Construction accounting shares some bookkeeping practices with general accounting but has many unique features, such as revenue recognition based on percentage-of-completion, job costing, change orders, progress billings and retention. Since it is project-based, contractors must treat each new job as a unique profit center. Knowledge of construction accounting principles is vital to succeeding in the industry.
Why You Need to Understand the Difference
A construction company can only operate for a short time without strong and consistent accounting practices. The business is dynamic by nature and faces challenges such as changing scopes of work, complex cost estimates, and large overhead costs. Construction companies need to track costs, expenses, and production across each project separately, each having distinctive requirements and inputs.
What Makes Construction Accounting Unique?
Companies must track each project as a separate profit center with its own inputs, requirements, and production activities. For example, you shouldn't charge office administration costs to the project, but you should charge direct materials like lumber.
Construction accounting recognizes decentralized production, also called distributed production. Even though the company may have a permanent head office, labor occurs at various construction sites, each with unique requirements. Projects can be unpredictable, with fluctuating input costs that you need to track separately.
Due to the nature of the industry, construction contracts can span multiple years and phases. Issues like change orders, payment disputes, and retention can further complicate construction accounting for long-term contracts making tracking, reporting, revenue recognition, collection, and cash management difficult.
Construction companies may have a general ledger for the entire business, but the real focus is project-level job costing. Job costing is the practice of tracking costs and production activities associated with each project separately. While some expenses are easily identifiable, some indirect costs are not.
For example, how do you categorize the cost of maintenance and repairs for construction vehicles owned by the company while operating on multiple projects? Knowing how to treat such overhead is key to ensuring accurate accounting and decision-making.
Contract Revenue Recognition
Given the long-term nature of contracts, revenue recognition can be a challenge. There are two main approaches you could choose:
Percentage-of-Completion(GAAP) – Recognize project revenues and expenses over time and bill for work as it is completed based on comparing the estimated costs to actual costs.
Completed Contract Method(Tax Only) - Recognize project revenues and expenses after the project is complete.
These can be different for book and tax purposes. GAAP requires accrual percentage-of-completion, and tax returns can use multiple methods (cash, accrual, or completed contract).
The chosen mode of revenue recognition affects taxation and how the company realizes income. The ASC 606 Revenue Recognition Standards issued by the Financial Accounting Standards Board (FASB) stipulate how all companies engaged in customer contracts should recognize revenue.
Depending on the contract terms, the project owner can retain a certain percentage of payments until they are satisfied with the finished project. Upon completion of the project, after any final inspections, compliance certificates, or other requirements in the contract, the retainage is released and paid to the contractor.
Specialized Construction Billing
The construction industry has multiple sectors (general, heavy highway, specialty sub, etc.) that operate under different types of contracts. Due to the varying nature of work, contractors often have different contract types for each job.
Fixed Price - Contract price is based on a detailed estimate made by the contractor and is typically a hard bid or negotiated bid. A hard bid leaves the risk on the contractor rather than the project owner, while a negotiated bid may account for unforeseen circumstances, lowering contractor risk. Fixed price contracts are typically billed as the job progresses (percentage-of-completion) and will withhold retainage.
Time & Material - Contract price is based on hourly labor rates, material costs, and overhead at marked-up rates, which puts the project owner at risk.
Unit Price - The contractor charges the project owner a fixed price per unit rate (such as per mile of highway paved), which shares the risk between the owner and the contractor as quantities may end up higher or lower than the original estimate.
Another complex factor of construction accounting is payroll. Due to the varying nature of contracts, type of work, and location (city, state, etc.), there are multiple factors that may impact payroll, including wage requirements, compliance standards, union agreements, workers' compensation insurance, and other factors that must be considered. Additionally, these must be job costed.
Lutz Can Help!
Construction accounting may be complex, but the Lutz Construction Accounting and Consulting team has extensive experience in the field. As the only member of the Construction Industry CPAs/Consultants Association (CICPAC) in the area, our experience and affiliations mean you get unparalleled resources to help your business grow. Get in touch with us to learn more about our construction accounting and consulting services.
We work to simplify complexities, help make critical business decisions, and confidently focus on the things that are truly important to you. We embrace your business as our own to spark the right solutions and help you thrive.