Everything You Need to Know About Construction Accounting
If there is one thing that businesses cannot avoid considering, it is bookkeeping or, more officially put, Accounting. After all, it is how they determine how much they receive, how much they spend, and the profit they have made. The reality is that this idea is not just restricted to big companies. Although the scope of the bookkeeping will be different, it also applies to small businesses.
Now, while the importance of accounting is evident, getting it done is not always easy. This is even perhaps more prominent when it comes to the Construction industry and Construction Accounting. Still, understanding the idea of construction accounting is simply unavoidable if you are in the construction industry.
As such, in this article, we will break down the whole idea of construction accounting and tell you everything you need to know about it. We will even tell you what differentiates it from other accounting systems.
What Is Construction Accounting?
The idea of construction accounting is one that you can easily identify from its name. It is a form of accounting that relates to construction or the construction industry. Still, this is only a surface understanding of the idea. So, what exactly does the word construction accounting mean?
This is a form of accounting that requires the cost to be assigned or attributed to a particular contract. So, for every new construction project that a company intends to carry out, they need to set up a different job in their accounting system. This is largely because most of the costs are diverse and only attributed to the specific construction project in question.
Keep in mind that the costs involved are not restricted to only direct costs like materials and labor. It also extends to other indirect costs attributed to the particular project, such as equipment rentals, insurance, support cost, and the supervisory cost.
Difference Between Construction Accounting and Regular Accounting
Of course, there are similarities between construction accounting and regular accounting. However, the reality is that there are core differences between construction accounting and traditional or regular accounting. We bet you are wondering what differentiates them. Well, here you go!
Cost of Products or Goods Sold
When it comes to the cost of the products sold, it is easier to record this in regular accounting. However, this is far from simple when it comes to construction accounting. This is thanks to the reality that a single job incurs direct and indirect costs classified under multiple categories.
In turn, fully accounting for all these costs across various categories is where the challenge comes in. This is why the use of accounting software has been prominent within the field of construction accounting.
Typically, businesses record sales under one to five general categories when it comes to regular accounting. However, when it comes to construction accounting, the list is broader. This is because there is a wider range of categories when it comes to services. For instance, there is consulting, engineering, design, labor cost, service work, materials, and physical products, among others.
In turn, while it is easier to keep track of revenue in regular accounting, it becomes harder to do so in construction accounting. This is thanks to the multiple revenue streams associated with construction accounting. So, when it comes to construction accounting, revenue recognition is trickier compared to regular accounting.
Overhead Cost or Expenses
There is a clear distinction between overhead and the cost of goods sold when it comes to regular accounting. However, this is far from the case with construction accounting. Precisely, the cost you would generally categorize as an overhead cost under regular accounting falls under the cost of goods sold when you are concerned with construction accounting. This is because they are directly attributable to the specific project.
Also, it is far easier to determine the break-even point when it comes to regular accounting. This is thanks to the direct and easily identifiable relationship between expenses and income. However, due to the wide variety of relevant cost categories, it becomes extremely difficult to determine the break-even point when it comes to construction accounting.
A combination of these differences brings one thing to light when it comes to construction accounting. That is the fact that, unlike regular accounting, construction accounting is project-based. Precisely, you consider each financial analysis concerning one job rather than an entire business line.
When you consider this, you will realize that this is largely thanks to the difference in production requirements across different jobs, different local variables, and diverse site conditions.
The Framework for Construction Accounting
Various concepts stand as the underlying foundation of construction accounting. We explain these various concepts below to ensure that you are well abreast of construction accounting.
This is perhaps the most important concept when it comes to construction accounting. With general businesses and regular accounting, what is necessary is the general ledger. It allows them to have an understanding of the whole financial status of the business.
However, thanks to the project-based nature of construction accounting, there is a need to track the transactions associated with a particular job. This is where job costing becomes relevant. It involves tracking or attributing costs to a specific production activity or project.
Now, the use of job costing does not exclude the use of a general ledger. Instead, you are to use both. In this case, job costing concerns itself with the specific project, while the general ledger concerns itself with the construction company’s overall financial status.
Generally, job costing consists of:
- Cost activities such as framing and foundation
- Cost types such as materials or labor
- Individual projects
In turn, it tracks the data related to a product while producing estimates and actual production reports, among others. Even more, it provides a veritable information package through which contractors can determine the profitability of a particular project.
The second relevant concept associated with construction accounting is revenue recognition. This is generally referred to as income recognition and involves how contractors identify if a project has generated revenue for them.
This concept is relevant thanks to the long-term nature of construction projects. Typically, these projects take a while to get completed, and they usually receive payment upon full completion of the project. For instance, a project may span as long as a year, making it impossible for the contractor to record revenue.
Now when it comes to revenue recognition, there are various methods of revenue recognition. It is usually left to the contractor to choose the available options to ensure revenue recognition. However, there are some cases where the contractor may apply more than one method. For instance, where the contractor applies a method for tax reporting and another for the business bookkeeping.
To achieve this, there are four available methods recognized under the relevant accounting standards. They are as follows:
- Cash Method
This is generally regarded as the easiest method to recognize revenue for construction accounting. In this instance, recognition occurs based on the receipt of payment and payment of expenses. The foundation of this method is that a company should only record a financial transaction when it impacts their finances.
As you can guess, under this method, there is no account payable or account receivable. Every recording only occurs where there is a cash transaction. However, keep in mind that while this method comes with its fair share of advantages, not every construction company qualify to use it,
In the United States of America, companies qualified to use the cash method for revenue recognition must have annual revenue below a prescribed amount.
- Completed Contract Method
The second recognized method through which a company can recognize revenue is through the completed contract method. In this case, the prompt to recognize revenue or expenses is not when the money gets received or spent. Instead, it is when the contractors complete the project.
In this instance, profit does not get recorded officially until the end of the project. The whole expenses and revenue enter into the company’s income statement at the same time. Also, keep in mind that this sometimes allows businesses to differ their obligations in cases where they don’t finish the project within the tax year.
As expected, there are some limitations to the use of this revenue recognition model. Precisely, the company’s annual revenue must be below a specified amount. Also, the project must get completed within a set duration.
- Percentage of Completion Method
Generally, this method is regarded as a variant of the accrual method. It requires that a construction company recognizes expenses as soon as they incur them. On the other hand, it also requires them to recognize revenue as soon as they earn it. In both cases, it doesn’t matter if they have not made the actual payment or received the payment, respectively.
With the percentage of completion method, the contractors can recognize the revenue in line with the percentage of the project they have completed. For instance, the contractor can issue an invoice to the clients based on a set milestone. Now, when each such milestone gets achieved, they can record it as income even though the cash has not been received.
- The ASC 606 Standard
This is a standard for revenge recognition that came into full force in 2018. Generally, companies that are governed by the GAAP are required to use this standard for their revenue recognition. On the other private companies who are not obliged to use the GAAP can apply this standard to keep in line with the existing best practices.
According to this standard, revenue recognition depends on the concept of transferring control. So, revenue is recognized when the control of the construction gets transferred to the consumer. Typically, under this arrangement, the contractor is expected to set a time when the control gets transferred to the client. Also, under this standard, contractors are expected to consider whether the project is one-off, or instead, multiple projects.
The next concept that is relevant to construction accounting is that of retainage. Generally regarded as retention, this refers to the amount, usually predetermined by the parties, that the client refrains from paying to the contractor until completing the project and its certification as satisfactory.
In most cases, it is between 5 and 10% of the total contract sum. However, there is no specified limit as it will depend solely on the agreement between the parties to the contract.
However, it is important to note that the amount set as retainage is not recorded as amount receivable when it comes to the accrual method of revenue collection. This is because the contractor is not regarded as having an unconditional right to the amount. As such, contractors are required to set a separate account for such a sum.
Keep in mind that this recording becomes irrelevant in cash recognition cases as there is no need for prior recognition until the contractor receives the amount.
Specialized Construction Billing
Another relevant concept to construction accounting is specialized billing. This is, in fact, one of the factors that distinguish construction accounting from regular accounting. For instance, while there is a fixed price for most goods and services, this is not the same with the construction industry.
With the construction industry, due to its project-based and decentralized nature, various billing methods have emerged. Some of the relevant billing methods include:
- Fixed Price
This is also quite common in the construction industry. It adopts a lump sum approach by estimating the total cost needed to complete the project from start to finish. This type of billing system can take two forms.
The first one is the hard bid form, where contractors stipulate the amount they intend to collect without an opportunity for negotiation. Under this arrangement, the contractor bears the risk to ensure that the amount is sufficient to complete the project.
On the other hand, with the negotiated form, the contractor can request additional capital input if there are unforeseen circumstances.
- Time and Material
This billing option involves combining the time spent on the project and the cost of the materials. Here, the contractor charge for each hour spent on the project in addition to the cost of the relevant materials.
- Unit Price
This is less common and relevant when contractors cannot effectively ascertain the project’s unit production. In this instance, the contractor bills the client per unit and applies a fixed rate. Keep in mind that when a contractor adopts this option, the increase in production cost is shared between both parties.
With construction accounting, another relevant concept is the construction payroll. This is extremely important thanks to the decentralized production system associated with construction projects. In turn, construction payroll arises to cater to the complex payrolls associated with this accounting system.
This is even more important when considered in light of the various jurisdictions’ requirements concerning payment for workers’ services. For instance, there are various requirements concerning workers’ compensation, union reports, minority compliance, and new hire reporting.
There is no doubt that construction accounting comes with its fair share of complexities. This is thanks to its project-based and decentralized nature. This is perhaps why a clear understanding of the idea of construction accounting is sometimes scarce.
Well, that does not have to be the case with you anymore. In this article, we have discussed the concept of construction accounting. We have also identified what differentiates it from regular accounting. We have then discussed the various relevant concept associated with construction accounting.
Now, while this is clear, there is one thing you must keep in mind. When it comes to construction accounting, the use of accounting software is almost avoidable. This is thanks to the complexities that we have identified above. So, go on and look towards automating your construction accounting.
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