Construction Accounting 101: A Simple Guide for Contractors
Are you running a construction business but feeling like the financial and accounting portion of it is a little overwhelming? You're not alone. Accounting for the different moving pieces of contracts and projects can be daunting.
This post provides an overview of construction accounting basics, from bookkeeping principles to advanced cost and tax considerations associated with running your own construction business. Even if you outsource your accounting, you'll have a basic understanding of the numbers and managing your finances won't feel so intimidating or confusing anymore.
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What makes construction accounting different?
Construction accounting is a highly specialized type of financial management because of the industry's unique characteristics. Unlike many other types of businesses, construction companies need to track and account for multiple contracts, construction projects, and job costs at any given time. This makes keeping tabs on all the moving pieces much more complex than in other industries.
For example, a typical business, such as a retail store, buys inventory and sells merchandise from a fixed location, so it's easy to understand the cost of each item sold and keep overhead relatively constant.
In construction accounting, every project is different, and there are different costs associated with each project, including labor, materials, subcontractors, and equipment. All of these costs must be accounted for by job so the company can ensure it's generating enough revenue to cover its expenses.
In addition, revenue from each project may come in over several months or even several years, so the company needs to track that revenue and figure out when to recognize revenue on its books and when to pay taxes on that income.
All of this makes construction accounting particularly challenging.
Construction accounting basics
The basic principles of construction accounting include tracking job costs and revenue recognition. Let's take a look at each one in more detail.
Job costing
Accurate job costing is one of the most critical aspects of construction accounting, as it involves accurately tracking and recording all costs associated with a particular project. This includes material costs, labor costs, subcontractor fees, equipment rental fees, and any other expenses incurred for the project.
When accounting for job costs, keeping track of the different expenses by project is essential. Keeping track of all these costs helps account for them in a way that ensures the company is making enough money on each project to cover its expenses and make a decent profit for the owners.
Revenue recognition
Recognizing revenue correctly is essential for construction accounting because construction contracts are often long-term and have an agreed-upon payment schedule.
Contractors have a choice of contract revenue recognition methods, and many use one for internal bookkeeping purposes and another for tax reporting. The most commonly used revenue recognition methods are:
Cash method. Under the cash basis of revenue recognition, income is recognized when cash is received from a sale or contract. This method of revenue recognition is simple and straightforward, and it's often used by small businesses that don't have complex accounting processes in place.
Percentage of completion method. The percentage of completion method of revenue recognition is a popular and commonly used accounting method for construction companies with long-term projects. Under this method, income from each project is recognized proportionally based on the amount of work that has been completed on that project. This allows the construction company to recognize revenue as the project progresses instead of waiting until the project's end.
Completed contract method. The completed contract method is a more conservative approach to revenue recognition than the percentage of completion method, as it doesn't recognize any income until the project has been completed and all performance obligations have been satisfied. This is beneficial because the company can delay paying taxes on revenue if it won't wrap up the construction project until the following year. The completed contract method can only be used for tax purposes by small contractors and on contracts with an estimated life of two years or less.
Best practices for accounting and bookkeeping for a construction business
Staying on top of accounting and bookkeeping for a construction business is essential for success in this industry. Keeping accurate records and financial data helps ensure you make a profit, track expenses and costs, and adequately allocate overhead expenses. Here are some best practices to help you get the most out of your construction accounting and bookkeeping:
Use construction-specific accounting software. Using specialized construction accounting software can help you manage your company's finances easier. It includes all of the features of generic accounting software but also adds features tailored to the needs of the construction industry, such as estimates, project accounting, job costing, and progress billing.
Manage change orders. Change orders are an essential and sometimes unavoidable part of the construction process. A change order is a written authorization to make changes to the original construction contract, such as changes to materials, pricing, labor costs, or deadlines for completion. Change orders are usually requested by the client, who may want additional features or services not included in the original contract.
Automate billing processes. Automating your invoicing and billing procedures will help cut down on time spent chasing down payments, provide a more consistent process for getting paid, and improve cash flow.
Properly classify workers as employees or independent contractors. It's crucial for a construction business to correctly classify workers as employees or independent contractors to comply with applicable laws and regulations. While it might be tempting to classify workers as independent contractors to reduce payroll taxes, workers compensation premiums, and employee benefits costs, the risks aren't worth it. Failing to classify workers correctly can lead to serious financial, legal and operational consequences.
By following these construction accounting best practices, you can ensure that your construction business is properly accounting for its costs and expenses and run a profitable business.
If you need help getting started or have outgrown handling your construction company's books on your own, schedule a call with Slate. We can help you take the right approach to managing your successful construction business and ensure you're generating enough revenue to cover all costs while still turning a profit.