Accounting is one of the most important parts of business management and administration. In the construction industry, contractors face certain difficulties in accounting due to their unique challenges. In this article, we aim to full fill contractors with the basic knowledge of construction accounting and the key differences between construction accounting and regular accounting.
The unique challenges of construction accounting
Typical businesses such as grocery stores or restaurants use a typical accounting principle that involves a straightforward system of income and expenses. Businesses pay for bills and products and if there are profits at the end of the month, it means they are operating successfully. However, in the construction business, due to its mobility and customized works. Construction companies have different types of expenses such as travel time, job costing, or mobilization costs. It is important for contractors to keep track of their expenses to accurately project profit and loss. Also, projects can be run for a whole year, during which the expense could be outweighed the income. In addition, the possibility of unexpected setbacks and changes in the contract can change the expected profit.
Construction Accounting vs Regular Accounting – Key Differences
Sales – The first difference is what construction companies sell. The regular business account usually offers 1-5 products and services categories. Construction account, on the other hand, offers a wider range of services categories such as consulting, and engineering. Labor, physical products, or materials.
Cost of goods sold – Regular businesses simply record the cost of the product sold but construction accounting is more complicated. The costs fall into hundreds of categories.
Expenses/Overhead – For regular accounting, there is a clear distinction between the Cost of goods and the Overhead. But it’s not simple in construction accounting. Many “Overhead” items in regular accounting fall into the “Cost of Goods Sold” category in construction accounting because they are directly connected to customers’ projects.
Break-Even – In regular accounting, it is fairly easy to calculate the breakeven point because the relationship between income and expenses is direct. Also, it is easy to determine which items are profitable and unprofitable in the reports and make suitable and timely adjustments. However, in construction accounting, there are too many categories to easily determine the break-even on a project. Moreover, there are customized jobs in the project that involve a variety of associated costs.
Common Costs Types in Construction Accounting
In its simplest terms, job costing is commonly used in construction accounting and bookkeeping to accurately calculate project expenses by looking at all the granular costs for each project. Construction job costing helps you more precisely bid on similar projects to ensure the profit margin. This method gives you a complete picture of all costs associated with a specific hob and looks at labor, materials, and overhead.
Work In Progress
Work in progress refers to jobs that are partially finished projects waiting for completion. It is an essential financial tool used as a general ledger account in which the total cost used to construct a project might be recorded. Contractors and accountants often use work in progress reports to understand a project’s status, and cash flow and determine the gross profit trend against the duration of the construction work.
Cost of Goods Sold
Cost of goods sold (COGs) refers to the direct costs that are associated with the performance and completion of a project for a contractor or subcontractor are considered to be the cost of goods sold. COGs are used to calculate the gross profit margin on specific projects and for the company overall.
Revenue recognition for contracts in the construction industry can get tricky and must be recorded consistently and within establish standards.
Cash vs accrual accounting
Cash basic accounting means that costs and income are recognized when cash is received and expensed when they are paid. This means accounts payable and accounts receivable aren’t recognized until a check is written to pay the bill, and revenue isn’t recorded until payment is received and deposited into the company’s account.
Cash basic accounting provides an accurate picture of cash flow. Since it doesn’t recognize costs and revenues in a timely fashion, you probably don’t know how profitable your project or company is.
Accrual accounting recognizes revenue and costs when a client is billed or when a bill is received, regardless of when the money is actually received or paid. Because both are recognized in the time period they were incurred, this method allows the current cash inflows and outflows to give a more accurate picture of a company's financial position.
Percent Complete vs Completed Contract Income Recognition
Revenue can be recognized in two ways in construction - percent complete and completed contract.
Percent Complete Method (PCM) allows for the recognition of revenues, expenses, and taxes on a project based on the percentage of costs that have come in.
For example, a construction company is undertaking a project that is under contract at a sales price of $100,000. The estimate of the cost to complete the structure will be $60,000. Under the percentage of completion method, if the project is deemed to be 40% complete, the business will report 40% of the $60,000 in expenses. This calculation will result in a current gross profit of $16,000 ($100,000 x 0,4) - ($60,000 x 0,4)
The completed-contract method (CCM) of accounting considers all income expenses directly related to a long-term contract until its completion. By using this method, contractors may enjoy a break from taxes during the working phase and sometimes may even qualify for certain tax incentives in the meantime. However, this method of construction of revenue recognition is not GAAP-approved.
Reports recommended for successful contractors:
1. Accounts Receivable
2. Accounts Payable
3. Profit & Loss
4. Balance Sheet
5. Cash Balance
6. Job Costing Reports
7. Job Profitability Reports
8. Earned Value Reports
9. Work-In-Process Reports
10. Estimates Vs. Actuals Reports
11. Payment Applications
12. And more...
In construction, billing can be a headache, largely because of the long-term and flexible nature of many projects so it’s essential to have streamlined billing practices in place to guarantee invoice accuracy and faster payments. There are four billing methods in the construction industry include:
Lump-sum contract refers to as fixed billing contracts, rolling the entire price of a project into one fixed price.
Cost-plus contract requires the owner to pay the contractor for the cost of the project plus a fee for profit.
Time and materials contract is based on hourly labor rates and supply costs used toward the project during a billing period.
Unit price contract breaks a project into segments instead of pricing a complete job and provides room for additional work or materials to a project.
AIA billing is based on the percentage of work completed, and invoices include detailed reports on what work has been done and billed.
Each method has its pros and cons and you have to take many factors projects into account before choosing the best appropriate one. In either billing method, it’s important to closely track the costs and progress incurred on a job is essential to producing accurate invoices.
Construction clients may additionally withhold some percentage of a contract’s payment to a contractor or subcontractor until a time specified in the contract with the owner’s satisfaction. Thí means that after completing a project, the contractor or subcontractor has to wait months or years before collecting all of the money owed to them. Retainage often limits a contract and subcontract’s cash flow and may cause financial hardships. As a business owner, you need to know all the retainage terms and retainage rules of the state you’re working in before signing any contract.
Construction accounting software helps you stay in control of project costs, change orders, and invoices in real-time. There’s a range of software out there to fit different business needs, from simple accounting software for contractors with one crew to ERP software for midsized construction companies.
Sage 100 Contractor (Best ones with basic construction ERP features combined with solid accounting functionality)
QuickBooks Online Plus (Best general purpose accounting software for tracking job costs)
FreshBooks (Managing business finances from your office, truck, or the building sites)
Xero (Managing business finances from your office, truck, or the building sites)
What should contractors do?
Construction accounting needs to start with understanding the different types of costs in the project. The accounting process requires carefulness. Contractors can apply construction software solutions to help. However, it is recommended that contractors should hire a professional accountant or bookkeeper to save time and potential money. Construction Cost Accounting with experienced and delicate accountants and bookkeepers can save you from accounting headaches. In Construction Cost Accounting, we provide full construction accounting services for contractors. Contact us now!
If you need any advice or services on any aspects of construction bookkeeping, accounting, or tax, our construction accounting specialists are ready to help. Get in touch with us for free quote.