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Construction Accounting – What you need to know

Across all industries, accounting plays a vital role in management and administration. Every business needs to record the costs of their good sold in order to calculate the gross profit margins. While the construction industry draws on this basic principle of general accounting, it also has several important and distinct features that need to be discussed.

The main characteristics of accounting in construction industry are:

  • Project based: Contractors need to treat each and every construction project as a unique, short-term profit center with unique inputs and requirements. Each project has different site conditions that have to be kept in mind such as, local variables like labor availability or cost of materials and legislation.
  •  Decentralized production: In contrast to retail and manufacturing, production primarily happens on different job sites rather than fixed locations. Use and labor equipment frequently move from site to site, and this can result in high mobilization costs. Labor costs for example, have to be tracked to each job with the correct wage rate depending on the location the project is taking place.
  • Long-term contracts: In construction, production contracts can last years and have multiple, extended payments over that time. Terms commonly allow 30, 60 or even more than 90 days to pay invoices. As a result, revenue recognition and cash management in construction both carry special considerations.
    Having a precise tracking, reporting, and cash flow strategy is very important.

Contractors and construction companies also need to keep in mind that there are some costs that can exist in many categories. This makes calculating the costs of sales a difficult process. A customized accounting software can be useful to segregate the processing amounts and also help record costs on a regular basis.

REVENUE RECOGNITION

Since construction contracts are usually long-term and often have delayed payments, contractors need to have a Revenue recognition method in order to determine when they’ve officially made money on a project, and determine when they should officially record an expense. The method they choose will determine when income and expenses “count”. In some cases, they might use one method for their own bookkeeping and for tax reporting. The main options have traditionally included cash-basis, completed contract, and percentage of completion.

1. THE CASH METHOD:

This is the simplest method to recognizing revenue. Everything is based on its real time impact on the company’s cash. Expenses are reported only when they are paid, and revenue is earned only when the payment is received. In the cash accounting method, if money didn’t change hands yet, there’s no transaction to account for. This method is not for every construction business, and according to the IRS, only construction companies with less than a set average annual revenue can use the cash method for tax purposes. If a business’ sales exceed that amount, they’ll have to choose another method.

2. ACCRUAL METHOD:

These methods will recognize an expense when its incurred and revenue when is earned, even if cash hasn’t come in or out yet. In other words, it tracks how money accrues or accumulates in holding before it moves as cash.

3. THE COMPLETED CONTRACT METHOD

Under the completed contract method (CCM), neither expenses nor incomes are reported until the project finishes. This means that expenses are paid, and the company can bill, but profits aren’t official until the end. The advantage of this method is that contractors are able to defer taxable revenue if the contract won’t be completed until the following tax year.
The CCM also has particular restrictions from the IRS. To be eligible, contractors can’t exceed a certain average annual revenue and their contracts must be able to be completed within a set timeframe.

4. THE PERCENTAGE OF COMPLETION METHOD

The percentage of completion method (PCM) allows a contractor to recognize revenue as they earn it over time. As a project progresses toward completion, the contractor can bill for the work they’ve performed. Each time they issue an invoice, they can record the earned revenue. In order to calculate how much of the contract they’ve earned for a billing period, they might choose among a number of methods, including cost-to-cost and estimated percent complete.

Specialized Construction Billing.

In the construction industries, billing styles and methods defer from other industries that operate around fixed-price and point-of-sale billing. Contractors may use the following contract styles and billing methods:

1. FIXED PRICE

Billing is based on a detailed estimate that gives a total cost for the entire project. There are two types to be considered in this method: The first one is fixed-price hard bid, in which the project is made in a determined amount of money. This causes the contractor to take all the risk of overruns or changing conditions. The other method is fixed-price negotiated, that might allow for some contingencies and unforeseen events.

2. TIME & MATERIAL

This method bases the contract price on a per-hour labor rate plus the cost of materials used. The contractor applies a standard markup to both the labor and material components. This builds their profit percentage into the amount and accounts for the cost of overhead.

3. UNIT PRICE

Under a unit-price contract, customers are billed at a fixed price-per-unit range. This is common when the contractors aren’t able to estimate the unit production for the project with a lot of certainty. Typically, this method is used among heavy-highway and utility construction companies.
Unit price method shares the risk between the contractor and customer, since production quantities can end up higher than estimated. Contractors can either increase their revenue, or lose money, depending on how well the unit price was estimated.

4. AIA PROGRESS BILLING

Named after the American Institute of Architects, this construction method is based on billing invoices to the customer based on the percentage of work completed for that billing period. This invoice generally consists of a signed summary sheet, followed by a schedule of values that details what’s been completed and billed to date.
All documents sent to customers are considered an “application” for payment, because the recipient will have a chance to review, accept, or dispute the billed amount. In case the recipient disagrees, they can send back redlines so that the contractor can revise and send the billing application again.

CONCLUSION

To conclude, there are several aspects’ that need to be accounted for. Therefore, it is necessary to apply customized accounting procedures and implement acceptable accounting principles to deal with the nature of expenses of the construction sector, such as costs of goods sold.
Although it demands a big investment, an integration between an accounting software and construction payroll services can save a lot of time and help a business stay on top of the numerous variables of running a project-centered, decentralized business.

 

Source:

Wikkiaccounting: COGS in the construction industry – Explained

Construction accounting 101 – A basic guide for contractors.

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