Construction Accounting 101: Choose the Right Method

The TCJA raised both the $5 million and $10 million thresholds to $25 million. That means all construction businesses with average gross receipts of $25 million or less can now use the cash method, regardless of entity type or whether they have inventories. As before, a company that doesn’t have inventories, and isn’t a C corporation or a partnership with a C corporation partner, can use the cash method regardless of income level. The states that treat construction contractors like retailers let you buy materials and supplies for a job tax-free—usually after you present a vendor with a valid resale certificate.

• Often that requires specialized software to track and create those billings.
• In contrast, under the accrual method, you recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments.
• You also record a receivable from that customer on your balance sheet.
• Most businesses simply record the cost of the products sold, but construction companies are quite different.
• It is the process of tracking costs to each project and its production activities.
• If you fall behind in your accounts, things can quickly get out of hand.

This helps to reduce the chances of having repeat and unnecessary accounts in your COA. Keeping your COA lean also eliminates clutter in transaction posting and reporting. Fewer accounts mean increased processing speed and reduce accounting time.

Accrual Basis 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. This method calculates income based on the inflow and outflow of cash. Under this method, accounts receivable, retainage, work in progress and prepaid assets are not considered to be a part of income for tax purposes until realized .

Be aware that personal expenses such as clothing that can be worn off the job site, fines and penalties, and the non-business use of vehicles or computers, can’t be deducted. Other expenses, including construction bookkeeping certain meal and entertainment expenses, may be deductible in part or only if certain conditions are met. As always, timely and accurate bookkeeping of these expenses is key to compliance.

Why is construction accounting different?

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• In cash accounting, everything is based on its real-time impact on your cash.
• Using the accrual method of accounting may result in a situation where the contractor is able to show significant income for financial statement purposes while minimizing taxable income.
• With a large workforce and multiple projects, managing payroll can become time-consuming and stressful.
• The cash method of accounting is great for small businesses with limited recordkeeping and bookkeeping skills.
• Because production can be less predictable, contractors often aren’t able to retain large amounts of inventory.
• If you own a construction business, you’ve seen materials’ prices skyrocket, supply chain disruptions trigger major delays, and labor shortages intensify the pressure on contractors nationwide.

To begin with, define the factors that impact your chart of accounts, for example, reporting requirements or expressed needs of stakeholders. 40% of CFOs confirm that reporting demands have increased and the reliable insight into financial health and performance becomes a top priority. In this case, COA becomes a hub of financial data pulled from across the company. Unlike overhead expenses, operating expenses result from the normal operations of your construction or service business.

Ways Businesses can Prepare for Tax Time

A few states treat construction contractors like resellers, who purchase materials solely for resale to an end user. And do not require that the contractor pay sales tax when purchasing materials. More states provide this treatment for itemized contracts than lump-sum contracts. Since filing employees under 1099 doesn’t require businesses to pay a portion of taxes and unemployment insurance, many construction companies use this to avoid paying significant employee taxes. Unfortunately, the penalty for these instances can often be thousands of dollars per employee — not to mention the added pressure from the IRS, which may manually pour over your entire return. Accounting for construction companies requires different practices than accounting for standard businesses.

There is an exception for long-term contracts to which Internal Revenue Code 460 applies. Under this new provision, the “all events” test is deemed satisfied when the income is recognized on the financial statement for tax years beginning after Dec. 31, 2017. An applicable financial statement includes an audited financial statement. The alternative minimum tax has been eliminated for C Corporations after 2017. Construction accounting is a specialized form of accounting that reflects the unique characteristics of the construction business.

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You will need to factor this into your construction accounting for each construction project and for the business as a whole. Choosing between cash basis and accrual basis accounting should be a non-issue for many construction companies given that any firm that needs to produce GAAP financial statements must use accrual. To address those accounting challenges, construction companies may choose from several accounting methods. Keep in mind that construction companies may be able to use different accounting methods for the same project for general accounting and for tax purposes.

Often these methods allow businesses to improve cash flow by deferring taxes. That leaves contractors and construction accountants with a choice of revenue recognition method. In construction accounting, the main options have traditionally included cash-basis, completed contract and percentage of completion. However, contractors now have to consider guidance from the new ASC 606 revenue recognition standards with their construction CPA.

Advantages of Accrual Accounting (+)

Because lots of construction workers are classified as independent contractors, they are seen as self-employed professionals and don’t have taxes withheld from their paychecks like traditional employees. This means they can claim business-related expenses as tax deductions, have more of a tax preparation burden and have the potential need to see a tax professional. Fortunately, the Tax Cuts and Jobs Act repealed the corporate AMT and substantially increased AMT exemption amounts for individuals, so relatively few contractors will be affected. It may be best known for slashing corporate and individual income tax rates.

• While other types of contracts may be used in contracting with the government, these two are the most typical for nongovernmental contracts.
• 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.
• However, current updates to the bill have expanded the deduction to include businesses engaged in construction, engineering, and other activities.
• Recognizing revenue correctly is essential for construction accounting because construction contracts are often long-term and have an agreed-upon payment schedule.
• The accrual method is great for businesses that truly care about having an accurate financial picture at all times.