For most businesses, accounting involves a straightforward system of income and expenses. Products are purchased, bills are paid, and if you see a profit at the end of the month, you know you succeeded. Accounting for construction, however, is different. Projects can run over years, during which expenses can far outweigh the company's current income. A company can look like it’s failing for two years, then see the big payoff at the end of the project. Add to that the possibility of unexpected setbacks or changes to the contract (such as the addition of a new room), and your expected profit can change before you see the payoff.
While smart contractors know this and plan for it financially, it nonetheless becomes a problem when filing taxes. It also makes it hard to show your company’s viability when you apply for a loan. Thus, the generally accepted accounting principles (GAAP) include special provisions for industries that work long-term contracts, such as construction.
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Contractors have two kinds of expenses: overhead, called general and administrative expenses (G&A), and job costs, the costs involved in getting the actual job done. Job costs are broken into direct costs – labor, permits, materials and subcontractors; and indirect costs. Indirect costs are necessary for the project completion but not directly involved in the project itself. These include repair of equipment, renting facilities, quality control, depreciation and insurance. The IRS gives a complete list on its website.
Construction accounting methods
Some construction companies use one method for contracts and one for tracking G&A. However, the IRS has fixed rules for which method you can use and when. You have two kinds of accounting methods for G&A costs: cash accounting and accrual accounting. For contracts, you must use the percentage of completion method (PCM) if you are a large company, meaning you earned $10 million or more in gross receipts over the past three years. Smaller contractors may use one of four methods: accrual, PCM, estimated PCM or the completed contract method for any jobs that span multiple calendar years.
Cash accounting for construction is very much the same as that of most companies – you record income and expenses in the same year they happen. You may not use the cash method if . . .
- You make more than $1 million gross annually.
- You are a corporation or a partner of a C corporation whose average annual gross receipts exceed $5 million. There is no exception to this limit.
- Your total purchases of "merchandise" for the year are "substantial" compared to your gross income for the year. The IRS defines substantial as 10 to 15 percent of gross income. Merchandise means any materials used in construction that are part of the end product, such as lumber, tile, nails or cement.
You may use the cash accounting method on short-term contracts completed in a calendar year. You must count expenses in the year paid and income in the year constructively received. For example, if a client gives you a check on Dec. 29, 2017, but you don't cash it until Jan. 3, 2018, you still count it against your 2017 taxes.
With accrual accounting, you count income at the time you have earned it, even if you have not physically received the money. The IRS defines it this way: "You include an item in income in the tax year when all events have occurred that fix your right to receive the income and you can determine the amount with reasonable accuracy." Generally, this means you report income when it's earned, due from the customer or received from the customer, whichever is earliest.
Expenses are deducted the year you incur them or when the expense can be accurately determined, whichever is later. That means you may deduct expenses before you pay them, but if the material or machinery purchased benefits you for more than one year, then you need to spread the cost over the years you receive the benefit. For example, if you order flooring for a building in November and complete the project in January, then you need to spread the expense over both calendar years.
Percentage of completion method
This is primarily for large contractors, but small contractors can use it too. With this method, you estimate the percentage of the project completed and count the income you have earned for that percentage, even if you have not received it. For the year of completion, you report the remainder of the contract income.
Under PCM, the progress is determined not by milestones, but by costs incurred compared to estimated costs. For example, say you have a three-year contract for $150,000, and you expect expenses to run $100,000. In year one, you spend $40,000 on materials and labor. That means you completed 40 percent of the project and should claim 40 percent of the income, $60,000.
Exempt percentage of completion method
With the EPCM, you use the accrual method to determine both G&A and job costs. Like the PCM, it has the advantage of spreading out your reported income over the life of the contract. Losses can be recognized as a percentage of the contract. The IRS notes that banks and bonding companies prefer this method of accounting when evaluating a company for loans or bonding.
There are two ways to estimate completion. The cost comparison method works like the PCM: You determine completion percentage by the percentage of actual costs that year compared to the total estimated costs. The work comparison method looks at actual work completed and requires an architect or engineer to validate the percentage claimed.
Completed contract method
With the completed contract method, you report all income and deduct all expenses from a project in the year it's completed, as with the cash method. If you use this method, then you need to report your G&A expenses using the accrual method. This method is available not only to small contractors but also for home construction contracts.
Should you hire a professional?
Construction requires careful accounting. The U.S. tax codes for the construction industry are among the most complex of an already difficult system, and there are a lot of other factors to juggle, such as subcontractors, seasonal laborers and project-specific loans. Unless you are well-versed in tax law and good with the books, hiring an accountant – or at least a bookkeeper – saves you time and potentially money.
Bookkeepers keep up on your accounts, making sure everything is properly recorded. In addition to hiring a bookkeeper or a bookkeeping service, you can find excellent accounting and bookkeeping software that will also integrate with your inventory and billing systems.
Accountants go a step further. They can not only make sure your books balance and file your taxes, but advise you on the financial health of your company and make suggestions to increase your profit margin. They may also advise you on contracts to help you find the best price to attract customers while still making a good profit. You may not need a full-time accountant, but most accounting firms take multiple clients. You can find one locally, but virtual accounting services are growing in popularity as well, and the best offer qualified and high-quality service. Many firms have bookkeepers and accountants on staff, which makes collaboration easier.
When you look for a bookkeeper or accountant, be sure to find one with experience and qualifications in your industry. Even more than with retail or services, a construction accountant must understand the unique challenges and rules governing the industry.
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