In an industry that typically operates on tight margins like construction, it is important to take a holistic approach in construction accounting to make sure a system is in place to match income and expenses accurately, resulting in maximizing profit. Because ultimately, a successful and sustainable construction business is about financial management. Here are 6 key construction accounting best practice for your business.
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1. Cash-basis accounting
There are two options for how contractors want to recognize revenue or record income both on their books and for tax purposes. These are "cash accounting" and "accrual accounting". Because cash accounting is a simpler method, small businesses prefer to use it.
Cash accounting lets businesses note transactions in real-time. More often that is a bank account, or sometimes can be literal cash bills. Payment receipts are recorded when and only when you receive the money. Similarly, expenses are recognized when they are actually paid. That is why cash-basis accounting is simple and straightforward.
By applying the cash-basis approach in construction accounting, contractors who operate on a cash basis won't necessarily need to use sophisticated software. Contractors also take advantage of cash accounting to pay lower taxes. For example, construction companies might ask their customers to hold payment on December invoices until January. As a result, they're effectively delaying that money in the current year and not making that money in the current year. By that means, they can report a lower profit and pay lower taxes for now.
However, cash accounting has several drawbacks. The main one is that it may not provide an accurate picture of the liabilities that have been incurred but not yet paid for. As a result, the business might appear to be better off than it really is. Although this method is preferred by most small businesses, it doesn’t work well for larger companies with a large inventory.
2. Accrual-basis accounting
The alternative method, accrual-basis accounting, or accrual accounting is more complex, but it works well for larger businesses. In accrual accounting, transactions are recorded when revenues are earned, and expenses are incurred, regardless of the exchange of cash. In construction accounting, this usually happens with the invoicing process. Contractors note transactions before cash changes hands. This method will provide a more accurate, helpful financial picture for your business.
3. Job costing
Regardless of whether you’re running a general contractor, subcontractors, or something in between, you need a job costing system to accurately bid and estimate projects effectively. You use the job costing formula to calculate the budget for the labor, materials, and additional overhead costs required for a certain project. By working on job costing, you have a deeper understanding of your balance sheet and income statement.
>> Read More: Job Costing Essentials for Contractors
4. Percentage of completion method (PCM)
PCM is a widely used accounting approach where the recognition of revenue on an ongoing basis depends on the stages of a project’s completion.
It evaluates how to realize revenue periodically over a long-term contract. Revenue, expenses, and gross profit are recognized each period that matches with the percentage of work completed or cost incurred.
Contractors can measure the percentage of completion in the following ways:
The cost-to-cost method: With this method, all costs recorded to date on a project or job are divided by the total estimated amount of cost that will be incurred. The ratio then represents the overall percentage of completion that is used for billing and revenue recognition purposes.
Efforts-expended method: The method measures the proportion of effort expended to date in comparison to the total effort expended for the contract. The calculation might be based on direct labor hours, or machine hours, or material quantities.
Units-of-delivery method: This calculates the percentage of units delivered to the customer to the total number of units to be delivered under the terms of a contract.
5. Completed contract method (CCM)
The completed-contract method defers all revenue and expense recognition associated with a project only after the contract is completed. This approach should be used only for short-term projects lasting less than 12 months.
6. Tax reporting strategies
As the end of the year creeps up, use one or more methods that suit your company.
Using the right accounting method
By determining which projects are not considered long-term projects (more than one year) under IRC Code 460, contractors should ensure the tax reporting method for each contract is appropriate. For most long-term contracts, the Percentage Of Completion method is required. Also, income and expenses are reported during the period incurred instead of deferring it to the end of the project.
However, it’s legitimate that builders, general contractors, and specialty contractors use the Completed Contract Method if at least 80% of construction costs entered into are attributed to the building, construction, reconstruction, or rehabilitation of units contained in buildings with four or fewer dwelling units.
Qualify for an R&D tax credit
Contrary to popular belief, R&D activities do not have to be carried out in a lab to be eligible for sizable R&D tax credits. These credits provide tax savings on either the entire qualified project or the portion of the project that meets IRS criteria.
Examples of qualifying R&D activities in the construction industry include both innovative and technical activities, such as the design and development of new types of new techniques to perform the job more efficiently, research of new construction methods.
>> Read More: Best Practices for Construction Accounting
Access opportunities for deductions on pass-through entities
Contractors that are owners or invest in pass-through entities (including sole proprietorships, partnerships, most LLCs, and S corporations) can deduct their allocated share of losses to the extent of their basis (debt and equity). Contractors should have a sufficient basis to deduct allocable losses instead of carrying losses to a future year if they guess the income may be lower. In addition, contractors can also reduce taxable income such as maximizing retirement plan contributions.
Construction accounting is both complex and specialized. By applying the practices to construction accounting can help contractors maintain control over expenses and maximize profit.
Not sure how much your construction business made? Irvine Bookkeeping tracks every dollar that enters and exits each job so you may accurately determine your income.
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