How You Can Master the Basics of Construction Accounting

Accounting is a critical component of any business' operations, yet its importance is often overlooked. In the construction industry, accounting issues often crop up as secondary issues like cash flow management, sending or receiving late payments, and loss of profitability.

Successful construction businesses must develop and understand strong business accounting practices to stay viable in a competitive industry notorious for small margins.

This article will discuss the basics of construction accounting processes and what makes construction accounting different from other industries.

Construction accounting basics

Accounting is a big umbrella term for how a business keeps all its assets straight – from money to inventory. The accounting team tracks the movement of assets into and out of an organization. This process is critical for monitoring profitability and keeping financial activities transparent.

Construction accounting follows the same core accounting principles that apply to any other business. Still, some big differences in how the industry works make construction accounting processes a bit more complex. Mainly, the changes stem from the project-based nature of construction projects.

The entire cost structure can change from project to project, depending on the job's location, owner, working conditions, and current market price for labor and materials.

Furthermore, a new contract applies for each job a contractor takes on, and each contract may assign costs differently.

Here are some of the main ways the project-based structure of the construction changes accounting practices:

Fluctuating costs

Traditional accounting generally deals with consistent costs, but costs frequently change in the construction industry - sometimes on each new project. Differing construction project locations can affect the contract cost of acquiring permits to begin work, and labor costs swing widely across regions.

Change orders, which are commonplace for many construction firms, often also alter the costs of each individual project. A construction accounting system needs to reflect the new charges after each change order so that contractors can determine a project's ongoing profitability.

Varied service categories

Construction requires several, often changing service categories, such as consulting and engineering, physical products, equipment, and labor and design.

Ownership of costs

In many businesses, overhead costs are easy to determine. Think about how a hair salon might calculate its business costs: the salon charges the customer for a haircut but takes on the expense of payroll, hair products, and equipment.

In construction, it can be trickier to discern overhead job costs that the contractor includes in business expenses from project costs, which will be the owner's responsibility. For instance, a general contractor may cover the cost of equipment rental but pass labor costs on to the owner.

Unique needs

All this makes it very complicated to create and maintain consistent accounting practices company-wide. That's why many construction businesses have taken to a method called job costing, which allows companies to track costs on a project-to-project basis.

Construction has different accounting needs that require specific accounting practices.

Common construction accounting practices

Despite all these challenges, construction companies have a few different accounting methods to track expenses and income. A contractor's method may depend on personal preference or the characteristics of jobs the company commonly undertakes.

Cash basis or accrual basis

A cash basis is a straightforward approach to tallying up expenses and income: when a payment comes in, cash accounting records the income into the system. When the company pays a bill, the accounting system subtracts the amount from its total. Cash accounting doesn't look into the future or past – whatever is happening at the current moment is reflected as the company's reality.

An accrual basis works like balancing a checkbook. When the company earns revenue by reaching a billing milestone (whether or not payment has come), it is recorded in the accounting system. Similarly, when an expense comes up, the accounting system registers the subtracted fees even if the company hasn't yet paid the invoice.

However, these accounting systems are so simplistic that they don't always accurately depict a project's status. A company may have purchased the required materials for phases 1 and 2 of a project but only completed and billed for phase 1 – cash or accrual accounting systems would show a profound loss on the project to date. Bigger projects become too complex for this accounting system to accurately reflect their financial health and progress, which may explain why smaller companies with lower-revenue projects are the ones who most often use cash basis accounting.

Percentage complete

A second accounting system measures the profitability of a project based on its relative progress. It can better present a clear picture of the project's financial health during all stages of its completion.

As its name suggests, contractors using the percentage complete method calculate their earnings on a project based on how much of the job is finished. The contractor tallies expenses and income regularly as the work progresses. By comparing these numbers to the estimated overall cost and revenue the project will produce, the contractor can see how actual progress compares to expectations.

While this method uses estimations as a basis for comparison, it can produce the most accurate picture of a project's profitability. That's why percent complete is widely considered the best method for construction accounting, particularly on extended, multi-year projects that span multiple earnings periods.

Completed contract

The completed contract method tallies all revenue and expenses only after a project is completed. That's also when the contractor will record a profit or loss for the construction work.

This method works best when used on very short construction projects. It may benefit the contractor by allowing the construction company to defer profits on a project to another tax period, thus minimizing its tax implications. Before trying it out, make sure it's allowed based on your regional tax rules.

Best practices for construction accounting

1) Cost out your jobs as accurately as possible

Calculating correct expenses and budgeting is critical to pricing individual projects and earning a gross profit for your work.

2) Keep accurate records like your construction business depends on it

Because it just may. Record the information from receipts and invoices for every related business expense or income. Accounting software can make this process easier and more accurate.

3) Keep digital copies of financial statements

Digital copies of receipts, invoices and financial statements provide a fail-safe backup and allow you to access financial data from anywhere.

4) Find the tax strategy that works for you

Consider your revenue recognition methods, the type and timeline of projects you usually take on, and your business structure to ensure tax compliance for your construction business.

Keep your construction accounting straight

Any accounting strategy ultimately depends on accurate numbers to calculate profit and loss and the predicted profitability of a project. Digital records of all your expenses and revenue can facilitate good accounting practices and keep your projects on track.

With Truss, you can import bills and invoices from your accounting software, making it easier to stay on top of accounts payable and accounts receivable.

Ready to clean up your accounting processes for your contracting business? Get started with Truss today!