Accounting for construction contractors can be surprisingly complex. Getting your bookkeeping and accounting done correctly can lead to higher profitability, better tax outcomes, and a unique understanding of which types of jobs are more profitable. In this article, we will discuss some of the unique challenges, best practices, and things to look out for when preparing the books for construction companies.
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What’s Unique About Construction Accounting?
Although the basic principles of accounting generally don’t change between industries, there are a few things that make construction accounting more unique than other industries. Here are a few examples of accounting items unique to this industry:
- Revenue Recognition: Construction contractors often work on long-term jobs and contracts. This means fronting a lot of the costs prior to being able to bill the customer for the job. This leaves a few different options for recognizing revenue, which will be discussed in more detail below.
- Job Costing & Project Tracking: Since contractors often have larger jobs with more complex costs and time estimates, job costing is critical. This is how a contractor will determine how profitable a job is. Depending on how the contractor is billing (fixed fee, cost plus, etc.), accurate job costing will be the key to profitability in this industry.
- Transaction Tagging & Class Tracking: Many contractors will work on both commercial jobs and residential jobs. In this scenario, it may be important to track revenue and costs by job type. This can be done in a contractor’s books by tagging transactions or tracking classes. It allows the contractor to run profit and loss reports by business segment, which can be extremely useful.
- Union Dues: In some situations, contractors may hire other contractors to complete different parts of a job. Depending on the type of work, the construction contractor may need to pay union dues for the individuals they hire. This requires careful tracking of hours worked by each employee and diligent payroll processing within the company.
Construction Accounting Job Types
Fixed-fee contracts are construction contracts where the price is agreed upon prior to the start of the job. This means that regardless of additional costs incurred or unexpected items, the price generally does not change. If construction contractors can scale their business properly, these types of jobs can become extremely profitable. However, if not careful, they can also result in jobs that go “underwater,” meaning the costs are greater than the revenue of the project. Job costing is critical for these types of contracts in order to carefully monitor profitability.
Cost-plus contracts remove some of the risks associated with fixed-fee contracts for the contractor. In a cost-plus contract, the contractor gets reimbursed for all construction costs and materials throughout the contract by providing receipts/invoices to the customer. At the end of the contract, the contractor generally receives their profit. This is normally negotiated as a fixed fee for each job or as a percentage of the total contract value. When the project is completed, the contractor is generally paid their profit on the job. There may also be incentives negotiated as part of the contract, such as the total time to completion of a home build.
Time & Material
In these types of contracts, the contractor tracks all materials purchased and time spent on a job. Each employee is normally billed at a set hourly rate to the customer, which is generally higher than what the contractor pays them. Contractors bill for these hours plus the cost of material when invoicing the customer. Some contractors will also mark up the price of materials purchased for the job. For example, a plumber may purchase a water heater for $500 but sell it to customers for $1,000 plus the cost of the time it takes to install it. For these kinds of contracts, it can be easier to make sure they are profitable than for many others.
Unit Price Contracts
Unit price is when a construction contractor sets a fixed unit price for each item it installs or constructs for the customer. This is more common in large construction jobs, such as apartment buildings, utility construction, and a few others. Since much of the work is repetitive, this allows the contractor to set a price for each unit that will become more profitable as employees get more efficient. For example, if a plumber needs to install a water heater in each of the 60 units of an apartment building, they may charge a fixed price per water heater. When each unit is completed, the contractor can bill the customer for the work done.
Construction Accounting Methods (Revenue Recognition)
Accounting methods deal with how a construction company recognizes its revenue. Although this may sound simple in theory, it can get extremely complex as the number of jobs climbs. Here are some common accounting methods used in this industry:
- Cash Method: This method of accounting recognizes income when money is received from customers, and recognizes expenses when the contractor actually pays for goods or services. For 2022, this is only available for businesses with less than $27 million in average annual revenue for the prior three years.
- Percentage of Completion Method: This is for longer-term contracts. It allows construction contractors to recognize revenue based on the percentage of work that is actually completed. It also allows the contractors to recognize the appropriate percentage of expenses associated with the revenue recognized, leaving just the contractors profit margin.
- Completed Contract Method: This method recognizes revenue once each contract has been completed. This also means that the expenses are not recognized/deducted until the contract has been completed. Expenses generally sit in an inventory account until the job is invoiced.
Best Practices for Contractors
Focus on Job Costing
In this industry, understanding the profitability of each project or job is critical. Even though it takes more time and may even require a bookkeeper, this is the only way for a construction company to make sure it will be profitable in the long run. In this industry, costs are constantly changing. Whether it’s the cost of raw materials or subcontractors, job costing is the only true way to keep track of them and ensure that your prices are adjusted accordingly. This will also allow you to set targets for profitability percentages. Once those are in place, you can predict what it would look like to scale your business and add more employees. If profitability percentages start to drop, you can make adjustments quickly before they damage your bottom line.
Implement Class Tracking
Class tracking is the practice of segmenting your jobs into different classifications. This does not change your general ledger or chart of accounts, but is instead a way to track profitability using different measures in addition to traditional measures. For example, many construction contractors like to track their revenue and expenses by residential vs. commercial jobs. To do this, each expense and revenue item needs to be classified as residential or commercial. This allows contractors to run profit and loss statements by class, which can help the business owner focus more heavily on the types of jobs that are most profitable.
This can be segmented even further by drilling down into job types. For example, a plumber may want to track the profitability of water heater installations, sump pump installations, and toilet installations. A class can be created for each of these job types. The costs will still go into their respective general ledger categories, such as payroll expenses or cost of goods sold. However, each transaction will have this additional label that allows the business owner to pull reports on these classifications as well.
Use Accounting Software from Day One
Good accounting software can help you accomplish the objectives above with ease. You can use it to track job profitability, track classes, process payroll, and track many other critical functions of your business. Without accounting software, construction contractors are operating in the dark. Although it may not change the quality of your work or how you invoice, it will allow you to compare your expectations with actual figures and adjust your business strategies accordingly. This is critical for both small and large operations. Quickbooks Online is the most widely used accounting software, and it is excellent for job costing and class tracking.
Involve an Expert Early
Although it’s so important to keep your costs under control when starting a business, involving an expert can save so much time and money down the road if they are involved early in the process. When I say “experts,” I mostly mean lawyers and accountants. Get a good lawyer to structure all of your contracts and get your business organized properly, and hire a good accountant to help you get your books in order, plan for taxes, and predict future outcomes. Involving the right experts can pay dividends throughout the life of your business, and operating without them can be detrimental.
Because accounting for construction contractors can be complex, there are a few specific things to look out for and avoid as early as possible.
- Inventory: One thing that many construction companies get wrong is accounting for inventory. When people think of inventory, they think shelves full of products to sell. However, for construction companies, it can simply mean “jobs in progress.” Expenses associated with these jobs may need to end up in an inventory account. If missed, too many expenses will be deducted on the corporate tax return.
- Capitalization: It’s important to have a full understanding of equipment purchases that need to be capitalized. Capitalization is the expensing of the value of an asset over time. For larger purchases of equipment that will be used for more than one year, it’s important to add it to your books as an asset rather than expensing it.
- Depreciation: Many construction companies immediately expense all new equipment by taking bonus depreciation and section 179. Although this can be very beneficial in some years, it may not make the most sense in years where the shareholders may be in lower tax brackets. Understanding the implications of depreciation is critical for long-term business planning.
- Section 263(a): This is a really complex section of the tax code that very few people understand. It involves making a year-end adjustment for construction costs associated with jobs in progress and capitalizing them as inventory. If not done correctly in year 1, it is very difficult to fix in future years.
Frequently Asked Questions
Why is accounting for construction companies important?
Having proper bookkeeping done is critical for job profitability, tax planning, and general business planning. Without proper accounting, businesses are operating in the dark with no real understanding of their trajectory.
What is the most common accounting method?
Among smaller companies, the cash method of accounting is most commonly used. However, some of the accrual methods, such as percentage of completion or completed contracts, can help owners develop a better understanding of their business.
Does Quickbooks Online have a job-costing feature?
Yes, it does! Quickbooks Online calls this “project tracking.” It works well for small and large businesses. It also has a function that will track time spent on each project, allowing owners to assign wages and insurance costs to each project.
When should revenue be recognized?
This is dependent on your method of accounting. If you are using the cash method, revenue is recognized when the money is received. Revenue recognition varies under other accounting methods (see above).
Allow Casey Moss Tax and Accounting to handle all of your construction accounting needs!
If you are looking to involve an expert in your construction accounting, we are here to help! At Casey Moss Tax, we handle accounting for many construction companies and have the industry experience you need to understand your numbers. Contact us today for a free consultation so you can focus more on what you do best.