How to Choose the Right Construction Accounting Method (2024)

Construction accounting is a specialized practice, subject to unique financial reportingmethods and tax rules. The nature of the construction business — with long contractterms,unique deliverables and “asynchronous” billing that can be disconnected from thepace of jobprogress, fiscal reporting periods or both — creates complicated issues for accountingandtax treatment. Accounting standards bodies and the IRS have responded with many optionalmethods for construction industry accounting.

Further, recent changes in regulatory standards from accounting bodies and the federalgovernment may influence construction companies’ choice of accounting method; they arestillin the process of being adopted by a good number of companies in 2021.

Here’s how to choose the right accounting method for a construction business or forindividual projects within a construction business.

How Is Construction Accounting Different?

Construction accounting has its own set of unique rules for both generally acceptedaccounting principles (GAAP) and taxes. The rules adapt the central principles of GAAP andtaxation to the unique characteristics of the construction business, including aproject-based workstyle; decentralized production, with operations at job sites instead ofinside a factory; and long-term production cycles.

In the construction world, revenue comes from building contracts with custom terms,specifications and deliverables, which complicates revenue and expense recognition. To helporganize each project, contractors use job costing, a process where revenue and expenses foreach project are segregated into distinct profit centers. This process is quite differentfrom that of a typical manufacturer, which might think about product profitability based onsales and production expenses. Job costing applies to both direct costs, like materials andlabor, as well as indirect costs, such as equipment and utilities.

Further, construction doesn’t happen in a warehouse or on an assembly line — itoccurs onvarious job sites. This difference requires a unique set of controls surrounding materials,labor and work in process. Careful supply chain management and laboroversight are necessary to keep projects moving along.

Moreover, the costs involved to deliver on the project need careful management.

Lastly, the nature of construction is that the product is built over time — themajority ofprojects last more than a year. Production cycles of less than a year are consideredshort-term. The long-term nature of the construction business causes accounting and taxchallenges when it comes to fiscal period cut-offs. It also exacerbates the disparitybetween when revenue is earned and when it is billed, which in turn impacts cash flow.Common industry practices like change orders and retainage — not to mention disputes — leadto uniqueaccounting and tax complications.

Construction Accounting Methods

To address those accounting challenges, construction companies may choose from severalaccounting methods. Choosing among them depends on several criteria. Keep in mind thatconstruction companies may be able to use different accounting methods for the same projectfor general accounting and for tax purposes.

Cash Basis Method

How does cash basis work? Cash basis accountingis a method that recognizes revenue when cash is collected and expenses when cash is spent.Income or loss is the difference between cash in and cash out.

Example: A customer pays a deposit upon signing a contract for an officebuilding to be built over the next two years. Under the cash basis method, the contractorrecognizes the amount of the deposit as revenue when it is received, regardless of whetherthe project has begun.

Limitations of cash basis: Cash basis accounting can cause large swings inresults simply due to the timing of cash receipts and expense payments. This disconnectsfinancial results from the actual activity of the project and can make comparative analysisless meaningful.

Advantages of cash basis: The biggest advantage of the cash basis method isits simplicity. Additionally, this method avoids potential cash flow timing issues, since abusiness pays taxes only on cash that has been received. In fact, cash basis accountingaffords some businesses significant flexibility to manage their income levels by timingdisbursem*nts around period deadlines. By delaying receipts, income can be deferred toanother period.

On the other hand, by accelerating payments, profitability may be reduced in a period, whichimpacts tax liability.

Accrual Basis Method

How does accrual basis work? The accrual basisfollows the matching principle of accounting, recognizing revenue in the period earned, notwhen received, and expenses in the period incurred, not when paid. This method uses revenueaccruals, such as accounts receivable, and expense accruals, such as accounts payable, tocapture transactions regardless of when money changes hands.

Example: A contractor whose fiscal year coincides with the calendar yearbills a customer for a completed job on Dec. 15, with 30-day payment terms. The contractorrecognizes revenue by creating a receivable account when sending the invoice, even thoughthe bill remains unpaid at the end of the fiscal year, on Dec. 31.

Limitations of accrual basis: Accrual basis is more difficult to maintainthan cash basis and is even more challenging in the construction industry because contractsoften span more than one fiscal period. Job costing under the accrual method requiresadjusting journal entries and a high level of vigilance. By its nature, accrual basis isdisconnected from cash flow, requiring companies to separately monitor cash so they can meettheir obligations. For example, a company may owe taxes on revenue that was earned andaccrued, but where the cash has not yet been collected.

Advantages of accrual basis: The primary advantage of the accrual basis isthat it provides a full, more accurate picture of financial results. It is the only methodthat complies with GAAP and therefore may be required by lenders and investors. Within theaccrual basis, small construction companies can establish a policy for handling retainage—money earned by the contractor for services rendered but withheld by the customer pendingfinal project approval — that defers tax liability on the retainage portion ofrevenue.

Cash vs. Accrual

Choosing between cash basis and accrual basisaccounting should be a non-issue for many construction companies given that any firmthat needs to produce GAAP financial statements must use accrual.

Additionally, contractors that meet the definition of a “large company” (over $26million)must also use accrual basis methods for tax purposes. For all others, issues to considerwhen choosing between cash versus accrual include:

Project terms: Short-term projects, completed within a single fiscal year,might be appropriate for the cash basis. However, if contracts are long-term, the accrualmethod will provide better financial data to analyze the health of the business.

Capital machinery: Construction companies that purchase expensive machinerycan capitalize and depreciate those costs in the accrual method. This approach spreadsequipment costs out over time, based on the life of the equipment; if using cash basis, thecompany would recognize the entire expense in the period the equipment was paid for.

Customer payments: If customers pay in cash soon after the work iscompleted, then the cash method may be easier to use. However, when billing schedules aremore complex and asynchronous, such as the American Institute of Architects (AIA) billingprocess that provides for retainage, scheduled payments and stored materials concerns, thenthe accrual method is a better fit.

Accounting support: Consider your available accounting expertise and tools.Without the support of a qualified construction accountant and capable accounting software, the accrualmethod may necessitate an inordinate amount of effort from owners or business managers.

Long-Term Contracts Method

Long-term contracts are those that span more than one fiscal year and require specialtreatment for both GAAP accounting and IRS tax purposes. Two common methods for accountingfor long-term contracts are the percentage of completion method and the completed contractmethod, which are both accrual-based.

Percentage-of-completion method (PCM): PCM is the most common wayconstruction companies recognize revenue and expenses because it apportions both over time,using a ratio aligned with the project’s progress. Most lenders and guarantors requireit.

PCM estimates the total amount of inputs or outputs for a construction project and applies aratio of actual activity in a period to the project’s total estimated activity.Constructionaccountants must make journal entries to reconcile the differences between revenue andexpense amounts calculated using PCM and revenue amounts billed and expenses accrued. Thismay result in balance sheet assets or liabilities, depending on whether the project isoverbilled or underbilled compared with the percent of activity completed when a fiscalperiod ends.

Completed-contract (CCM): Under CCM, all financial activities are deferreduntil a project is completed. In other words, no revenue or expenses are recognized untilthe accounting period in which the contract is fully or substantially completed. At thattime, all accumulated accrued revenue and expenses are recognized on the contractor’sincomestatement. CCM is most appropriate for short-term projects but is not GAAP- or tax-compliantfor most long-term contracts.

New GAAP Rule: Accounting Standard Codification 606 “Revenue FromContractsWith Customers” (ASC 606)

The Financial Accounting Standards Board (FASB) issued a new rule, ASC 606, that affectsgeneral construction accounting. ASC 606 is already in effect formost companies, although some were given an extension due to the COVID-19 pandemic. ASC 606does not change tax accounting.

Fundamentally, ASC 606 changes the parameters around revenue recognition, shifting fromPCM’sstage of completion to fulfilling performance obligations and transfer of control from thecontractor to the customer. Then, based on whether the transfer of control happens at apoint in time or over a period of time, revenue is recognized in total or proportionally, aswith PCM. ASC 606 provides detailed definitions and guidance around each step in itsfive-step model of revenue recognition:

Performance obligations are distinct deliverables within a contractthat provide benefit to the customer. Construction contracts can have one or manyperformance obligations. For example, a contract that promises construction of two officebuildings is likely to have two performance obligations. The components of buildingactivities, like plumbing, electrical work and painting, would not be considered performanceobligations.

The overall transaction price in the contract is determined and then allocated among theperformance obligations. Contract price might simply be a fixed price, or it may includeagreed-on variable compensation, such as incentives, discounts or change orders. Allocationof the total transaction price to the various performance obligations is based on estimatesof standalone pricing for each obligation.

Finally, revenue can be recognized at the time when control of each performance obligationtransfers from the contractor to the customer. It’s important to address the controlcriteria in the contract. If control of all the performance obligations transfers at asingle point in time, then all revenue and expenses are recognized at that point — asinCCM. However, if control transfers over time, then revenue for each performance obligationis recognized as it is completed. Contracts may dictate that control phases in for eachperformance obligation, rather than when the obligation is completed. In that scenario,financial results for the obligation would be recognized using a PCM approach.

How to Choose the Right Construction Accounting Method

Beyond GAAP considerations, contractors need to consider tax rules when deciding whichaccounting method is right for them, using the guidelines of Internal Revenue Code section460 (IRC 460). IRC 460 provides industry-specific tax rules and includes several exceptions.

Tax treatment can be determined on a contract by contract basis, so a company can use severalmethods simultaneously. Selecting the right method includes analyzing each contract thoughthe following three filters:

Classify construction contracts by length

Short-term: The IRS defines short-term contracts as those entered into andcompleted within the same tax year. Short-term contracts can use cash or accrual methods.

Long-term: Long-term contracts span more than one tax year. IRC 460 requireslong-term contracts to be accounted for using PCM. Two notable exceptions include smallcontractors that have contracts shorter than two years and home contracts, as we’lldiscuss.

Classify long-term contracts as home or general construction contracts

Home contracts: Home contracts involve fewer than five dwellings. Homecontracts enjoy several exceptions. First, construction companies of any size are notrequired to use PCM for home contracts. Second, home contracts do not require a “lookback,”which is an IRS provision that requires a true-up of tax liability from prior periods usingactual data rather than PCM estimates. Look backs are triggered when the actual contractincome is greater than 10% of the amount reported in each prior year. This exception can bea significant benefit, since contractors are required to pay interest on any prior periodtaxes that were underpaid.

General contracts: For general contracts, PCM is required for long-termcontracts except for small construction companies. Additionally, PCM is used to calculatealternative minimum tax regardless of the method used for regular tax reporting.

Classify yourself as a small or large contractor.

This classification is important because there are several advantages to being classified asa small contractor. A small contractor is defined as having three-year-average revenue of$26 million or less. Historically, this threshold was much lower; it was raised to $25million for 2018 and indexed to inflation as part of the 2017 Tax Cuts and Job Act (TCJA).

According to the IRS, small companies can use the cash method of accounting for tax purposes,but large companies cannot. Plus, small companies can use CCM, avoiding PCM, for contractsup to two years, whereas large companies must use PCM for long-term contracts. And smallcompanies can avoid the IRS look back for contracts up to two years.

Make Construction Accounting Easier With Accounting Software

With all its specialized rules, construction accounting can be very labor intensive. Eachproject is normally treated as a separate profit center to assist with job costing. Eachcontract can be accounted for using different accounting methods. And the same project canuse different methods for general accounting versus tax accounting. Further, the specializedbilling used in the construction industry, such as AIA progress invoicing,increases the workload.

NetSuite’sconstructionaccounting software can help make this process easier. It organizes job costing,tracks profitability and helps with tax compliance. It can support multiple revenuerecognition methods and billing schemes. Choosing the right software will reduceadministrative burden, provide meaningful analysis and improve overall efficiency. Further,cloud-based systems enable access at decentralized job sites.

Construction accounting is a specialized form of accounting that reflects the uniquecharacteristics of the construction business. Job costing is the underpinning of thisspecialty, reflecting the unique components of each construction contract. New GAAP guidance— ASC 606 — has introduced the concept of performance obligations and transferof controlinto the variety of existing methods for revenue recognition. And the Tax Cuts and Jobs Actof 2017 made significant changes in classification criteria for small and large contractors.Together, there have been significant changes in the methods of accounting available forcontractors, mostly increasing the options available.

Construction Accounting FAQs

Q: What are the different types of accounting methods?

A: Accounting methods used in construction accounting include cash basis,accrual basis, the completed contract method (CCM) and the percentage of completion method(PCM). ASC 606 from the Financial Accounting Standards Board (FASB) provides updatedguidance for revenue recognition for GAAP purposes.

Q: How do you become a construction accountant?

A: A construction accountant typically earns a bachelor’s degree inaccounting followed by on-the-job training to develop construction industry experience. Someconstruction accountants hone their specialty by taking industry-specific training coursesgiven by construction associations or accounting societies.

Q: What is construction contract accounting?

A: Construction contracts are agreements that spell out the details of aconstruction project and the obligations of all the parties. Construction contractaccounting is a specialized type of bookkeeping and reporting for the building projectsoutlined in the construction contracts.

Q: What are the three methods of accounting?

A: Three methods of accounting include the cash basis, the accrual basis andthe hybrid method. The cash method recognizes transactions based on timing of cashinflowand outflows. The accrual basis reflects revenue when it is earned and expenses when theyare incurred. Hybrid methods are specialized approaches that use aspects of both cash andaccrual and are unique to a specific situation. The guidelines under ASC 606 and thepercentage of completion method (PCM) in construction are hybrid accounting methods.

Q: What are the two methods of revenue recognition for construction contracts?

A: Completed contract (CCM) and percentage of completion (PCM) are tworevenue recognition methods used in construction accounting.

Q: How do you account for a construction project?

A: Construction projects are accounted for using job costing, an approachthat captures the details of each project in a separate profit center. There are severalmethods of accounting for construction projects, which can be selected based on the specificcriteria of each contractor and project.