When it comes to handling the finances of a construction company, the system has several delicate aspects that need to be taken care of. In the construction industry, companies have to make difficult choices – from bidding on one project to another, selectively picking and financing the materials, manpower, and equipment, and setting profit margins at all levels – every aspect has to be carefully considered and handled.
The worst thing about this industry is it is volatile and has a high failure rate. The payment processing time is relatively higher and there is an inconsistent cash flow.
Tracking each of the expenses, calculating the revenues, and making a note of the financial data is key to keeping the company in a positive cash flow state. Accounting in construction is different from that of other industries.
In construction, there is a need, not just to segregate the projects, but also further break them down. The funding and the costs are then allocated to each of these tasks. These costs mainly comprise the material and labor charges. Consulting and architectural fees are a part of the indirect costs under which payments are made. The projects that incur supervision, equipment rentals, support costs, and insurance are part of indirect costs.
In this article, Finsmart Accounting – globally trusted for best outsourced accounting solutions – will share everything about construction industry accounting. Let’s start by understanding how construction accounting is different!
Construction Industry Accounting is Different
The construction industry deals with varying needs from clients, contractors, and other stakeholders. The way this industry operates is largely different from an average manufacturing unit. Here are some of the top ways why construction accounting is different from the rest:
Project-based: In construction, the method of production varies widely based on the project being undertaken. Each production process involves a whole different set of materials, equipment of varying size and cos, and various resources at all levels.
Decentralized location: Unlike other manufacturing industries, every project in construction takes place in a new location. Each of these locations has different site conditions and unique challenges. To address these problems, there is a cost involved.
Inconsistent vendors: This is, indeed, one of the major challenges in the construction business. In the duration of completion of a project, there is a need to contact vendors and suppliers for different specialties and most often they are neither consistent with the delivery of the materials nor with payments.
Retainage in payments: Another critical challenge in the industry is that in most cases some portion of payments are often withheld until the completion of the project, even after he contractor’s work is over.
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Irregular cash flow: This can put several aspects of a project’s completion in jeopardy. Due to retainage, slow payments, and high upfront costs, it leads to irregular and delayed cash flow cycles. In the initial days, this can even be perceived as a loss.
Job Costing in the Construction Industry
Like any other business, a construction company also maintains a general ledger to keep track of the finances and accounts. While accounts payable and receivable, accrued payroll, and marketing are some of the top costs that would cover all aspects in other industries, it is not enough for construction companies and their projects.
Job costing is a tool that comes in handy here. Each segment of a project involves costs and revenues that are recorded by the budget. Job costing is a cycle of using the previous data to make better financial decisions. The cycle includes:
- Recording all job-specific costs and codes that provide details of each expense.
- After the completion of a project, the job ledger is stored for future use.
- These job ledgers are analyzed by the management before the beginning of the next project to create better estimations and bids, based on the market.
Read on to discover more insights about construction industry accounting and best practices!
Methods of Accounting in the Construction business
There are 4 top accounting methods among construction companies. The approaches determine how they track income, expenses, and profit. It is important to analyze different aspects of the client’s business and pick a method that suits them.
Cash Method
What is it?
- The most straightforward means of tracking finances.
- A company recognizes as revenue when payments are received and as expenses when bills are paid.
- Cash received minus cash spent is the profit.
Advantages
- Having cash handy allows you to pay bills for the next year early. This means you can use the abundant cash to pay in advance. This way you can artificially reduce the profit and save on taxes.
- In the case of cash, you can ask customers to send end-of-year payments at the beginning of the next year, reducing the tax liability.
Disadvantages
- This method works only for small size businesses
- The statements cannot be trusted for proactive planning
- It might be too late by the time the company identifies a cash flow problem
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Accrual Method
What is it?
- This method identified revenues and expenses as soon as bills are sent and received
- Construction companies with retainage do not identify profits until the project is complete because of this method
Advantages
- This method can recognize income and expense before they occur, helping the financial managers prepare well in advance
- Management can foresee problems in advance and can make necessary adjustments
Disadvantages
- Businesses pay income tax on unrealized profit since the system records revenues before they have been received
Percentage of Completion
What is it?
- It is a type of accrual accounting but recognizes revenues, expenses, and profits based on how much work is completed
- This method is useful for large construction businesses and companies with long-term contracts
- Divide the costs to data by the estimated cost at completion to get the result
- Construction businesses with revenues over $25 million over the last three years use this method
Advantages
- This method helps financial managers get a clear view of the current financial status of each project
- Larger businesses also include general overhead costs of each project, which can provide a clear understanding of how profitable each job is
Disadvantages
- Using this method, businesses can underpay or overpay taxes, depending on the accuracy of cost estimation
Completed Contract Method:
What is it?
- This method does not allow recognition of income and expenses until a contract is complete
- This is used by construction companies when they have a high volume of short-term contracts
- The expenses and revenues are revealed as each contract comes to an end
Advantages
- This method helps eliminate the uncertainty associated with a project’s costs and revenues
- When the contract is completed and all costs are known, it allows an accurate picture of the company’s financial conditions
Disadvantages
- When all incomes come in together, it becomes difficult to manage the cash flow
- This is majorly the case for long-term contracts, which are generally more compatible with the percentage of completion method
Tips for Smart Construction Accounting Processes
Whether your firm is relatively novice when it comes to construction industry accounting or you have been struggling with it for a while, here are some tips that will help you manage your clients better.
Segregate business and personal expenses: No matter the size of the business, your clients must have a separate bank account for the business. All they need to do is visit a bank or a credit union to set up a business account that suits their firm.
To set up a business account, your client will need a Social Security number, Personal identification, copy of the business license, and organization documents filed with the state.
Job Costing: As we have already talked about how construction is a project-centric industry, as a construction accountant, you need to help your clients track, categorize, and report transactions for each job. Not only will this help the company stay prepared for the tax season, but help provide an accurate accounting for each job.
Record day-to-day transactions: Whether you use the traditional method of journaling or spreadsheet or you have upgraded to the accounting software, make sure to add a detailed record of the everyday transactions – date of transaction, amount, equipment and labor costs, and administrative costs. There are several invoice templates available that you can assist your clients with billing their clients.
Select a revenue recognition model: Understand your client’s construction business well and help them choose from the four revenue models – cash, accrual, percentage of completion, and completed contract. Consider factors like the size of the business, the model that works for the vendors, and contractors associated with the firm.
Track business expenses: Make sure to create as many categories as possible – by service, by individual jobs, etc. Using an expense tracker is important, especially for a construction business that indulges in so much petty cash daily.
Most common expenses of the construction industry will include Business registration and licensing, Bank fees, Tools and equipment, Travel expenses (including fuel), Electronics, Trade school tuition, Vehicle maintenance, Phone and internet expenses, Lodging, Software subscriptions, Membership fees (unions and associations), Mileage (tax write off), Insurance, Lease payments, Safety equipment, and uniforms, Employee payroll, Advertising, and marketing
Use accounting software made for the construction industry: As a construction industry accountant, it is important to make a foolproof process in accounting. And choosing software built to cater to this industry can help. Send invoices online, track expenses, monitor the status of the payment, generate financial reports and so much more. It also helps enhance accuracy, which helps your clients avoid unnecessary delays and errors.
Thriving as Construction Industry Accountant: Summary
While the role of an accountant in the construction industry is complex and multidimensional, completing the tasks does not have to be that hard. However, the accountant does need a deep understanding of industry-specific accounting principles, the intricate details of a project, and the nuances involved with the regulatory framework.
As the construction industry continues to evolve, it is important for the small accounting firms, engaging with the jobs of this industry, to keep themselves up-to-date.
Lack of the bandwidth to handle the complicated nature of the industry? Outsource with Finsmart Accounting. Write to us at connect@finsmartaccounting.com.
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Director Growth Strategy & Alliance
Maanoj Shah is a finance and outsourcing expert with strong Business Strategy and Scaling-up experience. Over the last 20 years, he has incubated multiple businesses and helped build global enterprises in verticals as diversified as hospitality, technology, and healthcare.
