Construction Accounting 101 – Guide for Small Business Owners
- Cost Construction Accounting
- May 4, 2022
- 6 min read
Updated: Feb 11
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 provide construction business owners with the basic knowledge of construction accounting and the key differences between construction accounting and regular accounting. We will also introduce essential construction accounting concepts specialized principles unique to the industry that cover everything from project estimation to revenue recognition and regulatory compliance.
What is Construction Accounting?
Construction accounting is a specialized field focused on managing the financial aspects of construction projects and companies. Unlike traditional accounting, it addresses unique industry challenges like long project timelines, fluctuating costs, and complex billing arrangements.
For construction companies, effective accounting is essential for tracking project costs, managing cash flow, and ensuring accurate financial reporting throughout the project lifecycle. By applying industry-specific principles, construction accounting helps companies monitor financial health, make informed decisions, and improve overall financial management.
The Construction Financial Management Association (CFMA) emphasizes that proper construction accounting helps businesses manage cash flow, control project costs, and maximize profitability. With the right processes in place, companies gain clear understanding of their financial position and can make strategic decisions that drive success.
The Unique Challenges of Construction Accounting
Most businesses like grocery stores or restaurants use straightforward accounting track income and expenses, and if there's profit at month-end, the business is successful. But construction is different.
Due to the mobile nature of work, customized projects, and operational complexity, financial management in construction is much more challenging. Construction companies deal with various expense types:
Direct and indirect costs
Equipment costs
Material costs
Labor costs
Travel time
Job costing
Mobilization costs
Contractors must carefully track construction expenses to accurately project profit and loss. Administrative costs and overhead must be allocated to each project to determine true profitability.
Adding to the complexity: projects can run for an entire year, during which expenses may outweigh income. Unexpected setbacks and contract changes can also impact expected profits.
Construction Accounting vs Regular Accounting
Sales
Regular Business: Typically offers 1-5 product or service categories
Construction: Offers a wider range including consulting, engineering, labor, and materials
Cost of Goods Sold
Regular Business: Simply records the cost of products sold
Construction: Much more complicated costs fall into hundreds of categories. Requires careful tracking of estimated costs (labor, materials, overhead) to ensure accurate project budgeting.
Expenses/Overhead
Regular Business: Clear distinction between Cost of Goods Sold and Overhead
Construction: The lines blur. Many "overhead" items in regular accounting fall into "Cost of Goods Sold" in construction because they're directly connected to customer projects. Accurately allocating overhead costs (administrative salaries, office rent, utilities) is essential for proper job costing and profitability analysis.
Break-Even
Regular Business: Easy to calculate breakeven because income and expenses are directly related. Simple to identify profitable vs. unprofitable items and make timely adjustments.
Construction: Too many categories to easily determine project break-even. Customized jobs involve various associated costs, making it crucial to closely monitor project finances to determine profitability.
Common Cost Types in Construction Accounting
Job Costing
Job costing is critical for managing project profitability and estimating costs accurately. It calculates project expenses by examining all granular costs for each project, including labor, materials, and overhead. This helps you bid more precisely on similar projects and ensure profit margins.
Work In Progress (WIP)
Work in progress refers to ongoing projects that are partially finished, tracked through WIP reports. These reports are essential financial tools used in the general ledger to record total costs incurred to date. Contractors and accountants use WIP reports to:
Understand project status
Monitor costs incurred
Assess cash flow
Determine gross profit trends throughout construction
Cost of Goods Sold (COGS)
COGS refers to direct costs associated with completing a project for contractors or subcontractors. It's used to calculate gross profit margin on specific projects and for the company overall. Analyzing COGS is essential for assessing project financial performance.
Revenue Recognition
Revenue recognition for construction contracts depends on identifying performance obligations within contracts and must be recorded consistently within established standards. The contract price directly influences the timing and method of revenue recognition.
Cash vs Accrual Accounting
Cash Basis Accounting
Costs and income are recognized when cash is received or paid. This means accounts payable and receivable aren't recognized until checks are written or payments are deposited.
Advantage: Provides an accurate picture of cash flow
Disadvantage: Doesn't recognize costs and revenues in a timely fashion, making it difficult to know project or company profitability
Accrual Accounting
Revenue and costs are recognized when clients are billed or bills are received, regardless of when money actually changes hands. Because both are recognized in the period they were incurred, this method gives a more accurate picture of financial position by matching current cash inflows and outflows.
Revenue Recognition Methods
Percent Complete Method (PCM)
Allows recognition of revenues, expenses, and taxes based on the percentage of costs incurred.
Example: A project under contract for $100,000 with estimated costs of $60,000. If the project is 40% complete:
Revenue recognized: $40,000 (40% × $100,000)
Expenses recognized: $24,000 (40% × $60,000)
Current gross profit: $16,000
Completed Contract Method (CCM)
Considers all income and expenses directly related to a long-term contract only upon completion. Contractors may enjoy tax breaks during the working phase and may qualify for certain tax incentives. However, this method is not GAAP-approved.
Reports recommended for successful contractors:
Accounts Receivable
Accounts Payable
Profit & Loss
Balance Sheet
Cash Balance
Job Costing Reports
Job Profitability Reports
Earned Value Reports
Work-In-Process Reports
Estimates Vs. Actuals Reports
Payment Applications
Financial Statements: Essential for construction accounting, these industry-specific reports ensure compliance, accurate financial tracking, and reflect the unique complexities of construction projects.
And more…
Construction Billing
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: 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 progress billing is a standardized invoicing process primarily used in commercial and government construction projects. It uses specific forms, G702 and G703, to clearly document the percentage of work completed for billing purposes, often requiring architectural approval and providing 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 Retainage
Construction clients may additionally withhold some percentage of a contract’s payment to a contractor or subcontractor until a time specified in the contract to the owner’s satisfaction. This 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.
Accounting Software
Construction accounting software helps you stay in control of project costs, and 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 (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 a free quote.
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