Menu

Growing Your Business

5 Terms You Need To Know For Construction Accounting

by
Frank Jenkins Jr
on
12/20/2017
5 Terms You Need To Know For Construction Accounting

If you run or own a construction company, you are probably well aware of both the rewards and the challenges that it offers. Few people outside of the industry understand the many nuances of construction’s business operations, and particularly of the specialized accounting process required as a result of multi-year projects.

Where most industries have fairly straightforward accounting methodologies based on calendar year expenditures and purchases and stable environments, construction projects and their related transactions are ever-changing. To respond to values that are constantly in flux, construction accounting involves its own terms and concepts, and as a result, the IRS has a complex code that is dedicated specifically to that application.

Because the accounting procedures for construction businesses are among the most complex of any industry, it is advised that you select an accounting professional who either specializes in the field or who has significant experience in its specific needs.

To help you better understand how construction accounting works and the importance of the accounting method that is chosen, we have provided five of the key terms used to describe accounting methods that are available for construction businesses.

  1. The Accrual Method – Of all the accounting methods available to construction companies, the accrual method is the one that is used the most because it matches specific expenses to the income from specific projects. Of particular use is the fact that for contracts that can be completed within two years of their start date, and whose don’t exceed $10 million in annual gross receipts for the three tax years prior to the start of the contract, construction businesses can combine the use of the accrual method with the completed contract method described below.
  1. The Cash Method – The cash method is one of the simplest and most straightforward accounting methods, and it is the one that is most commonly used in off-the-shelf tax software programs. It recognizes expenses as they are paid, rather than when they are incurred, and as a result, it doesn’t recognize revenue then, either. This makes it one of the least applicable accounting methods for construction, as does the fact that the IRS’s general guidelines suggest against its use by companies with annual total purchases that compare substantially to the business’s gross annual income. Additionally, this method is not available to incorporated businesses or businesses that have C corporation partners. 
  1. The Completed Contract Method – This accounting method is one of the most useful for construction businesses, particularly when combined with the accrual method. It allows for the unpredictable nature of construction, in which projects may not be completed by the end of the fiscal reporting period and cost fluctuations may impact the expenses and revenues of a long-term project. The method defers all expenses, revenue, and gross profit until the individual project is substantially completed or completed. This allows for deferred tax accounting, which is a big benefit for a contractor. Unfortunately, if you are a contractor such as an engineer, architect or management service firm that provides services, the completed contract method is not available for use. 
  1. Long-Term Contracts – Rather than being an accounting method, Long Term Contract is a specific term that the IRS provides to describe a project that can’t be finished in the same tax year as the beginning of its contract date. If a contract is considered to be long-term, the IRS requires construction companies to use a combination of the percentage-of-completion method (see below) and the accrual method.
  1. Percentage-of-Completion Method – This accounting method is complex, but it is the most helpful and most widely used in projects where you are able to say with reasonable certainty what percentage of the work is complete at any given time, as well as how much more you will need to spend before the project’s end. In order to use this method, Accounting Standards dictate that there be enforceable rights regarding all goods or services involved specifically provided for within your contracts. It is also expected that you are able to count on the contractor to perform the job that they’ve been hired to perform, and that they are able to count on you to keep up your end of the contract as well. 

When using the Percentage-of-Completion Method, there are two different ways to track your project’s progress: the cost-based method and the value based method. When using the cost-based method, you need to be able to say with reasonable certainty how much you have spent at on the work that has been done, as well as what the completion stage is. Alternatively, you can use the valued-based methodology, which provides the value of the work completed expressed as a percentage of what the contract will be worth at completion.  Where applicable, the value-based approach may be expressed in terms of physical units completed compared to the number that will have been delivered when the project is complete. 

Construction Accounting is Unique in Many Ways

Where most businesses are able to express their business’ tax numbers in a straightforward way based on the end of the fiscal year, construction accounting must take a much different approach. In addition to the issue of projects being in various stages, there are also additional complications including multiple sources of funding and a variety of contracts for services, equipment, and supplies. All of these factors combined make it a necessity to work with a CPA with experience in construction accounting.

If you would like to become more familiar with the nuances of construction tax accounting, the IRS’ website features a page dedicated to tips for both small and large businesses. Though we encourage you to take the time to educate yourself on the accounting requirements of your field, we also advise that you seek professional guidance when it comes to your business’ accounting needs. Combining the general complexity of the rules with the ever-changing tax landscape makes it essential that you rely on a professional to ensure that no costly mistakes are made.

Frank Jenkins, CPA writes for TaxBuzz, a tax news and advice website. Reach him at [email protected].

share this post
Search for matches...
Frank Jenkins Jr

Frank Jenkins Jr

Frank Jenkins Jr. is the managing partner of Adams, Jenkins & Cheatham, a CPA practice based in Midlothian, VA. Frank specializes in Consulting services, tax planning, accounting, audit & assurances. "I genuinely care about our clients because I have a personal connection with them. This job requires me to multi-task and work under tight deadlines. I get great professional satisfaction from balancing firm and client commitments while building a strong team here at AJC."

ADAMS, JENKINS & CHEATHAM
★ ★ ★ ★ ★
0 reviews

Virginia

Firm Profile

Recommended Professionals

In the face of economic uncertainty, TaxBuzz is the industry's most up-to-date tax information.

Join 60,000 who get our weekly newsletter. No spam.

We know tax and accounting issues are complicated.

Do you have additional questions on this topic for this author?

Related Posts

Latest Posts