In some ways, construction accounting is like general accounting. The principles of keeping up with income, bills, and debt are universal. But some industries face unique challenges that can make it tough to decide how to do that.
The construction industry is one of those industries. Due to the nature of the work, lining up expenses and revenues in a way that makes sense for business reporting and tax purposes can be tricky. To make matters more complicated, there are several construction accounting methods to choose from, as well as some rules about which companies are allowed to use them and when.
In this article, we'll look at seven common construction accounting methods and explain how they work. We'll also explain how to determine which method to use for your construction business.
Curious to learn how construction companies can automate their financial operations? Check out our guide for the construction industry.
Construction accounting concepts
First, let's briefly walk through a few universal accounting concepts and how they apply to construction companies. Then, we'll list some of the unique problems that the construction industry faces in applying these principles.
Construction accounting basics
The following basic accounting principles are especially important in choosing the best construction accounting method for your business.
The revenue recognition principle
In accounting, revenue should be recognized when it's earned and realizable, but that can mean different things in different situations. What happens over a long-term contract? What happens if the client asks for significant changes and upgrades? Different accounting methods handle these kinds of situations in different ways.
The revenue-expense matching principle
According to this principle, expenses should be recorded in the same accounting period as the revenue they helped generate. This makes sure that the right expenses are lined up with the right income so the company can see its true profitability. But, again, this can be complicated, especially when a construction company has to shell out cash for supplies and subcontractors weeks, months, or even years before final payment on the project.
The principle of consistency
This principle of consistency says that companies should use the same accounting methods and principles consistently over time. This ensures that financial statements can be compared meaningfully from one year to the next. Although it's possible (and sometimes necessary) to change from one accounting method to another, it shouldn't happen often.
The principle of conservatism
When presented with two alternatives, accountants should choose the one that is less likely to overstate assets or income. This helps prevent the overstatement of financial results and ensures a more cautious approach to decision-making.
The principle of materiality
The principle of materiality boils down to this: significant information should always be disclosed, but insignificant details aren't worth the effort. Accounting teams need to track every penny of expense, but they don't need to inventory every individual nail.
Special problems in construction accounting
The following realities of the construction industry can be especially challenging when trying to apply these accounting principles.
- Long-term contracts: When projects span months or even years, determining profitability midstream can be a real challenge.
- Progress billing: When payments are due according to completion milestones but expenses are already piling up toward later milestones, matching expenses to revenue can be tough.
- Subcontractor payments: Subcontractors may need to be paid before related revenue comes in the door, leaving accounting teams to navigate those cash flows. Verifying that work is complete and handling lien waivers can also be a challenge.
- Unforeseen circumstances: Construction work is full of surprises. Anything from sudden change orders to a string of bad weather can impact budget estimates and timelines.
- Standards and regulations: The construction industry is subject to specific regulations related to accounting and taxes. Accounting teams need to ensure compliance to avoid legal and financial penalties.
How does construction accounting work?
In theory, it makes perfect sense. Accountants add up all the material costs, labor, subcontractor invoices, and so on for a specific project to determine its total cost. Then, they subtract that from the project's revenue.
In practice, though, things get a lot more complicated. Materials bought during one project may not all be used, meaning only some portion of that cost should be attributed to that project. The same subcontractor might also work on several different projects, leaving accounting teams to figure out which charges belong where.
When accounting gets more sophisticated, reports become more accurate, but the work that goes into those reports gets even more complex. How much of each employee's time should be allocated to specific projects? What about mileage costs when a project manager drives back and forth among multiple projects?
The following construction methods help accountants make these kinds of decisions while staying on the right side of accounting regulations and tax laws.
What are the methods used in construction accounting?
Some of the methods listed below are either required or restricted under certain circumstances. Where that's true, we'll make a note of it to help you make the best choice for your business.
The cash basis accounting method
In the cash method of accounting, revenue is reported when cash comes in, and expenses are reported when cash goes out. This is arguably the simplest method of accounting, but it doesn't always result in the best financial reporting.
For example, if you get an early deposit for a job, that cash counts as revenue immediately, even before you start working on the project. The job looks tremendously profitable on paper, but that's just because you haven't started paying for any materials, labor, subcontractors, and so on. You won't know how profitable the job really is until it's final.
Under IRS regulations, this accounting method is only allowed for smaller companies that meet the gross receipts test, whose "average annual gross receipts for the 3 prior tax years were $26 million or less (indexed for inflation)."
Anything other than the cash method is called the "accrual method" of accounting. Accrual accounting methods record revenues, expenses, and profits as they're earned or owed instead of waiting on cash payments.
The completed-contract method (CCM)
Under the completed-contract method, contractors wait until a project is completely finished before reporting revenue and expenses on an income statement. This provides an accurate measure of profitability, but it can also push reported income out for years on a long-term contract. Needless to say, the IRS doesn't allow that.
The key things to know are that the IRS doesn't usually allow CCM for long-term contracts of more than 1 year, but small companies (under the gross receipts test) can use it for contracts of up to 2 years.
The percentage-of-completion method (PCM)
In many cases, PCM is the required method of income reporting.
- The IRS requires it for long-term projects of over one year (IRC 460)
- Unless it's a home contract involving fewer than 5 dwellings
- Or unless you're a small contractor, in which case you still have to use it for construction projects that are 2 years or longer
- The IRS also requires it in calculating "alternative minimum tax"
- Most lenders and guarantors require it for financing
As a result, PCM is the most widely used construction accounting method. As implied by the name, this accounting method enters revenue and expenses based on the percentage of completion for each project.
Here's how PCM works:
Step 1: Estimate the total revenues and expenses for the project.
Step 2: Look at actual activity on the project in a given reporting period and compare it to the estimated total activity for the project — maybe it's 5% of the total, for example.
Step 3: Use that percentage to calculate income and expenses for that period, based on your estimated total.
Of course, those are just estimates. Construction businesses' accounting teams have to reconcile these estimates against actual revenues and payments in their accounting software along the way to determine assets or liabilities on the balance sheet as well as actual income.
The ASC 606 standards method
ASC 606 is a GAAP rule (Generally Accepted Accounting Principles), issued by the FASB (Financial Accounting Standards Board). It isn't technically a law, but violating it can still lead to serious consequences, especially in states that require financial statements for licensed contractors.
While the IRS still requires PCM as outlined above, ASC 606 works a little differently. Instead of looking at the estimated stage of completion, ASC 606 looks at the performance obligations under each construction contract. Income and expense recognition happens on the basis of these obligations.
Here's an example. A construction contract to build 3 buildings would have 3 performance obligations. The total contract price gets split up (or "allocated") among the 3 obligations, meaning the 3 buildings. When you hand over control of each building to the customer, the revenue and expenses for that building are recognized.
If your entire project has only one performance obligation, ASC 606 looks a lot like CCM, the completed-contract method. But if control is turned over to the customer in stages, then the ASC 606 method looks more like PCM—it recognizes the different stages of the contract.
The contract-retainage method
Many construction contracts are structured with retainage, meaning some of the contract price isn't due until the contract is complete. This isn't an accounting method in itself—it's more a recognition that these kinds of contracts have to be accounted for in specific ways.
For construction businesses, retainage can also apply to your subcontractors. If you aren't going to receive some percentage of payment until completion, you may want to build the same retainage into your subcontractors' contracts too, holding back their payment until you get paid yourself.
How you account for retainage, in both customer and subcontractor contracts, depends on the overall construction accounting method you're using. If you're using CCM, for example, you won't report income and expenses until the project is completed, at which point the retainage will have been paid.
The fixed-price method
The fixed-price method is more of a pricing or contract method than an accounting method, although it does make accounting a bit simpler. In the fixed-price method, the scope of the work to be done is determined and agreed on ahead of time, and a fixed price is set for that work. This is most common for relatively small projects in which the work and costs are predictable and easy to define.
Construction companies may use budget templates to determine a fixed price that accounts for expected time and materials plus a set percentage for the company's profits.
The time-and-material method
The time-and-material method is another pricing or contract method. In this method, jobs are priced based on the time and materials they require. The customer pays for materials and a per-hour labor cost, and the contractor keeps up with materials costs as well as hours so they know how much to bill at the end of the job.
Whether your construction business uses fixed-price contracts, time-and-material contracts, or both, it's important to keep track of material and labor costs for each project to get an accurate picture of your profits.
How to choose the right construction accounting method
The choice of accounting method comes down to how you report assets, liabilities, and income on financial statements, not how you keep your books day to day. You still need to enter every expense, receipt, and payment as they happen. The question is, how are you going to report your income to the IRS, and how are you going to report it on your financial statements?
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