5 Types of Construction Accounting Methods
Accounting forms the cornerstone of every business, yet some industries have different accounting methods than others. The construction industry has its own accounting techniques and tax regulations because of the work’s long-term timelines, custom contracts, and unique project-based nature. Below, learn the advantages and drawbacks of each accounting method to decide which is best for your business.
What are the Main Construction Accounting Methods?
In any other business, there are endless options of generally accepted accounting principles (GAAP). Yet, a few set construction accounting methods work best and meet federal regulations. The main methods include:
| Method | How it Works |
|---|---|
| Accrual Basis | Records revenue when it is earned and expenses when they are incurred. |
| Cash Basis | Revenue is recorded when cash is received, and expenses are recorded when cash is paid out. |
| Hybrid | Allows companies to record transactions using both cash and accrual basis methods. |
| Completed Contract (CCM) | Companies can postpone recognizing revenue until after a contract is complete. |
| Percentage of Completion (PCM) | Recognizes revenue and expenses incrementally as a long-term project progresses. |
1 Accrual Basis
The accrual basis method accounts for money earned during a certain period, regardless of whether it has been received. The same goes for outgoing expenses, which may or may not have been paid. Using the accrual method, contractors can pay taxes based on estimated cost.
One drawback of this method is that a company might pay revenue taxes without having actually collected the cash. Understandably, this can make it difficult to balance accounts. For this reason, unearned revenue is also known as deferred revenue.
It’s important to note that any construction company using GAAP for its financial statements must use the accrual method. Many construction lenders and investors also prefer this method because it records potential deferrals.
2 Cash Basis
This accounting method measures cash flow separately from whether or not a project is complete. Cash in is counted as revenue, which can be used to cover expenses. It ignores proposed payment schedules and only acknowledges accounts payable or receivable revenue and expenses.
While it makes sense only to record revenue or expenses after a transaction is complete, the cash method of accounting can be difficult to maintain if there are unanticipated payment delays or disputes. Since cash collected is treated as revenue, granting a refund can lead to unbalanced books. Delayed customer payments can seriously impact your ability to pay bills and payroll.
This method is popular with small construction companies and independent contractors who work on short-duration projects that can be finished and billed in days or weeks. Even larger construction businesses can use this tax method when recording revenue transactions on smaller projects.
3 Hybrid Method
The hybrid method uses both cash and accrual accounting techniques. It utilizes various elements to create a more customizable solution. For some companies, cash methods can be used for small projects, while accrual is used for long-term contracts on large-scale jobs. This can be useful for companies that prefer the simple approach of a cash basis but need to use accrual for GAAP or IRS reporting.
However, this method can lead to inconsistencies when switching between the methods. It also requires careful tracking of which method is used for different transactions, which could increase administrative workload.
4 Completed Contract Method
The completed contract method (CCM) is a form of revenue recognition. Under this method, all revenue and associated expenses for a project are recognized only after the contract is complete. As a result, taxes are not considered until after the work is completed. This offers contractors short-term savings but can lead to more complicated finances later if the tax rate changes during a project.
5 Percentage of Completion Method
The percentage of completion method (PCM) is similar to accrual in recognizing revenue earned during the contract period. Payment is made based on completing project milestones or predetermined dates, i.e., a weekly or monthly schedule. The milestones can be broken down into completion percentages to determine the potential revenue separate from the total gross profit. Any necessary taxes or expenses are paid as payments are received. By the end of the project, each small percentage will add up to the full 100% for payment.
This method allows project managers to evaluate projects at each phase and can represent a more accurate representation of a company’s financial position. However, PCM requires a high degree of estimation, which can lead to potential errors and uncertainties.
##FAQs
What’s the Difference Between Cash and Accrual Basis?
The key difference between accrual and cash basis accounting is when money is recorded by your organization. Accrual basis recognizes revenue when generated, while cash basis recognizes cash when money actually changes hands. Accrual measures long-term finances from construction contracts, while cash better reflects real-time numbers.
What’s the Difference Between CCM and PCM?
To illustrate the difference between the two methods, consider a contractor who has accepted a contract to build a five-story office building. With CCM, payment is contingent upon completion. With PCM, continuous payment is made in installments whenever certain goals are met, such as the foundation being completed or the siding being finished.
Why is Construction Accounting Different?
Construction accounting isn’t as straightforward as other industries, with clear correlations between revenue and expenses. Small to medium construction projects in this industry can take weeks or months to complete. As a result, many project timelines may span different tax years. Revenue from large-scale projects, which may take years to complete, can require taxation across different fiscal years. Even short-term contracts can fall into different fiscal quarters. Retainerage can further complicate construction billing practices.
Different accounting methods are necessary to address all these potential issues, better streamline tax reporting, and maintain compliance with financial reporting agencies.
For example, imagine a construction project is nearing completion when a change order from the client comes through. Had there not been a change order, the job would have been finished on schedule and billed accordingly. With project completion delayed, the final invoice reflecting the accurate job cost won’t be sent until the next fiscal quarter, which will have a higher tax rate.
Construction accountants must frequently accommodate these complications when calculating tax rates. From change orders and retainage to weather delays and customer disputes, construction projects cannot be billed on a traditional production timeline. The varying construction accounting methods consider those factors to minimize interruptions to cash flow.
How Can Construction Accounting Software Help?
Independent contractors and small construction companies that cannot afford to hire a full-time construction CPA to handle finances turn to software to handle these needs. Fortunately, construction accounting software performs a type of project accounting developed for construction projects. These systems will track the financial data of every construction project your small business completes in real-time while also monitoring your expenses (like the cost of materials and labor), revenue, invoicing, and payroll.
There are many different methods of construction accounting available. Which you pick will depend on your preferences or existing business processes and the capabilities of the accounting software you select.
What Regulations Control Construction Accounting Methods?
The ASC 606 set by the Financial Accounting Standards Board (FASB) provides revenue recognition guidance for any revenue gained from customer contracts. In construction, this covers pretty much all revenue a company will receive. The Federal Acquisition Regulation for any federal construction projects with retainage is also available. The Davis-Bacon Act oversees the payroll of contractors for public projects. Similarly, local or federal union regulations should be considered based on your jurisdiction.
With so many regulatory agencies overseeing the construction industry, you must keep your finances compliant with current standards. Construction CPAs and accounting software can help streamline your accounting methods to ensure compliance.
