Good accounting procedures are necessary for operating a successful construction business.
But handling your company's finances effectively is only sometimes second nature, especially if you're not very good with numbers.
Additionally, construction business owners have unique challenges that set them apart from owners of other types of companies.
These topics, as well as the foundations of accounting, are covered in this guide.
The guidelines in this article should be carefully followed if you want to create a good accounting process, avoid costly mistakes, and enhance your income.
Accounting for Construction
Costs are allocated to certain contracts in construction accounting, a type of project accounting.
Each construction project has a distinct job set up in the accounting system, and expenditures are allocated to the project by coding charges to the specific job number as they are incurred.
Materials and labour make up most of these costs, with extra fees added for consulting and architectural services.
Construction projects also incur a number of ancillary expenses, such as expenditures for supervision, equipment leases, support expenses, and insurance.
Except with the customer's consent, administrative charges are not added to a construction project.
Different Forms of Construction Contracts
Contracts between a contractor and a client can take many different forms.
Depending on the situation, each type has distinctive qualities that seem to favour one party over the other. Each one is explained below.
1. Fixed Free Contract
A fixed fee contract is employed when the contractor agrees to receive a set sum from the customer.
In this case, the contractor's expenses had no bearing on the amount that was paid.
Given that there is no chance of going over the agreed-upon amount, this arrangement favourably favours the client.
In fact, this system is most frequently used in situations involving multiple parties bidding where several prospective contractors are compelled to compete against one another.
For a fixed fee contract, it is ideal from both the client's and the contractor's points of view to develop relatively explicit specifications so that there is no doubt regarding what is required of the contractor and what makes an acceptable result.
2. Cost Plus Contract
A cost-based method called a "cost plus" contract determines the price of a construction project.
The contractor calculates the price to be billed by adding the costs of direct materials, direct labour, and overhead for a project, as well as a markup percentage.
From the client's perspective, this can be a pricey pricing structure because costs might rise much higher than anticipated.
The system works best, though, when there is a lot of uncertainty surrounding the final product's design requirements.
3. Time and material contract
An alternative to the previous cost-plus contract is a time-and-materials contract.
Customers are charged the real cost of the supplies used in addition to the regular hourly rate for each hour performed.
The standard labour rate per hour being charged does not always correspond to the actual cost of the labour; instead, it could be based on the going rate for a certain skill set or on the cost of labour plus a specified profit margin.
4. Unit price Contract
In a unit-price contract, the client agrees to pay a certain amount for each unit of production.
This approach is infrequently used in a large, complex building project when there are few easily replicable output units.
For instance, a client is unlikely to want a unit-price contract for every residential building in a complex.
However, the general contractor may employ this sort of contract with its subcontractors for specific work arrangements.
For instance, a general contractor building a road might sign a unit-price contract stipulating a specific payment per square foot of installed sidewalk.
When it is impossible to identify the percentage of project completion, the revenue recognized under a contract may be calculated using the completed contract technique.
This means as the term suggests, that the contractor only acknowledges all project money and profit after a project has been finished.
The percentage of completion technique, which is more frequently utilized, allows the contractor to recognize revenue by dividing the anticipated profit by the predicted completion percentage.
This strategy enables the contractor to record revenue and profits during the course of a project at regular periods.
The cash method is an additional choice; under this method, revenue is only recognized when cash is received; this strategy performs best for smaller, shorter-term projects.
How to Select the Appropriate Construction Accounting Approach
Contractors should use the recommendations of Internal Revenue Code section 460 to determine which accounting system is best for them, considering tax regulations in addition to GAAP considerations (IRC 460).
IRC 460 outlines tax regulations unique to each industry and lists a number of exclusions.
An organization can employ multiple strategies at once since tax treatment can be decided on a contract-by-contract basis.
The three filters listed below should be used to evaluate each contract when choosing the best approach:
1. Sorting construction contracts based on length
Short-term: According to the IRS, short-term contracts are those that are signed and finished within the same tax year. You can use cash or accrual methods for short-term contracts.
Long-term: Contracts that are longer than one tax year in duration. Long-term contracts must be accounted for in accordance with PCM under IRC 460. Small contractors with agreements lasting under two years and home contracts, which we'll discuss, are two notable exceptions.
2. Identify long-term contracts as residential or general construction agreements.
Home contracts: Home contracts only cover four or fewer residences. There are various exceptions to home contracts.
First, PCM is not required for residential contracts by construction companies of any size.
Second, house contracts are exempt from the IRS's "look back" requirement, which calls for the true-up of tax liabilities from earlier periods using actual data instead of PCM estimations.
Look-backs are initiated when the real contract income exceeds 10% of what was reported in each prior year.
Since contractors are obligated to pay interest on any underpaid taxes from prior periods, this provision might be quite advantageous.
General contracts: All parties, except for small construction firms, must use PCM for long-term contracts.
3. Put yourself in the small- or large-contractor category.
Because being categorized as a small contractor has several benefits, this classification is crucial.
A small contractor generates an average of $26 million or less in revenue over the previous three years.
This threshold was previously significantly lower, but the 2017 Tax Cuts and Job Act increased it to $25 million and indexes it to inflation for 2018. (TCJA).
Additionally, small businesses can utilize CCM for contracts up to two years while avoiding PCM; however big businesses are required to use PCM for lengthy contracts.
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Accounting for construction projects can be easy. Even if you have no prior accounting knowledge, the appropriate method can help you save time on your invoicing, accounting, bookkeeping, and tax preparation.
Understanding the peculiarities of construction accounting and identifying the many job cost types that can be incurred on each project are the first steps in streamlining your workflow.
Tracking your daily transactions, regularly reconciling your accounts, and using clever accounting software are the best ways to keep organized.
You have all you need to handle accounting for your construction company properly with the help of the procedures in this manual.
Cash basis, accrual basis, the completed contract method (CCM), and the percentage of completion approach are among the accounting techniques used in construction accounting (PCM). The Financial Accounting Standards Board (FASB) has updated guidelines for revenue recognition for GAAP purposes in its ASC 606 standard.
A construction accountant often completes on-the-job training after earning a bachelor's degree in accounting to gain expertise in the field. Some construction accountants develop their areas of expertise by attending industry-specific training sessions offered by building groups or accounting societies.
To account for construction projects, job costing is used, which records each project's specifics in a different profit centre. Depending on the unique requirements of each contractor and project, one can choose from a variety of accounting techniques for construction projects.
Construction contracts are legal documents that outline the specifics of a construction project and each party's responsibilities. A specialized form of bookkeeping and reporting is known as construction contract accounting for the building projects described in the construction contracts.