Construction accounting involves unique concepts based on the construction industry’s specialized estimating and billing practices. It includes methods of recognizing revenue and complex tax rules that must be followed. Contractors often choose to use the accrual method of accounting, which recognizes income when it’s earned and expenses when they are incurred. It allows them to get real-time financial statements that empower proactive decision-making.
Job Costing
Construction job costing is a highly detailed pricing method that allows contractors to see all the individual expenses associated with specific projects. Rather than looking at overall business costs like a general ledger, the technique breaks down all the project components so you can closely monitor budgets and make accurate estimates for future projects.
Labor is the most essential expense for construction companies, so a comprehensive job-costing system should include every worker hour spent on a task. It includes employee wages, payroll taxes, and workers’ compensation. It’s also vital to have equipment costs, mainly when you rent or lease your machines. Many construction businesses rely on a combination of owned and rented equipment, so it’s crucial to track the rental fee and the maintenance costs that go into using those tools.
Another essential element of construction job costing is tracking overhead costs, which are often not directly associated with a specific project but are necessary to keep the company running. These costs include the internet to rent, administration, and utility bills. Tracking these overhead costs on a project-by-project basis is essential for keeping your profit margins healthy and avoiding unexpected financial surprises. Accurate records of all expenses are more accessible when you hire the right construction accounting firms.
Retainage
The amount of funds withheld from progress payments to contractors and subcontractors is known as retainage. This money is insurance against the risk of contractor default, work quality issues, and other problems that may arise during the project, so it is held until the contractor can demonstrate that their completed task meets the client’s requirements.
Usually outlined in the contract, retainage can be fixed or variable depending on percentage or project completion milestones. In the case of a fixed percentage, this is often tied to payment amounts, while a variable retainage rate can decrease or even disappear after reaching certain project completion milestones. State regulations governing retainage vary for public and private projects, with release timeframes depending on the contractor and the project type. For example, in Oregon, personal construction projects with a value above $500,000 must place the retained funds in an interest-bearing escrow account until the project is complete or substantially complete (which can differ from a buyer’s determination).
Withholding funds like this can create cash flow issues for contractors and subcontractors who have already spent their resources on materials, equipment, and labor to complete a project. It can also make it challenging to invest in new contracts if the current project’s withheld retainage will be paid out months after project completion. It’s essential that a construction accounting system tracks withheld monies and keeps an eye on the balance sheet so that these amounts can be appropriately billed in the event of project completion.
Revenue Recognition
When you track a job, you’ll need to use a method that accurately recognizes revenue over time. Many industries operate around fixed-price point-of-sale billing, but construction production is project-based and often decentralized, with each project having unique inputs, outputs, and local variables. As a result, contractors may use various contract types and billing formats. For example, a cost-plus contract typically reimburses the contractor for actual costs plus an additional fee that covers overhead and profit. This type of contract requires detailed job costing to calculate the total contract amount and identify the materials, labor, and equipment used on each task. To recognize revenue over time, you must choose an accounting method to determine when income and expenses “count.” Cash accounting is the most straightforward option but can be limiting, as it only recognizes revenue when payment is received and costs when bills are paid. In contrast, an accrual-based approach (including completion percentage and completed contract methods) gives you a real-time view of your financial health. It allows you to forecast future business decisions.
Additionally, most states require businesses to file taxes based on their net income (revenue minus expenses). To ensure you file your tax returns correctly, you must keep accurate records of all transactions in and out of your company. Keeping separate accounts for payments from customers, payroll, and taxes makes record-keeping easier and prevents errors in your tax return.
Taxes
While traditional accounting relies on the general ledger for tracking revenues and expenses, construction accounting takes a more project-oriented approach. It is due to the nature of the work – unlike factories or plants where production happens in one place, most construction activity occurs on different sites. It requires a significant amount of movement of equipment and labor, which leads to mobilization costs. In addition, prices of raw materials can vary wildly. Global economics, interest rates, and even natural disasters often affect these changes.
For this reason, many construction businesses use the percentage of completion method for accounting. This method recognizes revenues and expenses based on how much the contract has been completed. This method also helps with cash flow because companies can avoid paying income tax on profits that have yet to be realized. However, there are better choices than this method of accounting for all construction companies. It can create discrepancies between the company’s financial statements and the actual change in assets and liabilities, which can cause problems when trying to make sound business decisions. It can also result in inaccurate income taxes since profit is calculated based on the current year’s revenue minus the previous year’s costs. To combat these issues, a sound construction management system like Buildern can help you manage accounts payable and receivable, track progress on each project, record changes in specifications, and submit AIA invoices.