Most often, Construction companies walk a financial tightrope. They must juggle multiple projects, secure financing for materials and equipment, and determine profit margins in an industry known for its volatility, high failure rate, delayed payment cycles, and unpredictable cash flow.
To thrive, construction companies must meticulously track costs and revenues and establish robust accounting processes to allocate financial resources efficiently.
In this article, we will take a deep dive into different types of construction accounting and understand what kind of accounting you should select to balance your books.
What is Construction Accounting?
Construction accounting is a specialized type of management accounting designed for construction projects. It helps construction companies keep tabs on the financial and operational aspects of each project.
With construction accounting -
- Cost records are usually maintained for each job and updated regularly.
- Both direct and indirect construction costs are included in accounting reports.
- The percentage of completion or completed contract method is used to recognize revenues and costs.
How different is accounting from construction accounting?
Even though all types of accounting share the same basic principle (recording, interpreting, and reporting financial transactions), construction accounting has unique challenges and requirements. Unlike most industries, the construction sector deals with long-term, high-cost projects, where income and expenses are recognized over multiple fiscal periods.
Therefore, it is imperative to implement specialized accounting strategies for construction projects, rather than relying on generic techniques.
Common Dilemmas in Choosing the Right Accounting Method
One of the most common issues that construction businesses face is the choice of accounting method.
Do you adopt the cash-based method, allowing you to account for your expenses when you pay them and your revenues when you receive the cash?
Do you go for the accrual method, which requires you to count your expenses when you incur them and your revenues when you earn them?
Understanding Construction Accounting Methods
Before we dive into the specifics of different construction accounting methods, it is crucial to understand each system's advantages and drawbacks.
Cash accounting is undoubtedly the simplest form of accounting. Under this system, income and expenses are logged when money changes hands. Implementing Cash-based accounting can be beneficial for smaller construction firms as it is easy to understand and provides a clear picture of your available funds.
- You recognize revenue when payments are received and expenses when paid.
- It's straightforward and eases tax planning.
However, it may not accurately reflect the financial status of your larger projects that span multiple financial years.
Accrual accounting operates on an income and expense recognition basis. This means revenue is logged when earned and expenses when incurred, regardless of whether payment has been exchanged.
- This method of accounting gives a realistic picture of your profit margins at any given time.
- It’s standard practice for larger businesses.
However, this method might give you a cash flow illusion, as it might show that you have earned revenue even when the cash hasn't hit your bank account yet.
Percentage of Completion Method
The Percentage of Completion Method is a standard accounting method used in the construction industry. It tracks and records income and expenses in relation to the percentage of work completed, thus:
- Offers a real-time view of the project's profitability.
- Improves the predictability of revenues and expenses.
But, this method requires diligent record-keeping and can be complex to implement.
Completed Contract Method
Under the Completed Contract Method, income is recognized only when a contract is completely finished.
- It is simple, as revenues and expenses are easy to calculate after project completion.
- Suitable if your projects are short-term and stay within a financial year.
However, it doesn't depict a company's financial status mid-project and may defer tax liability.
Cash-based Accounting in Construction
Cash-based accounting is the simplest accounting method, where transactions are recorded only when cash changes hands. This means income is recognized when it's received and expenses when they're paid, resulting in a direct reflection of a company's cash flow.
Pros and Cons of Cash-based Accounting
For many small construction businesses, this straightforward approach has many distinct advantages. Advantages include ease of use, immediate awareness of cash balances, and a straightforward method to record transactions.
- Ease of use.
- Immediate awareness of cash balances.
- A straightforward method to record transactions.
- Easy to understand and implement
- Gives an accurate picture of how much actual cash your business has
However, it is not without its disadvantages:
- It may overstate the health of a company that’s fast-consuming cash but has lots of unpaid bills.
- It can provide a misleading picture where large sums of money are received or paid.
When is Cash-based Accounting Suitable for your Construction Business?
Cash-based accounting may be suitable for your construction business if you're a small to medium-sized company with relatively simple transactions, mainly operating on a cash basis without considerable accounts receivable and payable. It's also suitable where job completion timeframes are short, and costs are paid promptly.
Accrual Accounting in Construction
Accrual accounting is a method that records transactions at the time they occur, whether or not cash has been exchanged. This approach provides a more comprehensive financial picture, considering both receivables and payables.
Advantages and Disadvantages of Accrual Accounting
Accrual accounting provides several benefits:
- Offering a detailed financial snapshot that is key to making informed business decisions.
- Ensuring revenue and expenses are matched makes comparing different periods easy and meaningful.
However, it is not without its drawbacks:
- This method is more complex and thus requires more time and resources.
- Because it includes transactions yet to be completed, it can sometimes give a misleading picture of cash flow.
Understanding When to Choose Accrual Accounting for your Construction Enterprise
Accrual accounting is often the preferred method for larger companies with a significant volume of transactions. If your construction business involves complex contracts and long-term projects adopting Accrual method provides a holistic view of your finances, aiding in strategic planning and financial decision-making.
Percentage of Completion Method in Construction Accounting
The Percentage of Completion accounting method recognizes revenue and expenses proportional to the degree of work finished. That is, the revenue and costs are recorded based upon the percentage of the project completed.
Strengths and Weaknesses of Percentage of Completion Method
This accounting method provides an accurate reflection of financial performance during ongoing projects. It’s advantageous in situations where -
- It depicts the overall financial standing more accurately, as revenues and costs are matched to the same operating period.
- It allows revenue recognition in larger contracts spanning over a long period.
On the flip side, the Percentage of Completion method can be complex to implement because -
- Detailed tracking of costs and project progress is required.
- Inaccurate estimations can lead to misreported financials, impacting future projects.
Determining if the Percentage of Completion Method Fits your Construction Business
Consider the Percentage of Completion method if your business primarily deals with large, long-term projects. However, ensure that you can manage precise tracking of project costs and progress and accurate revenue recognition. Evaluate your resources and capabilities to avoid any pitfalls in implementation.
Choosing the Right Accounting Method
When selecting the right construction accounting method, two key factors to focus on are the nature of your projects and your financial capacity.
Analyzing Your Projects and Financial Capacity
First, the kind of projects you undertake will largely influence your choice of accounting method. Are your projects long-term, with fluctuating scopes and timelines? Or are they short-term projects with fixed, predictable costs and schedules?
- Long-term projects often suit the percentage-of-completion or accrual method because these methods allow cost and revenue recognition throughout the project.
- Short-term projects typically fit better with cash-based accounting, where income is recorded when received and expenses, when paid.
At the end of the day, understanding your business' financial capacity is also crucial. While you may prefer one method, you might lack the resources to implement it effectively— so choose what your company can realistically maintain.
Matching Accounting Methods with Your Long-term Goals
A key part of this decision involves aligning your chosen accounting method with your long-term business objectives.
Adopting an accrual or percentage-of-completion method may be beneficial if you're seeking scalability and large-scale growth, given their ability to provide insight into long-term financial trends.
Alternatively, if your goal is to maintain a small, highly efficient operation, a more straightforward, cash-based accounting approach might be better.
Implementing Your Chosen Accounting Method
Once you have decided on the right construction accounting method for your business, the next step is successful implementation. The following are the initial steps in implementing a cash-based, accrual, or percentage-of-completion method.
Initial Steps in Implementing Cash-based, Accrual, or Percentage of Completion Method
You should first educate your accounting team about the chosen method for a smooth transition. This involves detailing the basics, practical applications, and how it will affect financial statements. Next, invest in accounting software tailored to the chosen approach to streamline tracking and calculation processes. Lastly, strictly adhere to the new method and monitor it regularly to ensure its effective integration.
Addressing Challenges in Implementation
Despite careful planning, challenges may arise during implementation. It's important to anticipate potential obstacles like resistance to change, technical difficulties with the new software, or complex calculations for percentage-based accounting. Establishing a solid change management process, offering continuous training for your team, and seeking help from accounting professionals specializing in construction will help mitigate these issues and ensure a smooth transition to the right accounting for your construction business.
In this article, we have explored how cash-based accounting, accrual accounting, and the percentage of completion method each have merits and applicability.
We've also discovered that choosing your accounting method is pivotal to your business's financial health and should resonate with the nature of your projects, financial capabilities, and long-term objectives.
We suggest following these simple steps to make this decision:
- Evaluate your company's size and the scale of operations.
- Study the nature of your projects and their timelines.
- Understand your financial standing and goals.
- Consult an accounting professional if needed.
Proper accounting plays a crucial role in the growth and sustainability of your construction business. It can clarify project profitability, help management anticipate future financial challenges, and plan resources responsibly.
Remember, in the end, it's not just about choosing the right construction accounting method but about implementing it effectively and staying committed to financial transparency and accountability. Striking a balance here will lead your business toward sustained success.
While choosing the right construction accounting process is essential, it is also vital that you have a skilled bookkeeper to manage your books. That's where Lumber comes in.