Since construction contracts are typically long-term with delayed payments, contractors are rarely able to complete, bill, and collect on a contract in the same month. In fact, for many contractors, this never happens. With multiple accounting options to choose from, it is important to opt for a method that works best for your construction company.
Simplest of all is the cash method. This method is based on its real-time impact on the company’s cash. Contractors record revenue only when payment has been received and report expenses only when they are actually paid. Because of this, there are no accounts payable or accounts receivable. Unless money has changed hands, there is yet to be a transaction to document.
Though there are several advantages to using a cash method, it is not for every construction company. Even though many small U.S. businesses prefer the cash method for its flexibility and simplicity, only some contractors qualify. In fact, organizations with more than $25 million in average annual gross receipts (AGR) do not qualify for the cash method.
Contractors who cannot use the cash method should consider the accrual method. More useful in determining job profitability, the accrual method matches expenses with revenues and should be used for short-term contracts. However, small construction companies can use this method for long-term contracts taking less than two years to complete. Again, an organization with no more than $25 million in AGR in the past three years is considered “small” as defined by the IRS. Conversely, companies with more than $25 million in AGR are deemed “large” businesses.
With the accrual method, as soon as you establish your right to receive income, you can count it. This means you have earned the income by simply billing the customer after completing the project properly. Expenses are deducted either upon receiving the merchandise or service or once you have determined the expense, whichever occurs later. Therefore, an expense that benefits you for multiple years must span all the years.
Special accounting, however, is required of long-term contracts that extend beyond one tax year. This method typically demands that you allocate job costs with the appropriate contracts. Direct job costs include wages and labor while indirect costs cover equipment and utilities. Whether you are a large or small construction company will determine the indirect costs you assign to contracts; that is why it is important to check with your tax advisor. There are two prevalent long-term contract methods:
Completed-contract: All income from a contract is reported and all expenses are deducted in the same year the job is completed. This method may be utilized by small companies using long-term contracts lasting no more than two years. By bunching income into one year, however, this may push you into a higher tax bracket. And while this method allows organizations to defer taxes on income, it prohibits them from deducting losses on nonprofitable jobs until that contract ends.
Percentage-of-completion: While small companies must use this method for contracts lasting two years or longer, large companies must use this method for all long-term contracts. Additionally, many lenders mandate that contractors use this method. With percentage-of-completion, all income and expenses for each year of a multi-year contract must be reported. Determining how much income to report requires a bit of math. Dividing the yearly deductible project costs by the total estimated cost to complete the project will give you the project completion factor. If a project, for instance, will cost $1 million to complete and you spent $250,000 for the year thus far, the contract is 25 percent complete. To determine how much income to report, you then multiply this percentage by the contract’s total value. This amount may not be the same as what you have already billed the project owner.
Keep in mind that for long-term projects, the job is not entirely done once the project is completed. When using the percentage-of-completion method, contractors need to refer back to the taxes paid for each year of the contract to determine if total taxes paid were higher or lower than if actual figures had been used instead of estimates. This, of course, does not change how much tax you owe; it simply means you will pay interest on the difference if you underpaid while the IRS refunds you if you overpaid.
How Can Accounting for Construction Help?
At Accounting for Construction, our financial professionals advise contractors by utilizing our depth of knowledge from decades of experience. 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 at 918-984-9262 today.