Good accounting systems and practices are important tools for managing any construction business. Given the uncertainty in the construction industry, it is particularly important to monitor job performance, control costs, improve profitability and manage cash flow. To help our construction clients, prospects and others better understand the basic accounting procedures, we have provided the guide below:
Construction accounting is different from other types of accounting because of the long-term nature of many contracts. In a typical business, revenues are recorded when they are earned and expenses are recorded when they are incurred. This generally happens at the time an exchange occurs. However, with a long-term construction contract, this may last for several months or even years, waiting until an exchange occurs. This may result in misleading financial information. In order to present an accurate reflection of the company’s finances, there are two options to recognize construction revenue and costs.
- Completed Contract. As the name suggests, the completed contract method does not recognize revenues or expense until a project is substantially complete. In a simple example, a construction company enters into a $100,000 contract in June 2017. The job is expected to be completed in May 2018 at a cost of $80,000. Using the completed contract method, the company would recognize all revenue and expense in 2018, regardless of actual costs incurred during 2017. The completed contract method is typically only used for short-term contracts or when contract costs are difficult to estimate.
- Percentage of Completion. Under the percentage of completion method, revenue and costs are recognized as a contract progresses toward completion. Most construction companies, with long-term contracts, should use this method. Using the contract example from above, assume the company has incurred and recognized $32,000 of costs as of the end of 2017, the project is considered to be 40 percent complete. Thus, the company would also recognize 40 percent of the total expected revenue, or $40,000.
These two methods are not interchangeable. Once an accounting method has been chosen, it must be applied consistently to all similar contracts.
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 are those benefiting 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 that they benefit. 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 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 success of the business.
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.