The simplest accounting method used in construction, cash basis, allows accountants to record revenue when it is received and when expenses are paid. However, once revenue is recognized and recorded, you must allocate expenses evenly, spanning the entire period of benefit when applied to a multi-year contract. Unfortunately, construction companies whose job materials cover more than 15 percent of the total cost to the consumer cannot use cash basis accounting on their tax returns. However, if your company makes less than 1 million dollars annually in revenue, you are exempt from this rule.
An essential practice in accounting, job costing, is the practice of allocating all direct and indirect expenses and revenues to each respective job. Within a single construction company, there may be several projects and jobs with varying lengths and sizes, making it challenging to match the exact expenses to their respective revenue source. Job costing simplifies tax preparation while providing details regarding the profitability of a given contract. As an efficient and necessary step, job costing helps track down income and expenses for each construction project, ensuring that the final service price covers all overhead expenses. This guarantees that a profit is made.
Completed Contract Method
Using this method means that no income is reported on any financial statement until a project is completed. However, payments may still be received before the end of the project. While this approach is best suited for short-term contracts (less than two years) with an average gross profit of less than $1 million, it is also convenient for contractors who prefer deferring their taxes. However, to include the cost of material and supplies allocated to the contract, a contract expense ledger account must be opened since they are considered assets until fully utilized by the project and deducted once completed.
Percentage of Completion
This refers to the process of matching revenues and expenses, a challenge due to a high number of jobs and varying lengths of contracts. However, using the percentage of completion method allows contractors to determine whether a project is on track to make a profit. To figure the profit or loss, the total expenses incurred for the job are divided by the total estimated job expenses. Multiplying the estimated gross profit by the percentage complete will determine the estimated gross profit. Accountants can accurately keep track of a given project by calculating profits based on the percentage complete. Though only estimates, the calculations are typically not far off, providing relevant financial data for the company even before a project is completed.
Tax Reporting Strategies
The main difference between the percentage of completion and completed contract approaches is the method of tax reporting. With completed contracts, incomes and expenses are recognized after the job is completed, and contractors can defer their taxes until the completion of the project. This creates several risks, though, since most countries amend their tax laws occasionally, increasing the company’s tax burden in the long run. This method also generates challenges for contractors looking to attract other investors to their firm if they have no valid tax records. Completed contracts are still the most preferred method in the industry despite this.
Since the percentage of completion method recognizes incomes and expenses in the year received, tax calculations are made in the year received as well. This means tax fluctuations are not as much an issue, making this approach the most common for long-term contracts. With this method, special permits have to be given by the Internal Revenue Service (IRS) in order to defer taxes. Additionally, firms may need to hire a licensed tax specialist for advice on deferring taxes under this approach.
Construction companies should give thought to using accounting software to alleviate stress while simplifying the accounting process. There is a variety of software available, catering to all types of construction of all sizes. Through integrated software, many of the methods detailed above can be done with added features, including real-time reporting, security, and auditing to avoid risks. Many businesses have seen efficiencies in accounting as well as other aspects of the company after incorporating accounting software.
How Can Accounting for Construction Help?
With knowledge from decades of experience, our financial professionals at Accounting for Construction are ready to help your company with the complexity of construction accounting. Accounting for construction requires a keen eye for detail, whether accurately tracking expenses or categorizing costs, and we know that there are unique challenges associated with the construction industry. Ensure that your company is benefiting from its accounting method by contacting us online or calling to get started!