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How Interoperability in Construction is Changing the GameConstruction Accounting and Why It’s Unique
A quick reference guide
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Construction accounting is a unique, complex practice that encompasses a number of processes that includes construction revenue recognition, job costing, construction billing, contract retainage, construction accounting software, and lots more.
In construction accounting, costs are assigned to specific contracts or projects. Separate “jobs” are typically set up in the contractor’s accounting system or ERP of record, with different phases of work broken out and specific cost items assigned their own codes, or “job costs.” Estimate figures are imported and synched with different job cost items, and as the jobs progress and work is done, job and job costs are typically updated on a percent complete basis.
This is designed to help contractors track each job and their related expenses. But without a deep understanding of how construction accounting works, it’s difficult to perform accurate job costing or be certain that expenses won’t exceed budget.
Construction accounting isn’t easy, even for the most experienced accountants and project accountants. This primer will give you the information you need to create efficient, precise accounting processes for construction work of all types, from small-scale commercial jobs to multimillion-dollar infrastructure projects.
Discover how to handle revenue recognition in construction with this free guide from Trimble Viewpoint.
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What Makes Construction Accounting Different?
Construction accounting is a specialized form of bookkeeping designed to handle the special challenges that come with construction projects. It shares many principles and practices with other forms of project accounting, but there are some key differences due to the uniqueness of the construction industry.
Construction projects are almost always one-off contracts that are tailored to the work they cover. Each contract contains unique terms for processes like the disbursement of payments to contractors and the management of cost overruns. As a result, account records in the construction industry must be customized for every project. You can’t simply create a generic accounting book template and use it for all of your projects indefinitely.
Fluctuating costs can make construction accounting difficult as well. The price of building materials and labor may change from month to month or even week to week, depending on market conditions. That means that the cost estimates made at the beginning of a project may become inaccurate as the project moves forward, especially for large projects that can last years.
The mobile nature of construction adds yet another layer. Unlike businesses in many other industries, builders don’t enjoy the luxury of being able to report costs from the comfort of an office. Instead, they are working in the field, often with intermittent web connectivity and power supplies. Ensuring that each expense is accurately recorded under these conditions can be difficult.
Despite these challenges, accurate construction accounting based on real-time financial information is crucial for making a profit. Average pre-tax profit margins for general contractors range from 2.4% to as low as 1.4%. With razor-thin margins like those, even small mistakes in job costing or tracking revenue can spell the difference between making and losing money.
To keep your books in the black, you need to understand the fundamentals of construction accounting and the tools available to ensure accuracy. Let’s dive into a few of the most important aspects of construction accounting so you can build processes that will stand the test of time.
Construction Revenue Recognition
Revenue recognition is an accounting principle that, as its name implies, involves recognizing and accounting for revenue. Accurate revenue tracking ensures that you know how much of a contract’s value you’ve actually realized to date, as well as how much profit that revenue represents relative to your costs.
For example, imagine that you have a contract to complete a construction project for $1 million, and you’ve agreed to complete the project within 12 months. In theory, the contract represents revenue worth one million dollars for the year. But in practice, the way you actually receive the revenue may prove to be more complicated. The project may end up taking 18 months to complete, which makes it worth less in terms of yearly revenue. The client may disburse payments in unequal installments, which means you receive more revenue in some months than in others. Without accounting for complexities like these, it’s difficult to know how the $1 million contract translates to actual cash and profit for your business.
There are three main approaches to revenue recognition in the construction industry, in addition to a new approach described by the Financial Accounting Standards Board (FASB) in ASC 606. While this guide provides an overview of each approach, you should consult your CPA to ensure you’re properly using the method that suits you best.
1. Cash Method
The most straightforward method is recording revenue only when you receive actual payments from the client. You also record expenses only when you actually make payments. This approach, called the cash method, is simple, but fails to provide an accurate picture of revenue as it is earned. In addition, cash accounting is allowed only for U.S. businesses whose average annual gross receipts fall below a set limit over the past three years.
The next two options for revenue recognition are both accrual methods, which means that revenue is recognized when invoices go out, rather than when payment is actually received. This has the advantage of tracking revenue as it is earned, resulting in a better real-time picture of where revenue stands.
2. Completed Contract Method
Under the completed contract method of construction accounting, contractors record revenue and expenses for each project when it’s completed. Even if they are billed and paid earlier, the costs and revenue don’t officially enter their books until the project is finalized. While this allows contractors to potentially defer taxable income until the following year in some circumstances, there are restrictions on when contractors can use this method, including completing contracts within a set period and falling below a set annual average revenue.
3. Percentage of Completion Method
The percentage of completion method, or PCM, allows contractors to record payments on a regular basis over the lifetime of a project. The payments are recorded in terms of the total percentage of the project that has been completed to date.
The PCM approach offers the benefit of allowing contractors to record revenue and costs closer to real time than they would if they wanted until project completion. However, the method only yields accurate results if you properly estimate the status of the project every time you record revenue. That can be hard to do given that projects may take more or less time to complete than anticipated.
For example, imagine a 10 month schedule to complete a project. At the end of the third month, you consider the project to be 30% complete, and you record payments received in that month accordingly under the PCM method. But if the project ends up taking 12 months, it was actually only 25% complete at the three-month mark, which means the revenue and profit projections you made three months in would probably not have been accurate.
What about ASC 606?
In recent years, many construction businesses in the United States have shifted to a revenue recognition method defined in ASC 606: Revenue from Contracts with Customers, official guidance from the FASB designed to standardize accounting practices across industries. While smaller construction companies may continue to use other methods, publicly traded companies are required to follow the ASC 606 rules.
The accounting principle at the heart of these rules is the idea of recognizing revenue as control over assets transfers from the contractor to the customer. Transfer of control either occurs at a specific point in time or gradually over time. Revenue should only be recognized using the point in time method when several conditions are met:
1. The customer receives no benefit from the work until the end of the contract
2. The contractor can utilize the asset if the contract is terminated
3. The contractor has no enforceable right to payment until the contract is finished
4. The asset is under the contractor’s own control
If all these conditions are not met, revenue should be recognized over time, similar to the percentage of completion method. If they are met, it should be recognized at a single point in time, as with the completed contract method.
Job Costing
Job costing, which means tracking the total costs of all resources required to complete a project, is a core component of construction accounting. You can’t accurately track revenue and profit if you don’t record your costs for labor, material, equipment, and other resources accurately.
Effective job costing begins by breaking costs into different categories and subcategories based on the project you’re working on. For example, your labor cost category may include subcategories for the different types of laborers you will have on a job, like masons, carpenters, and roofers. Similarly, material costs can be divided into categories like costs for concrete, framing lumber, roofing supplies, and flooring.
After determining which types of expenses you’ll need to track for the project, you can determine how many units you’ll need for each category of cost. If you expect to require 500 hours of labor from your masons and 1,000 from carpenters, for example, you can record that information accordingly. Then, you’ll determine what the cost of each unit is. Your masons might cost $40 per hour and your carpenters $35, for instance.
With all of this data on hand, you can estimate the total cost for the job, as well as break down costs by category and subcategory. You may also wish to link different categories of costs to different phases of the project.
Of course, estimating costs is only the first step in accurate job costing. It’s important to track your actual costs as the project proceeds. If you projected the cost of framing lumber at $1.00 per linear foot but the price increases to $1.50 six months into the job, you’ll need to adjust your costs accordingly. Adjustments like these are important not just for ensuring accurate accounting, but also so that you’ll know if you need to adjust your own prices in order to ensure that you’ve turned a profit by the time work is complete.
Construction Billing
The way you bill clients plays an important role in determining profitability. There are several common billing methods in construction, each with different pros and cons.
1. Fixed Billing
The simplest method is fixed billing, which means charging a lump sum for the total contract. While this approach is the easiest to manage, it leaves contractors little room for negotiation in the event that their costs end up being higher than they anticipated. Fixed billing is therefore best for small-scale projects that are not subject to major cost fluctuations.
2. Unit Price Billing
Under a unit price billing agreement, contractors charge customers based on the costs of the specific units that they expend to complete a job. These units may include the hours for different types of labor and the purchase of various types of materials. This method allows contractors to share cost risks with customers because the customer’s cost increases if the contractor ends up spending more units than originally expected. However, it also requires careful reporting and accounting of units.
3. Time and Material
Time and material billing allows contractors to charge clients based on the hours required to complete work, as well as the materials they install. It’s similar to unit price billing, with the main difference being that time and material billing is less nuanced. Rather than charging different prices for different types of labor and materials, time and material billing typically entails one flat rate for all labor and materials. Contractors determine the rate by estimating their actual average costs for labor and material, then marking them up to achieve their desired profit.
The time and material approach protects contractors from cost overruns to some degree by ensuring that customers will pay more if a job takes longer to complete or requires more materials than originally expected. However, if contractors underestimate their own cost of labor and materials, they may set prices too low, leading to a loss of profit.
Construction Accounting Software
Keeping track of all of the variables associated with construction accounting is nearly impossible if you attempt to manage reporting and bookkeeping manually. Disconnected systems in the field result in siloed cost reporting, with separate processes for recording the costs of materials from different suppliers, for example. In addition, costs may not be recorded in real time due to the difficulty of reporting data from construction sites and mapping it to cost information that may not be on hand in the field.
Construction accounting software simplifies these workflows and helps achieve more accurate accounting by centralizing job costing, revenue recording, and billing processes in a single platform. When you can see at a glance how much you’ve estimated a job to cost, how much you’re spending day to day, and how much revenue you’ve realized to date, you can easily adjust profit predictions and update your prices on a continuous basis. All of this adds up to early detection of cost overruns and underbilling, which in turn helps keep you profitable.
Construction Accounting Made Easy
Trimble Construction One makes construction accounting simple by providing an all-in-one platform for estimating project costs, recording revenue and expenses as they occur, and sharing cost data between stakeholders on a continuous basis. With Trimble Construction One, you no longer have to track each expense manually, reconcile cost data from multiple sources, or guess what your profitability will turn out to be. Trimble Construction One gives you accurate, real-time visibility into the state of every project.
See how Trimble Construction One can streamline construction accounting for yourself by requesting a custom demo today.
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