Four Approaches to Construction Accounting
Due to the nature and challenges of the construction industry, accounting and financial management can be complex. Depending on the project, some accounting methods may work better than others. It is important to review all options before deciding which method is right for your company.
Here are some methodologies to keep in mind for construction accounting.
In cash basis accounting, revenue is recorded when it is received and expenses are recorded when paid. It is the easiest and simplest method for construction companies, with some caveats to keep in mind. For example, expenses must be allocated evenly over the entire benefit period when applied to a multi-year contract. Also, for businesses making less than $1 million in revenue, job materials must account for less than 15% of the customer’s total cost or this method can’t be used.
Job costing or allocating all direct and indirect expenses and revenues to each construction job, is an efficient way to record income and expenses for businesses with multiple projects and jobs that may vary in scope. This method is useful because it provides detailed information about a given contract’s profitability and simplifies the tax preparation process. Job costing helps safeguard the profitability of a project, by ensuring all overhead expenses are covered by the final service price.
Percentage of Completion
The percentage of completion methodology can provide pertinent financial data by estimating expenses and profits while the project is still in progress. In this accounting methodology, the business’s goal is to match revenues and expenses. By dividing the incurred expenses by the total estimated job expenses, contractors can determine if a specific project remains on track to make a profit or if the job is projected to be completed at a loss. Multiplying the estimated gross profit by the percentage complete will determine the estimated gross profit of a job.
Tax planning: With the percentage of completion approach, income and expenses are recognized in the year received, which means tax calculations must be made in the year received. This is a preferred option for long term contracts because it can be effective in combatting tax fluctuations. The IRS also has specific rules surrounding using this method of accounting.
Completed Contract Method
For short term contracts of less than two years with an average gross profit of less than $1 million, the completed contract method can be effective. Under this method, income is not reported until the project is completed thus allowing contractors to defer their taxes until the completion The cost of materials and/or supplies must be allocated to the contract and the costs are regarded as assets and deducted when the project is complete rather than in the year paid.
Tax planning: When using this method, contractors can defer taxes until the project is completed, but that could increase the company’s tax burden in the future.
The appropriate accounting and tax reporting method will depend on a variety of circumstances for each project. A professional who is familiar with the construction industry can help determine the best approach for each unique situation.
If you have questions, contact HFM today. Our professionals are well versed on the latest issues to provide our clients with professional, personalized services.