Accounting is the capture and reporting of financial information. Accounting deals with when, where, how much, and why of financial transactions.
Because the types of financial transactions can vary from industry to industry, the accounting practices businesses implement vary from industry to industry.
There are general accounting principles that apply to every industry – revenues and expenses should match. You should report revenue when you earn it; you should report expenses when you incur them, but different industries implement these principals in different ways.
What should I know about construction accounting?
Construction projects generally take longer to complete than projects in other industries. Many times, a construction company will incur costs months or even years before receiving cash for their services. Then, when they do receive cash, a portion of the amount due from the contract is withheld, or retained until a milestone is met or until the end of the project.
A construction company might purchase all materials and supplies at the very beginning of the project. Then, for the entire life of the project, the company may incur no more or very little costs for materials and supplies.
If a construction company keeps track of its income and expenses on the cash basis, then it’s revenue and expenses on its financial statements will not match. Even if a construction company uses accrual basis reports in QuickBooks or Sage 50 (Peachtree), then the financial statements will still be incorrect.
In QuickBooks, Peachtree, and most other accounting systems, if you use accrual basis reports, you show income when you invoice customers and expenses when you receive a bill. Well, a construction company won’t send an invoice to the customer with the amount due until after the project is completed, and it will receive a bill immediately upon purchasing supplies or materials from a vendor.
How should a construction company handle its accounting?
Just as the accounting practices vary from industry to industry, proper accounting procedures will vary from company to company. They can even vary from project to project.
However, there are two general methods used to account for revenue and expenses by construction companies: the completed contract method and the percentage of completion method.
Completed Contract Method
Under the completed contract method, you report income and expenses when the contract is complete. When you pay cash to purchase materials or when you receive a bill from a vendor to purchase supplies, you classify the costs to an asset account, which is typically called “Work in Progress”. When you receive advance payments or draws towards the contract, you report the receipt to an liability account.
At the end of the project, you’ll move the balance from the work in progress account and the advance payment liability account to the appropriate income and expense account on the income statement.
Percentage-of-Completion Method
The percentage of completion method Under the percentage of completion method, you report income and expenses throughout the project based on the percentage of completion of the project. There are many factors you should consider when using the percentage of completion method. How will you measure your percentage complete. How will you handle cash received and spent during the life of the project?
Generally, you measure the percent you complete by dividing your total costs incurred to date by the total estimated costs on the project. You multiply the percentage of completion by the contract price to get your revenue to date. The adjustments you make to report your incremental earnings and expenses depend on how you’ve handled your cash receipts and expenditures throughout the month.
What about for tax purposes
The method you use to report income and deductions for tax purposes may or may not match the method you use to report income and expenses for external financial reporting or management purposes. There are other factors to take into account such as the size of your business, the length of the project, the type of the project, interest expense, overhead costs, and others.
When deciding how to implement an accounting system or when preparing for an audit or a review, you should be aware of the general accounting practices carried out by construction companies.