In any industry, well-established and accurate accounting is the backbone of a thriving company.
However, because of the unique way construction companies operate, construction accounting is quite different from regular accounting.
Construction accounting focuses more on managing the cost and portability of large, individual construction projects rather than product lines.
At the same time, accounting for contractors will help manage construction industry practices that include retainage, specialized billing, revenue recognition methods, and frequent change orders.
Continue reading for an in-depth guide to construction accounting, its specialized concept, the skills required, and what it can do for construction companies.
What are the differences in construction accounting vs regular accounting methods?
Though the basic accounting principles are the same across industries, construction accounting has some industry-specific challenges.
Construction companies typically aim to ensure that each project is profitable, making job costing vital.
Projects are often one-off, which means that project costs must be accurate from the start.
It’s particularly challenging for a project with multiple sites and a mobile workforce where prices fluctuate.
Construction accounting often deals with revenue recognition and multiyear billing projects, which can change over their lifetimes.
Read on for some of the challenges of construction accounting.
1. Construction accounting is project-based
Construction accounting focuses on custom projects, unlike other industries, and much of each project is managed for profitability.
Part of the difficulty stems from trying to be competitive in the market and remaining profitable while taking into account the unique intricacies of each project.
Labor costs, material costs, and local taxes vary widely depending on location, and all must be reviewed.
2. Construction is decentralized and mobile
Production never occurs at a fixed location for construction companies.
Instead, equipment and workers move from one job site to another, which means accountants must figure out the cost of travel, moving, and installing the equipment at each site.
Local wage scales and other regulations will also affect project costs.
Purchasing materials or renting equipment in outlets near the location will also affect the overall costs.
Leasing vehicles or equipment, which is what most construction companies tend to do, also adds to the costs.
3. Construction has long-term, flexible, and irregular contracts
Construction projects tend to become long-term contracts, spanning multiple accounting periods—sometimes even years.
Occasionally, smaller projects drag on from various issues, such as a shortage of materials or bad weather.
Throughout these long-term contracts, adequate cash flow is necessary, and construction accountants must keep a schedule of multiple payments as the contract progresses.
4. Construction has fluctuating direct and indirect costs
Within the construction industry, direct and indirect costs continuously fluctuate as the market changes, making it difficult to estimate job costs ahead of time.
These costs can change multiple times for long-term projects and are not always easy to predict.
Even indirect costs, such as insurance, can change on a multiyear project.
5. Construction companies have limited sales
Construction companies deal with large-scale projects more often than regular manufacturers in other industries.
As a result, these companies are likely to work only on a couple of contracts per year.
Construction accountants need to pay greater attention to the financial health of customers and the company alike to make sure there is enough cash flow.
6. Change orders in construction
Construction companies see change orders as the norm rather than an exception, especially on longer projects.
These change orders must be handled carefully and efficiently to not cut into project profits.
Contractors often start work on changes before they are approved and formally priced, which makes construction accounting accurately, in this instance, that much more important.
7. Predicting profitability is difficult in construction accounting
The profitability of construction projects is more challenging to determine than in other industries.
Every project brings unique obstacles surrounding construction bookkeeping and financial management.
Maintaining a positive cash flow and the construction company’s overall financial health will make it thrive for years to come.
5 construction accounting concepts to understand
Construction accountants need to understand concepts and best practices specific to accounting for construction firms before taking on such a large undertaking.
These concepts will help make sense of the construction accounting processes and can be used to run a successful construction business.
1. Contract revenue recognition methods
Revenue recognition is a complex topic.
The choice of which revenue recognition method to use will depend upon many factors, such as the size of the business and the scale of the upcoming projects, but it will make a difference in the long term.
a. Cash basis and accrual basis accounting
Cash basis accounting is one of the simplest accounting methods often used by smaller companies.
With this accounting method, revenue recognition happens the instant cash (or a variation thereof) changes hands—income when it’s received and expenses when they are paid.
On the other hand, an accrual basis is one of the more demanding accounting methods to maintain.
This is because revenue and expenses are recognized regardless of when money changes hands.
For example, a bill will be entered into the ledger the instant it is received and then again when the money changes hands.
Although the cash accounting method is appealing in its simplicity, it can paint a misleading picture of the company’s financial health.
For example, suppose the company’s major projects are not completed by the end of the accounting period.
In that case, financial statements will reflect all of the incurred expenses with none of the offsetting revenue.
A construction company will typically use the cash method only if they have an average gross receipt of $25 million or less.
Public companies and other larger businesses must use the accrual basis method and adhere to generally accepted accounting principles (GAAP).
b. Percentage of completion method
The percentage of completion method allows contractors and construction companies to recognize revenue throughout the contract’s life.
This makes the percentage of completion method especially useful throughout multiyear projects.
Contractors grossing over $25 million must use the percentage of completion method for a construction project that will take 2 or more years unless it qualifies as a home according to U.S. Code 460.
Contractors recognize revenue using the percentage of completion method in two ways:
- Cost-to-cost: Bases the amount on the percentage of estimated job costs that have been incurred to date.
- Estimated percent complete: Assesses the percentage of the work completed so far.
The estimated percentage of completion option is the most common because it discloses both revenue and expenses.
c. Completed contract methods
Under the completed contract method, all revenue and expenses are recognized once the project is completed.
There are some advantages to using the completed contract method:
- Deferring revenue to a future period.
- Maximizing tax liability in a current accounting period.
Generally, construction companies use the contract method in limited circumstances.
The primary disadvantage to using the completed contract method is that it is not GAAP compliant.
2. Job costing
Accurately estimating the cost of an upcoming project and doing so in a timely fashion is necessary for a construction business to thrive.
Job costing is the process whereby the total cost of completing each job within a project is determined in order to meet the agreed-upon contract specifications.
Construction job costing information is used to estimate, bill, and assess whether in-progress projects are on track.
Typically, the reviewed costs during the job costing process fall into 3 categories:
- Labor costs
- Material costs
- Overhead costs
To ensure a comprehensive overview of the project expenses, job costing will review each project stage, including providing estimates and potential change orders.
3. Contract retainage
Retainage, a term used throughout the construction business, refers to the portion of the contract price that is withheld until the job is completed or for a pre-specified period of time.
The end goal of retainage is to create a financial incentive for contractors to complete a project in a satisfactory manner.
Most of the time, retainage amounts are 5% to 10% of the overall contract amount.
4. Construction billing
In other industries, billing happens at the time of sale or on a fixed monthly schedule, but that is not the case with large-scale construction companies.
Below are some of the most common billing methods used by companies in the construction business.
Under the fixed-price method, the contractor and client agree to a price before the start of the project based on a detailed estimate.
This way, the construction company is held to complete the project within the agreed price regardless of the time and materials required.
A fixed-price contract might create a risk for contractors, but it does attract buyers that like to see the price altogether.
The time-and-materials method is used when it’s hard to narrow down the scope of the project upfront.
The contractor bills on a per-hour rate to cover the labor costs plus the costs of any materials used.
Standard markups may apply in this situation to cover the overhead costs and generate separate profits. A price cap may be placed on the contract to protect the buyer.
c. Unit price contract
With the unit price contract method, the contractor bills at a fixed price per unit—both the definition of “unit” and the price are set in the contract.
It’s most useful in situations where the contractor provides a repetitive item and predictable cost but might not know exactly how many items right away.
This method is mainly used in public construction projects, such as a unit price per mile of a highway.
To make a profit, accurate job costing, including labor costs, materials, and overhead costs, is extremely important.
5. Construction payroll
Construction payroll is more than tracking labor costs and investigating the local market for current trends.
a. Prevailing wage requirements
Contractors working on public or government projects must pay a government-defined minimum as a prevailing wage.
The definition is derived from the fact that the wage is determined by surveys taken of what others are receiving for similar work.
States will have set prevailing wages and will post that information publicly.
b. Union payroll
Constructions jobs are still largely unionized, unlike other trades.
As such, wages and conditions are determined by collective agreements, and companies must report these wages to unions to maintain compliance.
c. Multi-state payroll
Some contractors have projects in various cities and states, which adds to the intricacies of deducting the correct amount of taxes to comply with state and local ordinances.
The process can become more complicated when employees who live in one state but work in another are involved.
It’s important to understand the laws of your state and surrounding states to ensure all employees have their taxes withheld correctly.
Frequently asked questions
Construction accounting has many moving pieces.
Below are some tips to remember:
• Focus on accurate job costing. This is the key to ensuring a profitable construction business for many years.
All projects and cash flow will hinge on the information gathered during this step.
• Consider the cash method of accounting. When it comes to choosing an accounting method, go for the simplest.
It’s not too difficult to switch to another method if the company grows beyond using the cash method.
• Use software. There are many options regarding software to help make construction accounting run smoothly.
Invest in construction accounting software and any other software to help with the process of bookkeeping and financial management, job costing, and maintaining multiple projects.
Maintaining the books for a large construction project involves many intricacies.
Between different accounting methods and other regulations to keep in mind, it’s no wonder that construction businesses find themselves running into errors.
Below are the most common construction accounting errors:
• Poor estimates that lead construction contracts astray
• Inaccurate recognition of joint ventures
• Incorrect overhead costs
• Mismanaged changed orders
• Accepting unreasonable contract terms
Agata Kaczmarek has held a passion for writing since early childhood. A professional writer for many years, Agata specializes in writing articles and blogs focused on finance as someone who holds a Masters Degree in Accounting and Finance.
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