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Construction accounting is a critical part of any building project, and the key to ensuring it stays on-time and under-budget. What many don’t realize, however, is that there’s a lot more to construction accounting than meets the eye. This is a special category of accounting that factors in the many quirks of construction: from long-term contracts and deposits to project-based accounting and progress billing.
Construction accounting can be confusing even if you’re familiar with general accounting practices. The larger the project becomes, the more complex its financial considerations become. It’s easy to get lost in all the cost considerations—even when things go according to plan!
If you’re interested in delving deeper into the nuances of construction accounting, here’s a guide to get you started—from a small business banking app that understands what it takes.
What is construction accounting?
Construction accounting allows contractors to manage their financial records, cash flow, project progress, and compliance by tracking payments, expenses, and payroll. The goal is to know exactly where your funds are at any given time, so you have a clear snapshot of your business’s finances.
Like traditional accounting, construction accounting follows Generally Accepted Account Principles (GAAP). Transactions are recorded with the double-entry method. Although you might be able to manually track these transactions at first, as your company grows, you’ll almost certainly need to use accounting software, like QuickBooks. This helps reduce human error and can automate or streamline your accounting duties.
How construction accounting differs from traditional accounting
Construction accounting might bear a lot of similarities to traditional accounting, but there are many differences. In addition to accounts payable, accounts receivable, and payroll, construction contractors also need to deal with customer deposits, job costing, progress billings, change orders, and more.
Construction accounting is primarily project-based and decentralized. Because construction doesn’t offer the same kind of stability and predictability as other kinds of businesses, each project is treated as a short-term profit generator. Most construction projects have very different requirements, from subcontractor availability to building codes to material costs. The only way that construction contractors can make educated bids is to track and control their costs on a case-by-case basis.
Long-term contracts are a key feature of construction accounting. Most construction contracts are longer than your typical business contract. Deposits and payments are made over time, and companies may allow up to 90 days to pay invoices—and if there are disputes about payment, revenue can be delayed. Therefore, construction contractors have significant barriers to accurate tracking and reporting, not to mention a steady cash flow. Construction accounting aims to reduce those barriers and better predict cash flow.
Key construction accounting concepts
In traditional accounting, your general ledger gives you a snapshot of all your transactions and overall financial health. In construction accounting, however, those project-based and decentralized expenses need to be reported for each specific job. This is called job costing—think of it as financial information for each specific job’s costs and income.
Job costing and the general ledger work together: the general ledger provides an overall perspective, while job costing evaluates specific projects. Similarly, general ledgers have accounts for expenses or accounts payable, and job costing includes specific projects, cost activities (such as installing ductwork), and cost types (labor, materials, administration, and more).
Organizing this data allows contractors and project managers to oversee the costs associated with specific projects as they are incurred. This level of scrutiny is important because construction operates on extremely tight margins—you don’t want to underestimate and underbid or it will cut into your already-narrow profit margins.
Generally, job costing measures hours of labor, costs, and how much of the project has been physically completed. Expenses are categorized by codes, from materials to labor. Some contractors subcategorize by project phases or smaller portions of the job. Ultimately, as each job is tracked, recorded, and completed, contractors have an extremely detailed description of their expenses for each project. This allows them to make more accurate bids while remaining competitive.
Revenue recognition is also known as income recognition. This is how you can tell when you’ve officially started making a profit on a project, and when expenses should be recorded. Because construction involves long-term contracts, typically with delayed payments, revenue recognition helps contractors decide when their income and expenses should be officially recorded.
There are three main ways to do this: the cash method, completed contract method, and percentage of completion method.
- Cash method: The cash method is the easiest way to recognize revenue. Contractors record their revenue when they receive payment, and report expenses at the time of payment. There is no accounts receivable or accounts payable tracking. The transaction is not recorded until payment is made or received.
- Completed contract: In this method, the contract income and expenses are not reported until the whole project is finished. Contractors can still bill for labor and materials, and purchase what they need, but you’re not considered to have made a profit until the contract is completed. In other words, your income statement won’t reflect any expenses or income until the project is finished.
- Percentage of completion: The percentage of completion method recognizes revenue as it’s earned over the course of the project. The contractor bills for the work they’ve completed. For example, a contractor could bill for 25% of the completed project as soon as that portion of the work has been finished.
Construction accounting also includes withholding retainage—the money an owner can hold back from paying until they’re satisfied that the job has been completed properly. This amount is pre-determined in the construction contract ahead of time, and is usually around 5 to 10% of the contract value.
Because the contractor doesn’t have the right to the retainage, it’s not treated as accounts receivable for that project. It should be recorded in a separate “asset” account, then moved to accounts receivable when the project is completed.
Finally, because retainage laws vary, the amount of time the retainage is held can make a big difference in profits. It’s crucial for contractors to learn contract retainage management principles, lest it negatively affect cash flow over time.
There are a number of ways contractors can bill. Here are some of the most popular options:
- Fixed price or lump sum: This type of billing estimates the total cost for an entire contract. Contractors choose between fixed price hard bids (an agreement that they will complete a project for that amount of money and no more), or fixed price negotiated, which allows for contingencies.
- Time and material: This type of billing bills for labor by the hour, plus the cost of materials. Contractors can build markups into both labor and material to ensure they make a profit.
- Unit price: This type of billing offers a fixed price per unit. This is helpful when contractors are unable to accurately and certainly estimate how much a project will cost. This distributes the risk between clients and contractors if production is higher than estimated—as long as they’ve estimated the unit price properly.
If you have employees or subcontractors, you’ll also need to account for payroll. This can be quite complicated, thanks to decentralized, project-based accounting. You may need to account for multiple pay rates in multiple locations and compliance reporting, including certified payroll reporting. The more employees or subcontractors you have, and the more locations in which they work, the more complicated your construction payroll process will be.
Ultimately, construction accounting can be complicated—but good accounting software, specialized business banking services, and accounting classes can help you understand the finer points of this specialized accounting method.
Power your construction accounting with NorthOne business banking
NorthOne has designed business banking services for small business owners across America. Our services help small business owners manage their finances, save for expenses, monitor cash flow, and more. With 90,000 ATMs available across the United States, integrations with your favorite apps, and free financial management tools in the website and app, you can power your construction accounting with our robust services.