Accounting for building is an important part of managing money in the construction industry. It involves making tough financial decisions like which projects to fund and how to figure out their profits. Because of the industry’s unstable nature, slow payments, and unpredictable cash flow, it is important to keep correct financial records for growth and stability.
This blog will talk about how important it is for contractors to know how to do building accounting, how to deal with unique financial problems, and how to run a business well. Understanding these ideas and using good financial methods can make allocating resources, making choices, and being competitive in general a lot better.
Differences in Production Methods
Because they work on specific projects, construction companies work in a way that is different from most producers. In manufacturing, production is based on processes and takes place in controlled settings like factories, where prices are clear and consistent.
However, each construction job uses different methods, materials, and tools. They are also spread out in different places with different conditions, which makes them even more complicated.
Variations in Location and Vendors
Construction accounting and standard manufacturing are also different in terms of where things are made and how vendors work. Manufacturers have set places where they make things, which makes operations run more smoothly and maintains stable relationships with suppliers, which makes negotiations easier and supply lines more reliable.
On the other hand, building projects happen in spread-out places with different site conditions. This makes it hard to keep track of vendors and affects both efficiency and cash flow.
Contract and Cash Flow Variances
Contracts and managing cash flow are handled very differently in buildings than in other fields. Most contracts for manufacturing have clear payment terms with no holdbacks. This keeps cash flow stable.
On the other hand, building contracts often have clauses that keep payment from the contractor until the project is finished. This means that cash flow isn’t stable because payments are slow and costs are high upfront. These differences make it hard for building companies to make money.
Key Concepts in Construction Accounting
Fundamental to Construction Accounting are several crucial concepts that distinguish it from general accounting.
Understanding Job Costing
In traditional accounting, the general ledger (G/L) is enough for most businesses to keep track of all of their financial activities. However, in building accounting, projects are centralized while production is decentralized, so contractors need a way to keep track of and report transactions that are unique to each project.
Job costing is a way to keep track of the costs that come with different tasks and production activities in construction accounting.
The Role of Job Costing in Construction Accounting
The general ledger (G/L) and job costing work together in building accounting, like how a person’s left and right hands work together. The G/L shows the overall financial health of the business, while job costing is more focused on particular projects. Costing a job includes:
- Individual projects
- Cost activities (e.g., foundation, framing)
- Cost types (e.g., labor, materials)
Comparison between General Ledger and Job Costing:
General Ledger
- Tracks company finances
- Produces financial statements, aging reports, over/under billing
- Organized by chart of accounts
Job Costing
- Tracks project data
- Produces estimated vs. actual, production reports, WIP reports
- Organized by job cost structure
Job data that is correctly recorded and organized can be used to make reports that project managers and foremen can use. This lets contractors help their teams do a good job of keeping prices down and production up.
Estimators learn about the real costs of breaking even, which is important for making competitive bids. Project managers and superintendents can look at a “scorecard” to see how well their crews are doing and make changes based on that information.
Better estimating, bidding, and cost control help contractors keep their small profit margins and look for good jobs.
Revenue Recognition
Because building contracts last for a long time and payments are often late, revenue recognition, also called income recognition, is very important. Contractors need to know when they’ve made money and when they need to record their costs since they might not finish a job, send an invoice, and get paid for it all at the same time.
Contractors and building accountants need to pick a good revenue recognition method that tells them when to record income and expenses. Some may use different ways to report to their bosses and for taxes so that everything is consistent.
The most common choices are the cash basis, completed contracts, and percentage of completion techniques. The new ASC 606 standards make things more complicated, so you should talk to building CPAs for advice.
Approaches in Construction Accounting
Construction firms have various options when it comes to accounting methods: cash accounting, accrual accounting, percentage of completion, and completed contracts. These methods vary in how they record income, expenses, and profit.
Each accounting method comes with its pros and cons, and it’s important to note that some methods may not be accessible to large companies with substantial annual revenues.
Accrual Method
The accrual method in construction accounting records revenues and expenses when bills are issued and received. For instance, a construction company records invoiced revenue even if payment hasn’t arrived yet. Similarly, receiving a bill from a supplier prompts recording it as an expense, regardless of payment status.
Firms with retainage contracts defer revenue recognition until project completion, aligning with payment eligibility.
This method enables construction financial managers to base decisions on future cash flow forecasts from financial statements, anticipating issues for adjustments like short-term financing or project re-evaluation.
Cash Method
Cash accounting offers a straightforward method for financial tracking, although it has limitations. In this approach, revenue is recognized upon receipt of payment, and expenses are recognized upon bill payment. Profit calculation is simplified as it involves subtracting cash disbursed from cash received.
Cash accounting can defer income tax through two strategies:
- Early payment of next year’s bills: By settling bills due in the upcoming year ahead of schedule, a company can artificially lower its profit and subsequently reduce its tax obligations.
- Delaying incoming payments: Requesting customers to make payments at the start of the following year for services rendered in the current year can decrease revenue and lower tax liability.
Despite these advantages, cash accounting is typically suitable only for very small construction enterprises.
Percentage of Completion Method
The Percentage of Completion Method (PCM) enables contractors to recognize revenue as they work on a project. They invoice for completed work, recording earned revenue as the project progresses until completion. Contractors use methods like cost-to-cost or estimated percent complete to calculate earned contract portions each billing period.
Mastering Construction Accounting
To become a master of construction accounting, you need to know about debits, credits, and financial statements, as well as how to handle the specific needs of the construction business. Job costing, recognizing revenue, practices for keeping money, and managing building payroll are all very important.
Contractors, whether they are new or experienced, can gain a lot from working with a construction-specific CPA and using construction payroll services that work well.
