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Home Business Finance Construction Accounting: An Introductory Guide
Running a company and maintaining its books is challenging for every small business owner, but the construction industry presents additional accounting challenges.
Contractors usually have multiple projects running simultaneously in separate locations, each with unique costs, goals, and time horizons.
If you run a construction company, here’s what you should know about construction accounting to navigate the industry’s complexities.
Construction accounting has so many moving parts that it can seem intimidating, but the process doesn’t need to be stressful. If you have a system in place before you begin taking on projects, you can save yourself a lot of headaches.
Here’s a step-by-step guide you can follow to create an effective construction accounting system for your business.
The first thing every general contractor should do to minimize their accounting issues is to separate their business transactions from their personal ones. Open a checking account and credit card for your company and use it exclusively for your business activities.
If you mingle your personal and business funds in the same bank account, determining which transactions belong in each category can be incredibly time-consuming. You’ll waste hours going back and trying to sort everything out.
It’s also likely that you won’t do a perfect job since it becomes increasingly difficult to figure out past transactions as time passes. That could cause you to miss out on deductions, misattribute expenses, and create even more problems for yourself.
One of the primary complications of construction accounting is that projects have extremely variable completion times. You may be able to finish some within a few months, but others will span multiple tax years.
Contractors must account for projects they complete within a single tax year differently than those that take place in more than one. First, let’s explore the accounting methods allowable for jobs that last less than a year.
Generally, you can use either the cash or accrual basis of accounting for these contracts. Here’s how those methods work:
The cash method is typically easier to implement, but it’s better at tracking your cash flow than your actual business profits. Meanwhile, the accrual method takes more work, but it more accurately captures the strength of your financial position.
Construction companies can choose either one as long as their average gross receipts are less than $25 million over the last three years or their total time in business, whichever is less. If you exceed that threshold, you must use the accrual method.
3. Choose A Long-Term Revenue Recognition Method
Unfortunately, you can’t use the typical cash or accrual accounting methods for construction contracts that span more than one tax year.
Instead, you generally must use either the completed contract or the percentage of completion (POC) method to record your transactions. Here’s how they work:
As a simple example, say you have a construction project that you estimate will take you 18 months and $200,000 in materials, labor, and overhead to complete.
The client agrees to pay you $300,000 for the job, and you begin work on March 1st, 2022. By the end of 2022, you’ve incurred $137,500 in costs, and the client has paid you $200,000.
Using the percentage of completion method, you’d deduct $137,500 in expenses. To calculate your revenues, divide $137,500 by $200,000 to get 68.75% and multiply it by $300,000.
That equals $206,250 of revenue, which you’d recognize even though the client only paid you $200,000 so far.
Using the completed contract method, you’d record neither the expenses incurred nor the revenue received in 2022. You’d wait until you finished the project in 2023 to recognize both.
Once again, each option has its merits. The POC method is more accurate, but the completed contract method is easier to use and lets you defer earnings to later tax years.
Unfortunately, construction businesses don’t get to choose freely between the two options. If your average gross receipts exceed $25 million or your contract lasts more than two years, you must use the POC method.
The only exception to those rules is if your project qualifies as a home construction contract. That means 80% of the total project costs are for work on a residence with four units or fewer.
The POC method has become even more involved since Accounting Standards Codification (ASC) 606 took effect. You must apply the method to every individual “performance obligation” within each construction contract.
The complexities of ASC 606 are beyond the scope of this article, but you should consult a construction accountant for assistance in staying in compliance with it.
4. Implement Job Cost Accounting
Job cost accounting or job costing involves allocating all business expenses to individual projects. Typically, that includes materials, labor, and overhead.
Due to the project-based nature of contracting, job costing is at the core of construction accounting. It’s necessary for projects that last more than one year since you need to know each project’s costs for the completed contract and POC methods.
For example, say you agree to complete a landscaping project. When you first meet with your client, you estimate that it’ll cost you $25,000 in materials and 500 labor hours at $45 per hour to complete, which equals $22,500.
In addition, you estimate that your total overhead costs for the year will be $300,000, including office rent and utilities, administrative expenses, insurance, and equipment depreciation.
After consulting with an accountant, you plan to allocate overhead to each job based on its labor hours. In other words, you’ll apply a portion of your annual overhead to each project for every labor hour required.
To find your applied overhead rate, you estimate that you’ll incur 10,000 total labor hours during the year. Your $300,0000 overhead divided by 10,000 labor hours gives you an applied rate of $30 per labor hour.
Since you estimated that you’d have 500 labor hours for this project, you allocate 500 hours multiplied by $30 per hour to the job, which equals $15,000 of applied overhead.
As a result, your total estimated job costs would be $25,000 in materials plus $22,500 of direct labor plus $15,000 of applied overhead, which equals $62,500.
5. Perform Regular Reconciliations
Working in the construction industry involves managing multiple contracts simultaneously, many of which will likely change their scope at least once before completion.
As a result, staying on top of your construction accounting requires consistently checking in with your company’s books. Here are some steps you should consider taking each month:
Performing regular reconciliations is beneficial in any industry, but it’s essential for construction accounting. If you fall behind on your bookkeeping, it will be difficult to catch back up.
Construction accounting follows the same general accounting principles as regular accounting. However, the nature of the construction industry creates challenges that force construction accountants to take additional measures.
These are the primary traits of the construction industry that require you to use irregular accounting strategies.
The most significant difference between construction and regular accounting is that contractors must track their finances separately for each project. Few other industries need to resort to job costing to stay organized.
For example, a manufacturing company with a single product could easily keep separate financial records for every factory. Its materials, labor, and overhead would be consistent and predictable for each one.
Similarly, a lawyer might have multiple projects simultaneously, but they can easily account for them together. The hourly rate might vary slightly between services, but the labor, materials, and overhead cost inputs would be similar for each job.
However, contractors can have any number of projects going on at once, and each one has cost inputs that vary drastically. For example:
Though job costing takes more work, it’s the only way to accurately measure a contractor’s profitability by matching cost inputs with the related revenues.
Another reason construction accounting differs significantly from regular accounting is contractors often have projects that last for many months, even spanning more than one tax year.
Unfortunately, those long contracts are unavoidable. It takes much longer to construct or improve a building than to complete most other products or services.
That necessitates accounting methods such as the completed contract or the POC method. It also means that the accounting and tax rules in place at the start of a contract may change by the time it ends.
In addition, contractors often offer their clients extended payment options, such as net 30 or net 60 terms, which makes properly timing revenue recognition even harder.
The final issue with construction accounting that doesn’t affect regular accounting is that contractor job requirements change more often than not. In fact, there could be multiple change orders during a project that affect the scope drastically each time.
Even if a client doesn’t submit any change orders, there’s no guarantee that the initial job cost estimates will be accurate. It’s difficult to predict the material and labor costs over long-term projects, even for experienced contractors.
Unfortunately, inaccurate estimates due to changing scopes or poor predictions will disrupt your revenue recognition for long-term contracts. That’s another reason why construction accounting is often more demanding than accounting for other industries.
Our step-by-step guide to the fundamentals of construction accounting should help you get started, but we can’t cover all of the details involved in a single article. However, we can discuss some best practices.
Here are several high-level tips to make your construction accounting system more efficient.
Nowadays, there’s little reason to keep track of anything by hand. It’s too easy and affordable to find software that can handle administrative tasks without requiring much of your time or effort.
For example, construction accounting software is a must. Contractors have too many transactions across too many projects to keep track of everything manually.
Time tracking software is another tool that can make your construction accounting easier. Labor is one of the primary cost inputs for construction projects, but manually tracking the hours of multiple workers across several jobs is difficult.
Software like Justworks Hours can automate a significant portion of the process. Not only does it let each worker report their hours digitally and aggregate the data for you, but it can integrate directly with accounting software.
As discussed above, construction firm projects rarely stick to the initial scope of work. Clients often change their minds about certain aspects of projects or try to cut costs, causing them to alter the original plans.
Alternatively, construction contractors may change the scope or price of a project after learning something they weren’t aware of at the onset of the job.
As a result, it’s best to have systems in place ahead of time to account for these pivots. Make sure you have procedures for both approved and unapproved change orders.
It’s best to include your methods for handling change orders in your initial contract with your clients. That can minimize the amount of back-and-forth necessary when changes occur and help prevent any disputes.
In regular accounting, you might be able to get by keeping paper copies of your supporting documents like receipts, bank statements, and invoices. It’s never optimal, but it’s doable for many small businesses.
However, keeping physical records is unreasonable in the construction industry. You need to keep track of too many documents for too many projects.
While many businesses can get the supporting detail they need for most of their deductions from a bank statement, that’s usually not the case for contractors. They need more information for almost all of their expenses.
For example, imagine you buy several different materials from a supplier in bulk. You’d need to define each of those materials to perform accurate job costing, especially if you’re using them for multiple projects.
As a result, it’s essential that you keep detailed supporting records on hand. Digital copies are infinitely easier to store and review and less susceptible to getting damaged or lost.
Doing a company’s accounting and project management is always hard, but it’s even more difficult in the construction business. Not only is construction accounting more time-consuming overall, but there are many more potential complications.
As a result, it’s best to get construction accounting and tax services from an expert. Fortunately, that doesn’t mean you have to hire an accountant full-time. Many small businesses, including contractors, can benefit from outsourced accounting services.
Instead of hiring an employee, that involves paying an accounting firm for help from a Certified Public Accountant (CPA) specializing in construction accounting services and tax planning for contractors.
Nick Gallo is a Certified Public Accountant and content marketer for the financial industry. He has been an auditor of international companies and a tax strategist for real estate investors. He now writes articles on personal and corporate finance, accounting and tax matters, and entrepreneurship.
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