Accounting forms the cornerstone of every business, yet some industries have different accounting methods than others. The construction industry is one which has its own set of accounting techniques and tax regulations because of the long-term timelines, custom contracts, and unique project-based nature of the work.
In any other business, there are endless options of generally accepted accounting principles (GAAP). Yet there are a few set construction accounting methods which work best and meet federal regulations. The main methods include:
Each method has its own advantages and drawbacks. Learn more about each one before deciding what is best for your construction company.
The accrual basis method determines cash flow based on the matching principle. Promised payments are considered as revenue even if the corresponding invoice has not been paid. This method allows construction companies to know what their accounts receivable should be once payments are completed.
In essence, this method accounts for what money has been earned during a certain period of time, regardless of whether it has actually been received. The same goes for outgoing expenses which may or may not have been paid. By using the accrual method, contractors can pay any necessary taxes based on estimated cost.
A major drawback of this method is that, at the end of the day, a company might pay revenue taxes without having actually collected the cash. Understandably, this can make it difficult to balance accounts. This unearned revenue is also known as deferred revenue for this reason.
It’s important to note any construction company using GAAP for their financial statements must use the accrual method. Many construction lenders and investors prefer this method as well because it records potential deferrals.
This accounting method measures cash flow separately from whether or not a project is complete. Cash in is immediately counted as revenue which can be used to cover expenses. It ignores proposed payment schedules and only acknowledges revenue and expenses in accounts payable or receivable.
While it makes sense to only 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 immediately treated as revenue, granting a refund can lead to unbalanced books. And delayed payments from customers 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 which can be finished and billed in days or weeks. Even larger construction businesses can utilize this method for tax purposes when recording revenue transactions on smaller projects.
The hybrid method uses both cash and accrual accounting techniques. It utilizes various elements of each to create a more customizable solution. For some companies, cash methods can be used for small projects while accrual is used for any long-term contracts on large-scale jobs. This can be useful for companies which prefer the simple approach of cash basis but need to use accrual for GAAP or IRS reporting.
Completed contract method (CCM) is a form of revenue recognition. As the name suggests, it counts revenue in a different way. CCM is based entirely on when a project is complete, according to conditions set in the project contract. As a result, taxes are not considered until after the work is completed. This offers contractors some short-term savings but can lead to more complicated finances later if the tax rate changes during the course of a project.
In contrast, the percentage of completion method (PCM) is similar to accrual in that it recognizes 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 percentages of completion in order 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.
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 ahnds. Accrual is focused on measuring long-term finances from construction contracts while cash better reflects real-time numbers.
To illustrate the difference between the two methods, consider a contractor has accepted a contract to build a 5-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 siding being finished.
Construction accounting isn’t as straightforward as other industries, where there are pretty clear correlations between revenue and expenses. In this industry, small to medium construction projects can take weeks or months to complete. As a result, a lot of 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. And retainage can further complicate construction billing practices.
Different accounting methods are necessary to address all these potential issues to better streamline tax reporting and maintain compliance with financial reporting agencies.
For example, imagine a construction project is nearing completion when a change order comes through from the client. How is this change to the project timeline going to impact billing and payment? 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 costing 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, there are many reasons construction projects cannot be billed on a traditional production timeline. The varying construction accounting methods take those factors into account to minimize interruptions to cash flow.
Construction accountants are certified accountants who go into the construction industry. Because a construction accountant or CPA usually doesn’t receive any industry-specific bookkeeping training until after they’ve received their degree in general accounting, they have to catch up on the accounting and tax elements which have to be modified to fit the needs of construction, including specialized accounting methods.
Fortunately, construction CPAs at least have the necessary background to understand accrual and cash basis methods along with the benefits of CCM and PCM revenue recognition. Most large contractors can afford industry-trained CPAs, but other construction contractors usually turn to software to fill the gaps.
Independent contractors and small construction companies which 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 that has been 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, as well as invoicing and payroll.
There are many different methods of construction accounting available. Which you pick will depend on your own preferences or existing business processes and the capabilities of the accounting software you select.
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. There’s also the Federal Acquisition Regulation for any federal construction projects with retainage. The Davis-Bacon Act oversees payroll for contractors on public projects. On a similar note, any local or federal union regulations should be considered based on your jurisdiction.
With so many different regulatory agencies overseeing the construction industry, you need to keep your finances compliant with current standards. Construction CPAs and accounting software can help streamline your accounting methods to ensure compliance.