Construction accounting can be challenging because of the complex nature of the business, and because how some accounting methods are used differ from the norm in other industries. For example, contractors typically juggle many projects — distributed across multiple sites — and need to manage cost, revenue and profitability for each. Long-term projects also add to the complexity of revenue management.
Applying these best practices for construction accounting can help contractors maximize profitability and cash flow.
8 Key Construction Accounting Best Practices
Construction accounting has many facets, from accurately allocating direct and indirect project costs to optimizing tax reporting. Companies need to decide whether to use cash-basis or accrual-basis accounting, and those working on long-term projects need to pick the right revenue recognition method. For some projects, the way a contractor manages change orders can determine whether the project is profitable or makes a loss.
Here are eight construction accounting best practices for contractors.
Job costing: A construction company can work on many projects simultaneously. Accurately attributing expenses to each job is critical to controlling cost and measuring the profitability of projects. Efficient job costing ensures that all direct and indirect expenses are promptly allocated to the proper job, so a company can monitor whether its financials are on track.
Job costing, when done right, requires everyone involved to record expenses during the project, not after it is completed, and to submit those expenses daily. Time-tracking software can help monitor labor costs. Expenses should be categorized in the same way as in the estimate to enable accountants and project managers to analyze whether the job is proceeding as planned. The company should also have a standard formula for allocating indirect expenses, such as administrative overhead, to each project.
Using modern, cloud-based project management software that’s available on mobile devices from job sites will help contractors improve their on-time completion records, keep customers informed and minimize non-billable work.
Cash-basis accounting: When it comes to accounting methods, there are two primary choices: cash basis and accrual basis. Smaller construction firms often opt for the more straightforward cash-basis accounting system: The company simply records revenue when it is received and expenses when vendors are paid. Cash-basis accounting simplifies day-to-day financial management and requires less financial expertise. A caveat: Construction companies with average revenues of more than $25 million can't use cash accounting for tax purposes, regardless of job materials percentage.
Accrual-basis accounting: The alternative method, accrual-basis accounting, is more complex — but it’s required for larger companies, including public companies that must comply with the Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB). It also underpins specialized revenue recognition accounting approaches, such as the percentage of completion method, described below.
Accrual-basis accounting recognizes revenue as work is completed and expenses when they’re incurred, which may not be when money actually changes hands. It generally provides a more accurate representation of a company’s finances, but it can obscure short-term cash flow issues — a company may appear profitable on paper even if payment delays from customers are causing cash-flow problems.
Percentage of completion method: PCM is a widely used accounting approach that enables contractors to recognize revenue for each project as they earn it over time. During each project, the contractor bills in stages for work performed to date and records the earned revenue and expenses at each stage. It’s seen as the most accurate way of recording revenue and expenses so that they match the work performed, and banks and lenders often prefer it.
PCM works well if you are able to generate accurate estimates. PCM can also help ensure that contractors get paid for their work even if a construction project does not proceed to completion.
Contractors can measure the percentage of completion in several ways:
- The cost-to-cost method: With this method, contract costs incurred to date are divided by the total estimated contract cost. This ratio then represents the percentage of total contract revenue that has been earned. If most of the needed materials are bought at the start of the project, this method can enable contractors to recognize the largest portion of project revenue in its early stages.
- Efforts-expended method: This compares the proportion of effort actually expended to date with estimated total effort. The calculation can be based on direct labor hours, the amount of materials used or machine hours, if appropriate.
- Units-of-delivery method: This calculates revenue and cost based on the number of units delivered to the customer compared with the total number of units specified under the terms of the contract.
Completed contract method: With CCM, the contractor recognizes all project revenue, expenses and profit only when the project is completed. This approach should be used only for projects lasting less than a year. Using CCM can be an advantage for contractors who want to defer revenue to a future period.
Tax reporting strategies: Construction firms need to plan their tax strategies year-round in order to get the most benefit and ensure they comply with IRS requirements. Here are some reporting strategies that can help contractors manage their tax liability.
Select the appropriate accounting method: Large contractors should ensure they use the right tax reporting method for each contract by determining which projects are defined as long term (more than one year) under IRS Code 460. PCM is required for most long-term projects. However, there are exceptions. For example, contractors are exempt if at least 80% of construction costs are for homes or other dwellings with four or fewer units.
Smaller contractors with revenue of $25 million or less in the last three tax years are also exempt from the code. For short-term contracts, CCM may offer advantages if companies want to defer revenue to a future period to reduce their tax liability in the current period.
Qualify for a research and development (R&D) tax credit: Innovative and technically challenging projects that involve the design and development of new types of buildings, subsystems or processes may be eligible for sizable R&D tax credits. These credits provide a dollar-for-dollar tax savings on either the entire qualified project or the portion of the project that meets IRS criteria.
It’s important to accurately document the innovative aspects of the project, and companies may find benefit in enlisting the help of an outside expert. R&D tax credits that are not fully used in any year may be applied to the previous year or carried forward for up to 20 years. Contractors with an average of less than $50 million in gross receipts can use the R&D tax credit to offset Alternative Minimum Tax. In addition, qualified startups and small businesses that may not have an income tax liability can offset payroll taxes with the credit.
Reduce taxable income: Contractors that are owners of or investors in pass-through entities, including sole proprietorships, partnerships and most LLCs and S corporations, can deduct their allocated share of losses to the extent of their basis (debt and equity). Contractors can also minimize their tax liability by maximizing retirement plan contributions, thus reducing pretax income.
Change order management: Inevitably, construction projects undergo changes from the original plan. Unless contractors handle them carefully, change orders can cut into project profits or even result in disputes with customers. Ideally, the original contract should spell out exactly how to handle change orders, and contractors should establish a standard change order process with full documentation of the work and cost required for each change requested.
It’s a best practice for contractors to hold off on starting work until a signed agreement from the customer is received, but in reality, job site leaders often accept change orders without going through a formal approval process. Either way, it’s important to accurately record the change order in an accounting system so project cost and profitability can be tracked. There are several conservative accounting approaches to manage this. The best one depends on the status of the change order:
- Change orders that are unapproved and unlikely to be approved: If a contractor is incurring costs to implement changes and doesn’t know whether the customer will approve payment for them, a conservative approach is to add the costs associated with the change order to the project’s direct costs.
- Change orders that are unapproved but likely to be approved: If a contractor is implementing a change order that’s currently unapproved but expected to be approved, there are several options. One is to add the costs to an asset account until approval for the change order is obtained. Another is to add the expense to the project’s costs and increase the anticipated project revenue by the same amount.
- Approved change orders: Add all costs associated with the change order to the project costs, and increase the total contract value by the amount charged for the change order.
Accounting software: Using cloud-based accounting software that’s accessible wherever employees are can greatly simplify financial management and reduce manual bookkeeping efforts while enabling contractors to better track profitability and spend more time focusing on the core business. Software can help create accurate estimates, track a wide variety of costs and accurately allocate them to projects and manage revenue recognition using the PCM and/or CCM methods. NetSuite financial management software automates calculations for raw materials, labor hours, costs, budget changes and projected revenue. It handles job costing, change orders and construction-industry revenue recognition methods. Mobile support provides contractors with real-time access to current data from job sites and while traveling.
Clearly, construction accounting is both complex and specialized. In an industry that typically operates on tight margins, applying best practices to construction accounting can help contractors maintain control over expenses and maximize profits.
Construction Accounting FAQs
Q: How is construction accounting different?
A: Construction accounting differs in several ways from accounting in other professions. One difference is the focus on project-based costing and the need to track multiple jobs running concurrently. Another is that contractors have to manage specialized methods for revenue recognition and tax reporting on projects that can last months or years. In addition, construction accounting needs to handle the change orders and retainage, or money held back, that are typical on sizable construction projects.
Q: How does construction accounting work?
A: Construction accounting often involves accurately allocating costs and managing revenue for a diverse portfolio of projects. Each construction project is considered a unique, short-term profit center. Even similar projects often have different site conditions or variables, such as labor force availability, cost of materials and local zoning, that affect margins. Depending on the nature of their businesses, contractors need to determine whether to use cash-basis or accrual-basis accounting, and whether to use the percentage of completion method or completed contract method on large projects.
Q: What is best practice in construction accounting?
A: Construction accounting is complex, so contractors need to focus on best practices for various aspects of the task in order to maximize profitability. Accurate job costing is critical to ensure contractors accurately assign all relevant costs to each project and to determine project profitability. Choosing cash-basis as opposed to accrual-basis accounting can simplify financial management for small contractors. Larger companies need to decide whether to use the percentage of completion or the completed contract method for big projects. Implementing accounting software can simplify and automate many aspects of construction accounting and tax preparation.
Q: What are good construction accounting practices?
A: Good accounting practices should align with a construction company’s business model. Smaller companies may use cash-basis accounting, which is relatively simple, while larger firms will need to use accrual-basis accounting to support percentage of completion or the completed contract methods of revenue recognition. For most contractors, job costing and change order management are key to running an efficient and profitable business.