Construction accounting is complicated as Construction business has many moving components and it takes years to complete projects.
Merely Relying on your accountant is not advisable. As construction business owner, you should have fundamental knowledge of construction accounting.
In this article, you will learn how to implement the best construction accounting practices.
Why is construction accounting important ?
As per Census Bureau’s Business Dynamics Statistics, 36.40% construction companies fail. Reasons for failure are
- Scope creep
- Growing to fast
- Un skilled staff
- Accounting not being done regularly
- Poor job estimate
- Cash flow management
- Lack of advertising
- Poor project management
You can reduce chance of business failure by 30% by merely getting your books done regularly and following proper accounting method. Please note that proper cash flow forecast and management can be done only if you have accurate books.
Construction accounting methods:
Fundamental of accounting is same for construction accounting. However, it differs due to project time length and partnership / joint ventures.
There are 4 main methods of construction accounting.
In this method, you record purchase and sales when actually paid or received in cash. This method is easy to maintain but it does not reflect true profitability of business.
In this method, you record sales when invoice is issued and purchase when bill is received. Though this method is bit complicated but it gives you clear picture of profitability of business.
Completed contract method:
In this method, sales and expenses are accounted when the contract is complete. This method has fundamental flaw as construction contract lasts for more than one accounting period. If you are paying taxes using this method, you might have huge tax burden at the end of the contract.
Percentage of completion:
In this method, revenue and expenses are considered as per construction work in progress. This method is quite popular and it gives proper weight age to contract profitability each year. This method is also useful when there is partnership venture.
Construction accounting best practice:
Segregation of project cost: The biggest challenge is allocating project cost correctly. As there are multiple projects running together, it is quite difficult to track everything correctly. Simple income statement considering all projects is not your solution.
Solution: You should use job costing method. Get guidance of your accountant for it. By using this method, you can track each expense and receipt project wise. It is advisable to adapt this practice from the beginning of any project. You can write down the processes to record every thing day to day in the books. Skilled bookkeeper can help you with this.
Recording overhead: You can record variable cost on project basis easily but the biggest challenge is overhead such as site rent, training cost, sub contractor cost, wages.
Solutions : The right solution for this problem is allocate the overhead as per resource usage. Let say you have two construction contract in current year. You are using 25% space for contract A and 75% space for contract B. You need to allocate factory rent at 25:75 or 1:3 ratio.
Calculating profit : As there are multiple project running for more than one year, you face challenge in calculating year end profit or loss amount. As I discussed before, profit can be calculated together at the end of the contract or every year.
Solution : You can consider profit after end of the contract. But it is not right method. It is better to calculate project profitability on completion percentage method. In this method, you consider project profit as per completed work in progress each year. Let say one construction project finished in 3 years . The work in progress is 30% in first year, 60% in second year and 100% in third year. In this case, you need to allocate 30% profit in first year and so on. To use this method, we advice hire skilled bookkeeper or accountant.
Tax compliance : As the profitability of construction business is high. You have to comply multiple local and federal taxes. Keeping cash flow steady is vital to comply with huge tax amount.
Solution : As I discussed in my previous point, adopting completion percentage method is beneficial in terms of tax compliance. You need to pay tax on portion of project profit each year. But this saves you from huge tax burden at the end of the contract.
Inventory management: It is quite usual that you have one space to keep all inventory and the employee maintains single inventory record. The issue is considering right cost of inventory for each project.
Solution : You can ask your stock keeper to keep record of issue of inventory project wise. This way you can estimate the inventory usage project wise. You can also opt for inventory management software to make the process easier and fast.
Accounting software : There are multiple accounting software available in market. Each business is unique in some way and choosing right accounting software for your construction business is essential.
Solution : Don’t make mistake of going with free software.Software should be cloud based, has automation features with easy to use features.We recommend Quick books or Xero as it gives you ability to synchronize data with any other app or software you use.
Cash Flow Management : This is the biggest challenge of high turnover business. As cost factor is significantly high and price of material fluctuates frequently, you can easily run out of cash. However, you can adopt the best practices of construction industry.
Solution : Keep an eye on cost on weekly basis. Compare actual expense with monthly budgeted expense. You can also include price fluctuation terms in construction contractor. There is ideal practice of charging client immediately for material or when client pays supplier directly. This way you can avoid the cash flow crisis.
Giving construction estimate : This is the issue quite overlooked by contractors. Giving right construction estimate is the key to profitable project. It is quite difficult to give accurate estimate due to pricing, repair cost, travel cost or overhead issue.
Solution : Take enough time and do enough research and analysis before giving estimate. You can analysis past data and current trend to estimate the future price fluctuation. Narrate everything in contract and charge extra for scope creep. Be careful with estimated time and labor cost. Even 15 days extra work can increase cost significantly.
Partnership / Join venture : Partnership in construction business creates complexity in accounting. Calculating yearly profit and allocating the profit at right ratio determines success of partnership. Unfortunately, cost calculation and estimating time of completion of project is difficult. This may result in issues between partner.
Solution : Project estimate should be prepared by team of accountant and project manager of all the partners. Give quote agreed by all related partners. The cost allocation should be decided between partners before starting of project. All partners should have regular bookkeeping and month end journal entry should be made for partnership project. Clear processes should be determined for each project task. Arbitration method for the issues between partner should be written in advance.
Revenue recognition : Many contractors prefer cash basis method to recognize the revenue. However, there is significant risk of over or under calculation of profit in this method.
Solution : We suggest use accrual accounting method. It looks complicated at first place but has enormous benefit such as accurate profit and loss reporting. Combination of percentage completion method and accrual accounting is the ideal solution for construction accounting.
Wrap up :
It takes a lot to make your construction business successful. Key to reduce complexity by setting up proper processes from day one. It looks time consuming and unnecessary at first place but reward is very huge.
Though we have discuss ideal construction accounting method and best practices, it varies from business size and nature of work.
Discuss the doubts and issues with your accountant on first place to reduce confusion. Awareness is always better.