are correct - if asset is inventory then it will suffer from impairment or obsolescence if it cannot be sold (at Balance Sheet date, a check will be performed by engaging a valuation company such as Colliers or Knight Frank). If the asset is a fixed asset, then rental income is derived from it and it should be depreciated. Then again, property held as fixed assets are also revalued every year, and the revaluation difference taken to P&L (if a loss) or Balance Sheet (as a capital reserve). So te depreciation may have to be re-computed, and it's a complicated process (which is why we have dedicated people called Fixed Asset Accountants in large property companies).

As mentioned, I am not aware of the detailed accounting entries for construction companies as I am not in this industry. But I will go read up more and find out, because it's my interest to know this as well!

Thanks!

[mrEngineer]

The entry to reverse out CIP to COGS is correct, but for selling the property receivables needs to be recognized depending on method of payment:-

Dr Trade Receivables
Dr Cash
Dr Deposit Received in Advance
Cr Revenue

Hmm interesting point about the method of payment. I cant really imagine any other method of payments to construction companies other than collecting the cash from developers or banks that have loaned the property buyers or buyers themselves. Perhaps can help to elaborate more? Thanks!

To think about it, are there any singapore firms that actually buys up the account receivables and assumes the risk of bad debts? Haha abit OT here..

[Musicwhiz]

Hmm interesting point about the method of payment. I cant really imagine any other method of payments to construction companies other than collecting the cash from developers or banks that have loaned the property buyers or buyers themselves. Perhaps can help to elaborate more? Thanks!

To think about it, are there any singapore firms that actually buys up the account receivables and assumes the risk of bad debts? Haha abit OT here..

Hi MrEngineer,

The Company could ask for a shareholders' loan, or issue corporate bonds? Haha these are some of the possible modes of financing large projects. Equity issuances (i.e. private placements) can also have the effect of injecting cash into the Balance Sheet.

There are companies out there which offer factoring services. They will manage your accounts receivable and assume the risks of bad debts for a fee.

[Nick]

Hi MW,

Pardon my ignorance, but what is a shareholder's loan ? I see it quite a few times with regards to project financing.

Thanks