General and sub-contractors face accounting challenges unique to their industry. Here are some ways to determine the best accounting methods for your company.
Key takeaways:
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Accounting for contractors requires a different methodology.
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The four most common accounting methods used for contracting and construction companies are the cash method, the accrual method, the completed contract method (CCM), and the percentage of completion method (PCM).
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Job costing is considered an essential practice in contracting and construction accounting.
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Work with a professional before selecting an accounting method for your contracting or construction business.
If you are a general contractor or business owner of a construction company, you have specific bookkeeping and accounting needs. The realities of your work make tight project controls necessary. So tracking each job’s profitability is key to success.
There are more accounting methods open to contractors than other business owners because of the unique features of construction work and the difficulty of measuring profitability over a project’s life span. Here is some guidance for determining which accounting methods are best for your company.
Why it is different for contractors
In more traditional industries, overhead costs are generally stable and somewhat predictable. Manufacturers typically produce products in established locations and sell through fixed retailers. While market shifts will impact their production and distribution costs, they do not change with each production run.
Construction projects have costs that vary from job to job. Three key reasons why construction projects require different accounting methodologies are:
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Varying costs of goods sold (COGS): A contractors’ COGS changes for every project and includes both direct and indirect costs.
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Variety of services offered: Many projects require multiple services that fall into numerous accounting categories.
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Overhead costs: These are less clearly defined for contractors, and many fall under the category of COGS because they change according to each project’s needs.
The choice of accounting method for contractors will also depend on:
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if the business enters into short- or long-term contracts
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the status of the contract at the end of the tax year
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the company’s annual gross receipt
Tax reporting regulations can differ according to jurisdiction. In addition to uniform federal requirements, your company will be accountable to the local tax laws for the state where you’re doing business.
Cash vs. accrual vs. contract-centric
Here are four accounting methods for general contractors and construction businesses. An accounting professional can guide you to the best approach for your business.
1. The cash accounting method
The cash method is the most popular method of accounting for small businesses. Only large construction businesses in a select category can elect to use the cash accounting method, and the regulations regarding it are subject to change.
The cash method is allowed if your company is a corporation or a partnership with a C-corporation and has gross receipts that averaged less than $25 million for the past three years with a limited inventory.
The cash method recognizes income on the date payment is received and expenses when paid.
This method is the simplest and can be managed with basic bookkeeping. It provides flexibility in planning the receipt of goods and recognizing taxable income. It’s most helpful for smaller contractors who conduct most of their business in cash and business owners who deal with large receivable balances and small payables.
The downside is that it can be less reliable in providing an accurate view of a business’s overall financial health. Some accounts payable and receivable can fall through the cracks. Also, the cash method is not listed in the Generally Accepted Accounting Principles (GAAP), which may make it harder to obtain financing for businesses that use it.
2. The accrual accounting method
When using the accrual method, businesses record their income when they charge the customer. Their revenue includes all payments received as well as all outstanding invoices to be paid. Similarly, expenses are recognized when they’re charged, including all paid and unpaid bills.
The accrual method works best for longer contracts with expected delays between billing and payments. It is GAAP-approved and provides a more accurate overall picture of the company’s financial status than cash accounting.
The accrual method is not the best choice for companies paid in cash soon after completing the job. It is more difficult to maintain, does not accurately represent a business’s cash position without running additional payroll reports, and creates a tax liability before receiving payment.
3. The completed contract method (CCM)
This approach is the most preferred accounting method in the industry. Using the CCM, a business will not recognize profit on a construction contract until that contract is completed. This is guided by the IRS definition of when a contract is considered complete, which may occur before all work is completed or costs have been incurred.
When using the CCM, income and expenses are not “official” until the project finishes. Companies can bill as the project progresses, but nothing is recorded on the income statement until the end. CCM has tax benefits for contractors because they can defer taxable revenue on incomplete projects.
The IRS has placed several CCM restrictions, including annual revenue amounts and lengths of eligible contracts.
4. The percentage of completion method (PCM)
This is the most complex method of the four and centers on the specifics of the individual contract. The PCM allows contractors to recognize revenue as it is earned over time. Once work is performed, it can be billed, and its revenue recorded. PCM is a variation of the accrual method, meaning that revenue is recognized as a portion of the overall contract value.
This method requires vigilant and exacting recording of all payables and receivables as well as superior estimating skills.
This is also the most preferred method by larger construction companies, the IRS, most financial lenders, and accounting firms. It provides a more accurate picture of the financial health of individual projects and is advantageous to use on lengthy projects.
When to call in the experts
Regulations governing the construction industry are complex. Federal legislation like new tax laws and changes to government standards such as the 2018 ASC 606: Revenue from Contracts with Customers can complicate the accounting process for contractors, with implications for your business’s viability.
A seasoned professional who has worked with many clients in the construction industry can save you from making costly mistakes. Both large and small contractors benefit from professional help that can assist you in creating income tax deferrals and finding tax-saving opportunities. If you are struggling to stay on top of your books, it’s time to update your strategy and enlist some help.
For peace of mind concerning your construction company’s accounting, look to the small and medium business experts at Franco Blueprint. We specialize in working with general contractors and can help with managing your company’s accounting needs from startup through maturity. We can advise which accounting methods best fit your company’s projects and cover all the bases for tax management and financial compliance.
It is our business to assist business owners and help them secure their livelihoods. Contact us for a free consultation today.