Accounting and financial management in all industries is a difficult task. In construction specifically however, the varying lengths of contracts and a large and transient workforce make accounting even more difficult. Rather than simply taking records of debits and credits like other businesses would, accountants in the construction industry must use sophisticated accounting solutions to make sure a system is in place to match income and expenses accurately. This article discusses various methodologies that accountants should keep in mind, shedding light on what approaches work best for particular construction projects.
Within a single construction business, they may be balancing a variety of projects and jobs that vary in length and size. This makes it difficult to match the exact expenses to their respective revenue source. Because of the number of transactions that occur during the course of a given project, job costing is an essential practice in accounting. Job costing is defined as allocating all direct and indirect expenses and revenues to each respective job. Not only will job costing simplify tax preparation for accountants, it provides detailed information regarding the profitability of a given contract. Essentially, job costing is incredibly efficient and a necessary step to help track down income and expenses across each construction project. This ensures that the final service price covers all overhead expenses, while ensuring a profit is made. Click the link for more tips on improving cash flow and strategies you may want to consider.
Cash basis accounting is the easiest and simplest method to use in construction. It allows accountants to record revenue when received, as well as when expenses are paid. Some cautions apply however. Although revenue is recognized and recorded, you must allocate expenses evenly over the entire period of benefit when applied to a multi-year contract. Construction companies cannot use cash basis accounting on their tax returns if job materials cover up to more than 15% of the total cost to the customer. If your business makes less than 1 million dollars in annual revenue, you are exempt from this rule.
Percentage of Completion
Percentage of completion refers to a construction business’ ability to match revenues and expenses. This is often difficult because of the varying lengths of contracts and high number of jobs. Throughout the construction process however, contractors are able to use the percentage of completion method to determine whether or not a specific project is on track to make profit or loss. The total expenses incurred on the job can be divided by the total estimated job expenses to determine the profit or loss of a given job. Multiplying the estimated gross profit by the percentage complete to determine the estimated gross profit. Calculating profits based on the percentage completed is an accurate way for accountants to keep track of a given project. Although they provide estimates, the calculations are often not far off, and provide pertinent financial data for the company even before a project is completed.
Completed Contract Method
Under this method, no income is reported on any financial statement until the project’s completion, but does not prevent the receiving of payments before the end of the project. This approach is best suited for short term contracts of less than two years and have an average gross profit of less than $1 million. It is also convenient for contractors that prefer deferring their taxes. However, one cannot include the cost of material of supplies allocated to the contract without opening a contract expense ledger account. They are regarded as assets, until they are fully utilized by the project and deducted upon completion.
Tax Reporting Strategies
The percentage of completion and completed contract approaches mainly differ on the method of tax reporting. For completed contracts, incomes and expenses are recognized after the job is completed. Contractors can defer their taxes until the project is completed. However, this provides many risks since most countries are likely to amend their tax laws occasionally, which increases the company’s tax burden in the long run. Additionally, this method poses challenges to contractors who seek to attract other investors to their firm if they have no valid tax records in the first place. Despite this, completed contracts approach is the most preferred method in the industry.
Percentage of completion approach recognizes incomes and expenses in the year received. Consequently, tax calculations have to be made on the year received. This method is effective in combating tax fluctuations, making it the most preferred approach for long term contracts. However, in order to defer taxes in this approach, special permits have to be given by the Internal Revenue Service (IRS). Firms may also be required to hire licensed tax specialist for advice on how to defer taxes under this method.
Use Software to Simplify Accounting
To ease the stresses and simplify the accounting processes, construction companies should consider implementing an accounting software. As it stands, there is a variety of software available that caters to all types of construction businesses of all sizes. Many of the methods discussed in this article, including job costing and financial tracking can all be done through integrated construction software. Other features of software include security and auditing to avoid risks, as well as fast, real-time reporting. A number of forward-thinking businesses have already applied an accounting software, and have not only seen efficiencies in accounting but in other aspects areas of their company as well. For more information on software, check out our Top 10 Construction Software Solutions and our Top 10 HVAC Software Solutions.