Accounting and taxes for construction projects can be extremely complex. When completing your books, it is important to understand which accounting methods are available and what is right for your business. This article will explain which method to choose and how it will impact your tax situation.
The cash method of accounting is the simplest method for tax purposes. The cash method means that revenue is recognized when cash is actually received. For example, when you complete work and invoice a customer, that revenue is not recognized on your tax return until the customer actually pays you. Likewise, expenses are not actually deducted on your tax return until they are paid. These can be paid via cash/check or credit card. For example, if your vendor sends you a bill stating that you owe $20,000 for materials and you decide to pay half at that time, you only get to deduct the $10,000 you paid. The other $10,000 will be deducted when the remainder of the balance is paid. There are a few advantages and disadvantages to using the cash method of accounting for tax purposes.
- Very simple: This method prevents the need for complex accounting software. It essentially allows you to complete your books and taxes by looking at bank and credit card statements.
- Avoids tax on “phantom” income: The cash method means that you are only showing income on your tax return when you receive the money from customers. That means that you should not be paying income taxes on any money that you don’t have yet.
- More flexibility: When on the cash method, taxpayers have more flexibility when it comes to taking deductions and paying income taxes. For example, you may have low income in one year, but are expecting higher income in the next year. In this scenario, you may delay paying a vendor’s outstanding balance until the following tax year to take the deduction when you’ll need it most.
- Software savings: When on the cash method, the importance of having expensive accounting software with a receivables and payables module built in decreases. This means you can likely get by using spreadsheets most years instead of paying for expensive software.
- Murky financial statements: If your goal is to have a really good understanding of your financial situation, the cash method of accounting may not be for you. It can result in really large profits in one year and losses in the next simply due to the timing of deposits from customers.
- Banking limitations: Although it may be nice to take large deductions in one tax year and pay a small amount of income taxes, this may result in financing limitations at the bank for future profits. For example, in a year that customers delay paying until the following year, your business may show a loss, making it difficult to get loans for the following year.
- Not available for all taxpayers: While this method is allowed for most taxpayers, there are some that will not be able to use the cash method as their business grows. If a construction company has an average of $26 million in gross receipts in the previous three tax years, they’ll need to convert to the accrual method. This can be costly and cumbersome.
The cash method of accounting is great for small businesses with limited recordkeeping and bookkeeping skills. If you plan to keep your company small and simple, this method will likely work for the foreseeable future. However, if you intend to grow your business and obtain large amounts of financing, other methods will likely be more suitable.
The accrual method of accounting for construction companies means that income is recognized as it is earned and expenses are recognized when they are incurred. For example, if you finish a construction project and send an invoice to a customer, the revenue is recognized on your financial statements and on your tax return. You also record a receivable from that customer on your balance sheet. On the other hand, if you receive a bill from your vendor stating that you owe money to them, you recognize the expense on your financial statements and tax return and record a payable to the vendor. There are some pros and cons to the accrual method for tax purposes, and they are as follows.
- Precise financial statements and tax returns: The accrual method provides a more accurate picture of what is actually happening in your business when compared to the cash method of accounting. Since you’ll be recognizing income and expenses when they are incurred, you should (in theory) have a perfect financial picture at all times.
- Banking and financing: It may be easier to obtain financing for projects if all of your financial statements and tax returns are on the accrual basis. Lenders will often look at accounts receivable for borrowing base purposes. This is more difficult to do on the cash basis than the accrual basis.
- Better project tracking: Working on the accrual basis makes it easier to track the profitability of projects and longer-term contracts within your financial statements. Since you’ll be invoicing and assigning expenses to jobs within your accounting software, you’ll have a more accurate picture of job profitability.
- More complex: Accrual basis financial statements and tax returns are generally harder to produce than cash basis statements. Owners have to be very cautious with invoicing and entering expenses on time in order for these forms and statements to be accurate.
- Less flexibility: Since income and expenses are recorded when incurred, taxpayers do not have the same flexibility when it comes to taking tax deductions. For example, it may be impossible to accelerate or delay expenses since they are recognized the moment they are incurred.
- More costly: This method can require accounting software that may be more expensive. Since companies will have a need for invoicing and payables tracking, it will likely require robust software that can come with a hefty monthly cost.
The accrual method is great for businesses that truly care about having an accurate financial picture at all times. It is also the right method for large construction companies that may exceed $26 million in revenue at any point. It is important to consider the benefits and drawbacks of the accrual method as early as possible in your business’s life.
Percentage of Completion Method
This method is a subcategory of the accrual method that is used for long-term contracts. According to the IRS, long-term contracts are contracts that exceed one calendar year. If you are a small construction company that has less than $26 million in revenue, you can use this method, the cash method, the accrual method, or the completed contracts method (later). Under the percentage of completion method, revenue is recognized as a percentage of progress on a construction project. For example, if a $10,000 project is halfway done, your books and tax return should show $5,000 of revenue. It should also show half of the expenses associated with that revenue. In other words, if you bulk purchased all your material at the start of the project, half of that purchase should be recognized as cost of goods sold at the same point in time. Here are the pros and cons of this method.
- Accurate financial picture: This method gives an even more accurate picture of your financial health than the accrual method does. If items of income and expense are recognized as the project progresses, business will be more capable of making important pricing decisions on current and future projects.
- Better revenue and expense matching: Although the accrual method does a better job of this than the cash method does, the percentage of completion method can make this even more granular. For example, although you may have been invoiced for a truckload of material, you may not have used all the material yet for a job you are working on. This method solves the mismatch of revenue and expenses under the accrual method.
- Time-consuming and complex: The percentage of completion method can take up a lot of time for staff members of your company. Since each project needs to be analyzed on a regular basis, many owners wonder if the juice is worth the squeeze.
- Costly: Because you may be required to hire additional staff to track the completion of each project and allocate revenue and expenses, using this accounting method may become more expensive than alternatives. More complex software may also be required, which can be expensive.
- Difficult to estimate: In some construction projects, completion may be delayed to unforeseen material or labor shortages. This can cause the original percentages of completions that were determined to be very inaccurate, which can cause revisions to financial statements or unreliable data.
Although the percentage of completion method has some benefits, the time commitments make it one of the least common accounting methods for smaller and mid-sized construction companies. However, it is worth considering if your business consists primarily of long-term contracts.
Completed Contracts Method
The completed contracts method is another subset of the accrual method for long-term contracts. Again, long-term contracts are generally one year or more. Under this method, revenue and expenses are generally not recognized until each job or contract is completed. While the project is in progress, all expenses are essentially put into an inventory account on the balance sheet of your books. These are usually done with sub accounts for each job. Once the job is completed, the work is invoiced and the expenses are moved to cost of goods sold. Here are some of the benefits and drawbacks of this method.
- Accurate financials: Again, this method allows companies to track their financial health on a more consistent basis. Since revenue from projects that aren’t completed may never actually be recognized if something goes wrong, this allows companies to only see what is completed and invoiced.
- More consistent revenue recognition: Since a construction company can only work on so many projects at once, this method allows for relatively consistent revenue recognition throughout the year, making the financial statements more reliable and predictable.
- Cash-flow predictability: Since no revenue is recognized throughout the project, it can make it difficult to predict when money will actually be coming in. Under the percentage of completion method, projects are more closely monitored.
- Banking & financing challenges: If a construction company uses this method and attempts to get financing to bridge the completion of a project, they may run into challenges. Since the revenue from the project will not be recognized on their financials, banks and investors will not be able to obtain a good picture of their financial health for lending purposes.
The completed contracts method is a simpler version of the percentage of completion method. It’s great for companies who primarily deal with long-term contracts but may not have the resources to use the percentage of completion method. However, be cautious of selecting this accounting method if you do not have good bookkeeping or recordkeeping skills.