Sound accounting systems and practices are essential tools for managing any construction business. It is imperative to monitor job performance, control costs, improve profitability, and manage cash flow. To help construction industry companies better understand necessary accounting procedures, we have provided the guide below:
Construction accounting is different from other types of accounting because of the long-term nature of the contracts. In a typical business, revenues are recorded when earned, and expenses are recorded when incurred. This generally happens at the time an exchange occurs. However, with a long-term construction contract, an exchange may involve many performance obligations that span several months or years. If revenue is not recognized until all performance obligations are satisfied, this may result in misleading financial information. In order to present an accurate reflection of the company’s finances, construction companies must recognize revenues and costs equally throughout a project.
Prior to the implementation of ASC 606, Revenue Recognition, construction companies had different options to recognize revenue and accounting principles. With ASC 606, all industries and companies must use the same accounting principles to recognize revenue.
Construction companies now need to recognize revenue based on performance obligations and break down their contracts into distinct performance obligations or determine that their obligation is a single deliverable.
This conclusion will determine when revenue is recognized. Revenue will then be recognized as performance obligations are completed or as work progresses. This is similar to the percentage of completion methods that companies used before ASC 606.
Example: Assume a construction company enters into a $100,000 contract in June that is expected to be completed the following May and will incur total costs of $80,000. If the company had incurred and recognized $32,000 of costs as through December, the project is considered to be 40 percent complete (32,000 in costs/80,000 in total cost). Thus, the company would also recognize 40 percent of the total expected revenue, or $40,000.
Note: The above-simplified example does not consider all five steps of ASC 606 that companies need to review and assess for each of their contract types.
All construction jobs have direct and indirect costs associated with them. Direct costs include labor, subcontract expense, materials, equipment, and tools. Since these costs are directly related to a project, it is easy to allocate them. Indirect costs benefit more than one job, such as insurance, supervisor wages, rent, and utilities. A construction company needs a reliable method for allocating these indirect costs to the various jobs they benefit from. An accurate allocation method will lead to a more realistic representation of job costs and profitability.
CASH FLOW MANAGEMENT
A construction company owner should always consider ways to improve cash flow when negotiating contracts, specifically
A construction company owner should always consider ways to improve cash flow when negotiating contracts, specifically retainages, payment terms, and penalties for late payments. Ensure invoices and change orders are processed and sent quickly. Consider shortening payment terms with customers or offering a discount for prompt or accelerated payment. Effective cash management is essential to maintaining a construction company’s overall financial health and plays a vital role in the business’s success.
Industry knowledge and close collaboration are instrumental in providing our construction clients with the insight and awareness to make the best business decisions and seize growth opportunities. Smith Schafer is a recognized leader in providing accounting and consulting services to the construction industry since 1971. We have a team of experts, focused on working with the construction industry, and committed to helping our clients succeed. If you have questions about improving your business model, implementing an accounting practice, or tax planning strategies to improve operations, Smith Schafer can help. For additional information, click here to contact us. We look forward to speaking with you soon.