Construction accounting includes unique concepts that reflect the specialized practices and requirements of the building industry. These concepts span the entire project lifecycle, from estimating to billing and revenue recognition. The billing method agreed on with clients may vary based on the type of project and the risks involved.
Construction firms may even choose a specific revenue recognition method on a per-project basis depending on factors such as size and expected length. Complex regulatory requirements may also apply to each project.
Job costing
Because each project typically operates as its own temporary profit center, accurately estimating and tracking all project costs is a critical aspect of construction accounting. Job costing is the process of determining the total cost of completing each job to the contracted specifications. Contractors use this information for estimating, billing and assessing whether in-progress projects are on track. Generally, costs fall into three major categories: labor, materials and overhead. To provide a comprehensive picture of project finances, job costing should account for every stage of the project, including the cost of producing estimates and change orders.
Contract revenue recognition
For contractors, revenue recognition is a complex topic, largely because of the long-term nature of many projects. The choice of revenue recognition method depends on factors such as the size of the contractor’s business as well as the duration and type of projects the company works on.
Cash basis method: In general, companies can use one of two overall accounting methods: cash basis or accrual basis.
Cash basis is the simplest approach to recognizing contract revenue. With cash basis accounting, you record revenue when you receive payment and record expenses when you actually pay them. With acrrual basis accounting, you record revenue when it is earned and expenses when they are incurred, regardless of when money actually changes hands.
However, construction companies can generally use the cash basis method only if they have average gross receipts of $25 million or less (the threshold was raised from $5 million in the Tax Cuts and Jobs Act, which came into force in 2018). Public companies and many larger businesses must use accrual basis accounting to comply with U.S. Generally Accepted Accounting Principles (GAAP).
Although the simplicity of cash basis accounting is appealing, it can paint a misleading picture of a company’s finances. If a company hasn’t completed a major project by the end of an accounting period, for example, its financial statements will reflect all the project expenses it’s incurred but none of the revenue it’s earned.
Percentage of completion method: The percentage of completion method (PCM) enables contractors to recognize revenue as they earn it over the life of a contract. Most contractors recognize revenue using this method, especially if they work on multiyear contracts. In general, contractors with gross revenue over $25 million must use this method for projects that take two years or more, unless a project qualifies as a home construction project.
During a project, contractors recognize revenue for the portion of the work they’ve completed to date. There are several ways to calculate this: The cost-to-cost approach bases the amount on the percentage of estimated job costs incurred to date, while the estimated percent complete approach uses an assessment of the percentage of work completed. A big advantage of the percentage of completion method is that, because it reports income and expenses together throughout each project, it paints a more accurate picture of the company’s finances and smooths out potential swings in revenue and expenses.
Completed contract method: With the completed contract method (CCM), contractors recognize all revenue, expenses and profits only when the project is completed. An advantage of this method is that contractors can defer revenue to a future period, thus minimizing tax liability in the current period. Generally, firms may use this method only in limited circumstances, notably for home construction projects. A disadvantage is that CCM is not GAAP-compliant.
A recently introduced GAAP revenue recognition standard, ASC 606 affects how contractors should recognize revenue for long-term contracts using PCM. ASC guidance is that companies should recognize revenue based on performance obligations, which are promises to deliver distinct goods or services to a customer. A contract may include a single performance obligation, or it may include several. Contractors must identify performance obligations in the contract and allocate a price to each.
A second key consideration is transfer of control — the point at which ownership and control of the end product passes to the customer. In situations where the ownership and control of a contractor’s work product becomes the customer’s over time, PCM would be applied to each performance obligation rather than the total contract price.
Contract retainage
Retainage is the portion of the agreed-on project price that is withheld until the job is completed, or for a specified period. The goal of this long-standing practice is to create a financial incentive for contractors to complete the project satisfactorily and to protect owners if problems appear. Retainage amounts are often substantial, amounting to 5% to 10% of the contract value.
Retainage is commonly applied to both private-sector and public-sector projects; the regulations for handling retainage vary from state to state. Because many contractors operate on relatively low profit margins, the amount withheld for retainage can represent a large portion of a project’s profit. To mitigate their risk, contractors may in turn withhold retainage from their subcontractors.
Construction billing
In many industries, billing takes place at the time of sale or on a fixed monthly schedule — think of buying office supplies or subscribing to a streaming service. In construction, billing can be much more complex, largely because of the long-term and flexible nature of many projects.
Some of the most common construction billing methods are:
Fixed price: The contractor and client agree to a set price for the project at the beginning of the venture, based on a detailed estimate. This commits the construction company to completing the project for that price regardless of the time and materials actually required, although contracts may allow for price changes if unforeseen problems emerge. Although this approach creates risks for contractors, it can attract customers who want to see the full price up front.
Time and materials: The time and materials based is often used when it’s not possible to pin down the scope of a project in advance. The contractor bills based on a per-hour rate for labor, plus the cost of materials. Contractors may apply a standard markup to both labor time and materials to cover their overhead and generate a profit. To protect buyers, some contracts include a price cap; the buyer agrees to pay for time and materials only up to a specified limit.
Unit price: The contractor bills at a fixed price per unit, and both the nature of the “unit” and the per-unit price are established in the project contract. The unit price contract method is useful in situations where the contractor is providing repetitive items with a predictable cost, but it’s not clear at the outset how many items will be needed.
Unit pricing is often used on public construction projects. For example, a contractor might provide a unit price per mile of highway. To make a profit, a construction firm needs to be able to accurately estimate all the costs — labor, materials, overhead — involved in delivering each unit.
AIA progress billing: The American Institute of Architects (AIA) billing method is commonly used in commercial and government-funded construction projects, so gaining familiarity with it can help contractors expand into those areas.
The AIA defines allowed billing processes and forms. Contractors bill clients for the work completed in each billing period. By standardizing the process, forms and language used, AIA Billing is designed to make it clear to owners exactly how much work the contractor has completed to date; it also requires architect signoff on each invoice. For each period, the contractor provides a summary cover sheet (Form G702) and a detailed description of the work completed (Form G703).
Construction payroll
In many industries, wages are determined by simply investigating the local market rate and minimum wage requirements for various roles. Though that’s also true for some construction jobs, specific rules apply to public projects and the use of union labor.
In addition, contractors have to navigate a complex web of labor laws and local tax regimes.
Prevailing wage: Contractors working on public projects must pay government-defined minimum wages for each type of worker. These are known as “prevailing wages” because they’re based on surveys of what people are paid to do similar work in each region.
For federal projects, are publicly posted information. Most states also set prevailing wages for state-funded public projects. Contractors usually have to certify that they comply by submitting forms to the appropriate agency. Meeting prevailing wage requirements can be complex because rates change frequently and vary between jurisdictions.
Union payroll: Unlike many other industries, construction trades are still largely unionized. Wages and other working conditions are determined by collective bargaining agreements, and companies typically need to report wages and other information to each union to verify compliance. Companies may also need to deduct union dues from payroll and accurately track time to ensure tradespeople are working only the hours specified in their contracts.
Multi-state payroll: Contractors that have projects in several cities and states are exposed to the Complexities of multiple payroll and labor laws. They need to ensure they deduct taxes appropriately for each employee to comply with city and state taxes. This can get complicated if a company has employees who live in one state and work in another or perform work in multiple states. Nearly all states require employers to withhold tax from employee wages for work they perform in that state. However, most states also have the right to tax their residents. Some states have reciprocal agreements, so if employees perform work in multiple states, their employers only need to withhold taxes for one state. But in some cases, a contractor might have to withhold taxes for multiple states from one employee’s wages.
Compliance reporting: In addition to meeting local tax requirements, contractors have to track and often report compliance with employment regulations. This may involve reporting to federal, state and local agencies.
At a federal level, the Occupational Safety and Health Administration (OSHA) requires all employers to report work-related deaths and serious injuries, and the Equal Employment Opportunity Commission (EEOC) requires employers with more than 100 employees to submit an annual report with data about the ethnicity, race and gender of employees.
Financial Statements Specific to Construction Accounting
Due to the distinct and unique nature of the industry, certain financial statements only exist for construction accounting. These tailored statements address the complexities inherent in construction operations and provide stakeholders with accurate, relevant, and actionable financial data.
Work-in-Progress (WIP) Schedule
The Work-in-Progress (WIP) Schedule is an integral financial tool in the construction industry. It offers a detailed snapshot of the current financial status of ongoing projects, providing crucial insights into costs incurred and revenues earned. This report includes projected total cost, costs incurred to date, billed revenue, and recognized revenue. Accurate interpretation of WIP data aids in identifying potential project overruns or underruns, assessing project progress against the budget, and guiding financial decision-making for ongoing projects.
Construction-in-Progress (CIP) Report
The Construction-in-Progress (CIP) Report is designed to track financial data for projects that have commenced but are yet to be completed. It’s instrumental in providing an ongoing record of costs and revenues. The CIP report includes a detailed account of ongoing costs, including labor, materials, and overhead. It also shows data on cumulative revenues based on the percentage-of-completion or other recognition methods. With the CIP report in hand, construction firms can evaluate the financial health of individual projects, detect potential financial risks or challenges early on, and ensure consistency in profit margins across projects.
Job Cost Sheets
Job Cost Sheets serve as the financial blueprint for each construction job. They provide granular insights into the expenses associated with specific tasks or phases. This report includes a comprehensive breakdown of individual job costs, from materials to subcontractor fees and a continuous comparison of actual costs against budgeted amounts. By regularly updating and reviewing job cost sheets, companies can monitor budget adherence in real-time, make timely adjustments to resource allocation, and predict final project costs with greater accuracy.
Other Relevant Statements
- Profit and Loss (P&L) Statement: This statement provides a consolidated view of a project’s revenues and expenses, giving stakeholders insights into the project’s profitability.
- Balance Sheet: The construction industry balance sheet reflects assets and liabilities unique to the sector, including retentions, advances, construction equipment, and project-specific financing. Properly maintained, it offers a holistic view of a company’s financial position.
In the dynamic and multifaceted realm of construction, these specialized financial statements play a pivotal role. They not only ensure precise financial tracking but also underpin the strategic decision-making essential for the sustained success of construction entities.