Construction Accounting 101: Expert Guide for Contractors

Efficient and accurate accounting is as vital to success in construction as in any other industry. But despite being built on standard accounting principles, construction accounting is a specialized discipline because of the unique way construction companies operate.

Construction accountants focus on managing the cost and profitability of large, individual projects versus product lines, for example, while helping their firms manage industry practices such as retainage, specialized billing and revenue recognition methods and tracking frequent change orders.

Because construction accounting involves specialized concepts, it typically requires specialized accounting skills.

What is Construction Accounting?

Construction accounting is a specialized branch of accounting that caters specifically to the unique financial and operational needs of the construction industry. It addresses the distinct challenges presented by construction projects, such as long-term timelines, complex costing structures, and contractual obligations. Unlike traditional accounting which focuses on routine business transactions, construction accounting revolves around individual projects, ensuring that each is financially viable and monitored closely from initiation to completion.

Key Takeaways

• Construction accounting is a specialized domain, distinct from general business accounting, focusing on the unique dynamics of construction projects.
• Techniques like the Percentage-of-Completion Method and Completed Contract Method determine when revenues and expenses are recognized in construction accounting.
• Specialized financial statements, such as the Work-in-Progress Schedule and Construction-in-Progress Report, are essential for tracking ongoing project finances.
• Implementing and utilizing modern accounting software, along with consistent professional training, are paramount for maintaining accuracy and efficiency in construction accounting.

How to Account for Construction

As in other industries, construction accountants perform critical activities to manage the company’s finances, such as recording transactions, managing cash flow and analyzing profitability. Much of the work of construction accountants is involved with tracking the individual projects that make up most contractors’ workloads. The practice of job costing helps businesses estimate and analyze costs and revenue for each project, keeping projects on track and profitable.

Construction Accounting vs. Regular Accounting: What’s the Difference?

Though construction accounting shares the same basic principles as accounting in most other industries, it involves a number of industry-specific concepts and challenges. For example, construction firms typically aim to ensure that each project is profitable, which makes accurate job costing vital. And, projects are often large and one-off, so leaders must get the numbers right the first time. This is particularly challenging because a company’s projects are typically distributed across multiple sites, use a mobile workforce and are subject to fluctuating costs.

In addition, construction accountants often need to manage revenue recognition and billing for multiyear projects that may undergo many changes over their lifetimes.

Project-based

Unlike companies in other industries, such as retail or manufacturing, construction accounting typically focuses on custom projects, each of which must be managed for profitability.

Estimating quotes to be competitive while profitable and keeping them on track can be difficult because of the unique intricacies of each project. For example, labor, material costs and local taxes can vary widely depending on the type of building and where it is based. Furthermore, contractors are often juggling resources among many projects at the same time, each with its own schedule.

Production is decentralized and mobile

With construction companies, production generally occurs on project sites rather than in a single fixed location. Workers and equipment move from site to site, so firms must be able to account for the costs of travel and moving and installing equipment.

The company must also ensure it complies with local wage scales and regulations in effect at each site, and it may need to purchase materials or rent machinery from outlets near each site. Many contractors choose to lease rather than purchase vehicles, and lease accounting brings its own challenges.

Mobile technology that enables workers to access and enter information in the field can help companies stay up to date on project progress and cost.

Long-term, irregular and flexible contracts

Large construction projects tend to be lengthy, spanning multiple accounting periods or even years. Even smaller projects can stretch out due to problems such as raw material shortages or bad weather. To ensure adequate income and document cash flow, contractors typically need to manage a schedule of multiple payments during the contract based on work completed to date.

In addition, work tends to be seasonal, and it’s often difficult to predict when jobs will come in.

Fluctuating direct and indirect costs

Continuously fluctuating direct and indirect costs make it difficult to estimate project expenses. The price of labor and materials can change considerably over the life of a long-term project, and those changes are often not easy to predict. Contractors are particularly vulnerable to changing costs for materials because it’s difficult to stockpile building supplies in advance. Even indirect costs, such as administrative overhead and insurance, can change during a multiyear contract.

Limited sales

Construction firms — especially those undertaking large-scale projects like commercial or municipal buildings — may win only a few contracts per year. Thus, a typical chart of accounts for a contractor will look different from a manufacturer or high-volume retail or hospitality business. Sales staff will also be remunerated differently, and accounting needs to pay significant attention to the financial health of customers.

Change orders

For most contactors, change orders are the norm rather than the exception — especially on longer projects. If they’re not handled efficiently, they can cut into project profits. It’s important to accurately document the financial impact of each change to the overall project, which isn’t always easy because contractors often start work on changes before they’re formally approved and priced. Ideally, contractors should document a change order process in the original project contract.

Predicting profitability is difficult

Determining whether construction projects will be profitable is more difficult than in industries such as retailing or manufacturing, due to all of the factors above. Each project brings its own unique challenges, while change orders and fluctuating expenses during projects further complicate the picture.

This emphasizes the fact that accurately accounting for all costs is key to determining whether projects make a profit, break even or lose money.

Construction Accounting Concepts

Construction accounting includes unique concepts that reflect the specialized practices and requirements of the building industry. These concepts span the entire project lifecycle, from estimating to billing and revenue recognition. The billing method agreed on with clients may vary based on the type of project and the risks involved.

Construction firms may even choose a specific revenue recognition method on a per-project basis depending on factors such as size and expected length. Complex regulatory requirements may also apply to each project.

Job costing

Because each project typically operates as its own temporary profit center, accurately estimating and tracking all project costs is a critical aspect of construction accounting. Job costing is the process of determining the total cost of completing each job to the contracted specifications. Contractors use this information for estimating, billing and assessing whether in-progress projects are on track. Generally, costs fall into three major categories: labor, materials and overhead. To provide a comprehensive picture of project finances, job costing should account for every stage of the project, including the cost of producing estimates and change orders.

Contract revenue recognition

For contractors, revenue recognition is a complex topic, largely because of the long-term nature of many projects. The choice of revenue recognition method depends on factors such as the size of the contractor’s business as well as the duration and type of projects the company works on.

Cash basis method: In general, companies can use one of two overall accounting methods: cash basis or accrual basis.

Cash basis is the simplest approach to recognizing contract revenue. With cash basis accounting, you record revenue when you receive payment and record expenses when you actually pay them. With accrual basis accounting, you record revenue when it is earned and expenses when they are incurred, regardless of when money actually changes hands.

However, construction companies can generally use the cash basis method only if they have average gross receipts of $25 million or less (the threshold was raised from $5 million in the Tax Cuts and Jobs Act, which came into force in 2018). Public companies and many larger businesses must use accrual basis accounting to comply with U.S. Generally Accepted Accounting Principles (GAAP).

Although the simplicity of cash basis accounting is appealing, it can paint a misleading picture of a company’s finances. If a company hasn’t completed a major project by the end of an accounting period, for example, its financial statements will reflect all the project expenses it’s incurred but none of the revenue it’s earned.

Percentage of completion method: The percentage of completion method (PCM) enables contractors to recognize revenue as they earn it over the life of a contract. Most contractors recognize revenue using this method, especially if they work on multiyear contracts. In general, contractors with gross revenue over $25 million must use this method for projects that take two years or more, unless a project qualifies as a home construction project as defined under U.S. Code 460.

During a project, contractors recognize revenue for the portion of the work they’ve completed to date. There are several ways to calculate this: The cost-to-cost approach bases the amount on the percentage of estimated job costs incurred to date, while the estimated percent complete approach uses an assessment of the percentage of work completed. A big advantage of the percentage of completion method is that, because it reports income and expenses together throughout each project, it paints a more accurate picture of the company’s finances and smooths out potential swings in revenue and expenses.

Completed contract method: With the completed contract method (CCM), contractors recognize all revenue, expenses and profits only when the project is completed. An advantage of this method is that contractors can defer revenue to a future period, thus minimizing tax liability in the current period. Generally, firms may use this method only in limited circumstances, notably for home construction projects. A disadvantage is that CCM is not GAAP-compliant.

In addition, contractors must pay attention to ASC 606 new revenue recognition standards.

A recently introduced GAAP revenue recognition standard, Accounting Standards Code (ASC) 606 affects how contractors should recognize revenue for long-term contracts using PCM. ASC guidance is that companies should recognize revenue based on performance obligations, which are promises to deliver distinct goods or services to a customer. A contract may include a single performance obligation, or it may include several. Contractors must identify performance obligations in the contract and allocate a price to each.

A second key consideration is transfer of control — the point at which ownership and control of the end product passes to the customer. In situations where the ownership and control of a contractor’s work product becomes the customer’s over time, PCM would be applied to each performance obligation rather than the total contract price.

Contract retainage

Retainage is the portion of the agreed-on project price that is withheld until the job is completed, or for a specified period. The goal of this long-standing practice is to create a financial incentive for contractors to complete the project satisfactorily and to protect owners if problems appear. Retainage amounts are often substantial, amounting to 5% to 10% of the contract value.

Retainage is commonly applied to both private-sector and public-sector projects; the regulations for handling retainage vary from state to state. Because many contractors operate on relatively low profit margins, the amount withheld for retainage can represent a large portion of a project’s profit. To mitigate their risk, contractors may in turn withhold retainage from their subcontractors.

Construction billing

In many industries, billing takes place at the time of sale or on a fixed monthly schedule — think of buying office supplies or subscribing to a streaming service. In construction, billing can be much more complex, largely because of the long-term and flexible nature of many projects.

Some of the most common construction billing methods are:

Fixed price: The contractor and client agree to a set price for the project at the beginning of the venture, based on a detailed estimate. This commits the construction company to completing the project for that price regardless of the time and materials actually required, although contracts may allow for price changes if unforeseen problems emerge. Although this approach creates risks for contractors, it can attract customers who want to see the full price up front.

Time and materials: The time and materials billing method is often used when it’s not possible to pin down the scope of a project in advance. The contractor bills based on a per-hour rate for labor, plus the cost of materials. Contractors may apply a standard markup to both labor time and materials to cover their overhead and generate a profit. To protect buyers, some contracts include a price cap; the buyer agrees to pay for time and materials only up to a specified limit.

Unit price: The contractor bills at a fixed price per unit, and both the nature of the “unit” and the per-unit price are established in the project contract. The unit price contract method is useful in situations where the contractor is providing repetitive items with a predictable cost, but it’s not clear at the outset how many items will be needed.

Unit pricing is often used on public construction projects. For example, a contractor might provide a unit price per mile of highway. To make a profit, a construction firm needs to be able to accurately estimate all the costs — labor, materials, overhead — involved in delivering each unit.

AIA progress billing: The American Institute of Architects (AIA) billing method is commonly used in commercial and government-funded construction projects, so gaining familiarity with it can help contractors expand into those areas.

The AIA defines allowed billing processes and forms. Contractors bill clients for the work completed in each billing period. By standardizing the process, forms and language used, AIA billing is designed to make it clear to owners exactly how much work the contractor has completed to date; it also requires architect signoff on each invoice. For each period, the contractor provides a summary cover sheet (Form G702) and a detailed description of the work completed (Form G703).

Construction payroll

In many industries, wages are determined by simply investigating the local market rate and minimum wage requirements for various roles. Though that’s also true for some construction jobs, specific rules apply to public projects and the use of union labor.

In addition, contractors have to navigate a complex web of labor laws and local tax regimes.

Prevailing wage: Contractors working on public projects must pay government-defined minimum wages for each type of worker. These are known as “prevailing wages” because they’re based on surveys of what people are paid to do similar work in each region.

For federal projects, allowable wages as defined by the Davis-Bacon Act are publicly posted information. Most states also set prevailing wages for state-funded public projects. Contractors usually have to certify that they comply by submitting forms to the appropriate agency. Meeting prevailing wage requirements can be complex because rates change frequently and vary between jurisdictions.

Union payroll: Unlike many other industries, construction trades are still largely unionized. Wages and other working conditions are determined by collective bargaining agreements, and companies typically need to report wages and other information to each union to verify compliance. Companies may also need to deduct union dues from payroll and accurately track time to ensure tradespeople are working only the hours specified in their contracts.

Multi-state payroll: Contractors that have projects in several cities and states are exposed to the complexities of multiple payroll and labor laws. They need to ensure they deduct taxes appropriately for each employee to comply with city and state taxes. This can get complicated if a company has employees who live in one state and work in another or perform work in multiple states. Nearly all states require employers to withhold tax from employee wages for work they perform in that state. However, most states also have the right to tax their residents. Some states have reciprocal agreements, so if employees perform work in multiple states, their employers only need to withhold taxes for one state. But in some cases, a contractor might have to withhold taxes for multiple states from one employee’s wages.

Compliance reporting: In addition to meeting local tax requirements, contractors have to track and often report compliance with employment regulations. This may involve reporting to federal, state and local agencies.

At a federal level, the Occupational Safety and Health Administration (OSHA) requires all employers to report work-related deaths and serious injuries, and the Equal Employment Opportunity Commission (EEOC) requires employers with more than 100 employees to submit an annual report with data about the ethnicity, race and gender of employees.

Financial Statements Specific to Construction Accounting

Due to the distinct and unique nature of the industry, certain financial statements only exist for construction accounting. These tailored statements address the complexities inherent in construction operations and provide stakeholders with accurate, relevant, and actionable financial data.

Work-in-Progress (WIP) Schedule

The Work-in-Progress (WIP) Schedule is an integral financial tool in the construction industry. It offers a detailed snapshot of the current financial status of ongoing projects, providing crucial insights into costs incurred and revenues earned. This report includes projected total cost, costs incurred to date, billed revenue, and recognized revenue. Accurate interpretation of WIP data aids in identifying potential project overruns or underruns, assessing project progress against the budget, and guiding financial decision-making for ongoing projects.

Construction-in-Progress (CIP) Report

The Construction-in-Progress (CIP) Report is designed to track financial data for projects that have commenced but are yet to be completed. It's instrumental in providing an ongoing record of costs and revenues. The CIP report includes a detailed account of ongoing costs, including labor, materials, and overhead. It also shows data on cumulative revenues based on the percentage-of-completion or other recognition methods. With the CIP report in hand, construction firms can evaluate the financial health of individual projects, detect potential financial risks or challenges early on, and ensure consistency in profit margins across projects.

Job Cost Sheets

Job Cost Sheets serve as the financial blueprint for each construction job. They provide granular insights into the expenses associated with specific tasks or phases. This report includes a comprehensive breakdown of individual job costs, from materials to subcontractor fees and a continuous comparison of actual costs against budgeted amounts. By regularly updating and reviewing job cost sheets, companies can monitor budget adherence in real-time, make timely adjustments to resource allocation, and predict final project costs with greater accuracy.

Other Relevant Statements

• Profit and Loss (P&L) Statement: This statement provides a consolidated view of a project’s revenues and expenses, giving stakeholders insights into the project's profitability.
• Balance Sheet: The construction industry balance sheet reflects assets and liabilities unique to the sector, including retentions, advances, construction equipment, and project-specific financing. Properly maintained, it offers a holistic view of a company's financial position.

In the dynamic and multifaceted realm of construction, these specialized financial statements play a pivotal role. They not only ensure precise financial tracking but also underpin the strategic decision-making essential for the sustained success of construction entities.

4 Construction Accounting Best Practices

Applying best practices for construction accounting can deliver benefits across the entire business. Accurate job costing, for example, can help businesses see where they’re making or losing money and react quickly before profitability is negatively impacted.

1. Focus on accurate job costing. Since contractors are project-based businesses, accurately determining the cost of every project is key to managing profitability. Detailed job costing helps businesses estimate projects accurately, and then track actual versus estimated costs.

   Costing isn’t easy, though. To accurately estimate a job, every aspect of its labor, materials and overhead costs must be understood. Tracking labor costs is tough when you have a mobile workforce deployed on many different projects. It can be easier when job costing is made a priority for all employees, so they understand its value to the company. Good accounting software and clear, intuitive coding for each job and each cost category can make it easier.

2. Use cash basis accounting. For many smaller businesses, cash basis accounting is an appealing choice. Its simplicity typically means lower bookkeeping costs than when using accrual basis accounting, and it usually provides a clear picture of a company’s actual cash position — which is particularly helpful for smaller businesses with limited funds. Because you only record revenue when you receive payment, you don’t have to pay taxes on sales for which you haven’t yet collected the money. And because you record expenses when you pay them, you may be able to reduce your current year’s tax bill by purchasing additional materials at the end of the year.

3. Determine the best tax strategy. Many factors can affect contractors’ income tax liability, including their choice of revenue recognition method, the type of projects they work on and their business structure. The best tax strategy will depend on the business and its needs. Most contractors use the percentage of completion method for recognizing revenue on large contracts. This has the advantage of smoothing out swings in revenue because it records both revenue and associated expenses over the life of a project.

   Contractors working on home construction projects may be able to use the alternative completed contract method, which recognizes revenue and expenses only at the end of a project. This can be advantageous for firms looking to reduce tax liability in the current year because it defers revenue and associated income tax to a later period.

   Owners or partners in construction firms should think carefully about the tax implications of their business structures. For example, those structured as pass-through entities, such as sole proprietorships or many LLCs, can reduce their personal income tax liability by deducting business losses.

4. Invest in construction accounting software. Modern accounting software can simplify financial management while helping contractors comply with tax laws. Good construction accounting software should automate much of the otherwise laborious work of job costing. Reporting capabilities enable you to track projects and analyze overall business finances in real time, so you can quickly identify problems and take steps to correct them before it’s too late. By managing accounts receivable and accounts payable, software can help contractors ensure they collect what they’re owed and stay on good terms with suppliers. Construction accounting software should also help to ensure accurate tax filings, with enough flexibility to support the range of revenue recognition methods used by the construction industry.

Top 6 Construction Accounting Errors

For growing firms trying to manage hectic schedules, it’s all too easy to make construction accounting mistakes, from inaccurately estimating jobs to signing contracts without adequate scrutiny. Here are six of the most common construction accounting errors.

1. Disorganization: It’s not easy to run a well-organized construction accounting department, especially for small contractors. When you’re trying to grow a business while staying on top of fluid project schedules and an ever-changing labor pool, careful accounting may not be your top priority. But failing to build an organized construction accounting process can have serious consequences. Among them: failing to keep tabs on project costs and running up against tax problems. Hiring an experienced construction accounting professional can help. So can implementing capable construction accounting software that will help you determine job costs, track finances in real time and comply with tax requirements.

2. Poor job cost estimates: Inaccurate estimates lie at the heart of many contractors’ business problems. A too-low estimate can result in a loss-making project or awkward renegotiations with clients. Estimates that are too high can mean losing work to competitors. For companies using the percentage of completion method, poor estimates can cause problems with revenue recognition. To create accurate job cost estimates, it’s essential to develop a good understanding of all the components of job costs — which include overhead, labor and materials.

3. Inaccurate recognition of joint ventures: Joint ventures are common on large construction projects, in which companies often come together to pool resources and share risk. Each company contributes capital in the form of funds or equipment. But companies involved in joint ventures are required to use one of several specialized accounting methods to reflect their participation, so it’s critical to set up the correct accounting structure at the outset to ensure each company’s investment, revenue and profit is accurately reported. The choice of accounting method for joint ventures typically depends on the company’s level of investment in and control of the combined joint venture company, but construction companies sometimes don’t realize this until it’s too late.

4. Incorrect overhead calculations: Contractors typically allocate their overhead costs to projects as a percentage of overall project costs. So if they incorrectly calculate their overhead, the result can be inaccurate job costing and reduced profits. That’s unfortunately not uncommon: Contractors tend to have high overhead costs that change frequently, and it’s a challenge to make sure every item is included and up to date. It’s important to regularly review all costs and ensure they’re included in overhead calculations. Overhead may include office costs, insurance, maintenance and training.

5. Mismanaged change orders: If managed well, change orders can add to a project’s profits while helping to keep clients happy. But contractors often take on change orders based on quick on-site conversations, resulting in extra work that isn’t adequately documented, accurately priced or correctly accounted for in the project’s finances. This can increase costs and create a distorted picture of profitability. Even though it can be time-consuming, it’s important to perform a thorough estimate of costs and get each change order documented and approved before starting work.

6. Accepting unreasonable contract terms: Growing businesses often find it tough to quibble about the terms of a contract, especially if it’s a big job that will significantly boost the company’s revenue or stature in its community or industry. But accepting unreasonable contract terms can lead to huge problems later. Unacceptable penalties and conditions, especially if they’re linked to circumstances outside your control, such as the weather or the actions of third parties, can lead to losses and customer disputes. To avoid problems, ensure you carefully review contracts, with the help of an attorney if necessary, and ask clients to address any unreasonable terms. You may find they’re willing to accommodate your requests.

Mitigate Risk and Improve Construction Accounting With NetSuite

Accurate job costing helps companies make sure labor, materials and overhead costs are tracking to budget. Cloud-based financial management software simplifies and automates construction accounting, reducing manual effort and helping construction firms manage cost, improve profitability and comply with tax regulations.

NetSuite’s unified billing platform handles multiple construction project pricing models, including unit price, cost plus and time and materials contracts while automating revenue recognition, helping businesses comply with ASC 606. Because NetSuite is part of an integrated suite of business applications that also includes payroll and customer service, companies can manage their entire businesses with a single platform. Contractors can view real-time financial reports of project status and consolidated financial information from across the business. Mobile support means users have that data at their fingertips from anywhere — in the office, at project sites or while on the road.

A solid accounting function contributes to the success of any construction company. Construction accounting requires specialized skills to support the construction industry’s unique practices in areas such as job costing, retainage and revenue recognition. Accounting software can help companies reduce administrative effort, simplify financial management and increase profitability.