The next installment of our ‘Accounting for HVAC’ series highlights how HVAC related direct expenses are generally treated, the importance of job costing, and the financial reporting impact when converting cash-basis financials to accrual-basis. It is imperative that these items get treated properly, so your HVAC business can ensure your financials are ‘complete’ and properly understand your margins on a monthly basis.
Most HVAC direct expenses are related to job materials, equipment, and labor. Frequently, job materials are purchased in the same month a job is completed, and therefore, no accruals need to be recorded in the general ledger at the end of the month. Rather, the cost of materials is directly expensed to the P&L as Cost of Goods Sold (“COGS”). Accruals for expenses will primarily be recorded as Accounts Payable on the Balance Sheet for invoices that remain unpaid by month end. These invoices are often paid within a couple of days of month-end, so there likely won’t be long-outstanding AP balances.
To avoid long lead times, larger equipment, such as furnaces, AC units, and water heaters, may be purchased ahead of time from suppliers and stored until needed. In this case, the equipment needs to be logged and recorded at cost onto the Balance Sheet as Inventory. Companies should keep an inventory listing of all the equipment they have in stock. When a piece of equipment is used on a job, it will be removed from inventory and the cost will be recorded on the P&L within COGS. Diligent record keeping and establishing internal processes to track inventory are key for accurate inventory and cost related journal entries.
As for labor, it is common for a payroll accrual to be recorded at the end of each month, resulting from a lag between the end of the payroll period and timing of payment. Most labor jobs are paid weekly, so depending on the month-end close calendar, we can afford to wait until the final paycheck of the month goes out to get an accurate payroll accrual. Utilizing the actual paycheck to record the month-end accrual results in an accurate and precise journal entry at month-end, reflective of the actual dollars and labor hours incurred. This month-end accrual will reverse on the first day of the following month.
Job costing, a company’s way of calculating the gross margin of individual jobs, allows management to better price jobs, use resources effectively, and evaluate job profitability. Obtaining accurate job costing data starts at the field level. There are a handful of HVAC ERP systems that allow companies to track revenue and expenses at the individual job level. Technicians have the ability to enter and associate, or tag, all expenses and transactions related to a job directly into the system. Further, if the ERP system does not have an accounting module built into the system, most ERP systems can be integrated with your accounting system.
Integrating an ERP system into your business and establishing processes involve a lot of work upfront, but integrating operations, field workers, and accounting is a gamechanger for an HVAC company. This will not only save the company valuable time, but also allow the company to produce accurate financial reporting and deliver more meaningful insights into the business – especially from a transaction (M&A) perspective.
Accrual-basis financials are the preferred method of accounting by lenders, investors, regulatory agencies, and owners who want clear visibility into the performance of their business.
Most HVAC businesses are accounted for on a cash-basis. As such, converting the financials from cash-basis to accrual-basis accounting is recommended as it’s the first step to improving visibility into the performance of the business and producing job costing reports.
Once converted to accrual-basis accounting, we will be able to fine tune the business’ financial reporting, and deliver the information needed to evaluate the business. More importantly, the company will be able to drill down into different service offerings, which can be used to drive operational decisions such as marketing spend or bonus/commission incentives for employees.
Presented with this information for the first time, and, perhaps more importantly, removing accounting and financial reporting from an operator’s workload by hiring an outside fractional accounting firm, the strategic wheels really begin to turn. Operators know their business and once relieved of the accounting and finance burden, it is impressive to see their renewed excitement in their business and the growth potential going forward.
Stay tuned for Part 3 of CFOx’s ‘Accounting for HVAC’ series, where we will discuss the intricacies of properly building your company’s Balance Sheet to understand what assets you own, and what liabilities you owe.