Revenue recognition and accurate job costing adds to the complexities of construction accounting since typically every project is unique, and the cash flow depends on the nature of the business and the contract. Some jobs take a week, and others take years to complete. Some have upfront payments, and others have payments in installments throughout the project or after completion. Having a proficient team with the power to account and audit during a project is a must to run the business smoothly and help ensure profitability.
Revenue recognition in construction accounting depends on the nature and duration of the job, the expenses allocated, such as labour and materials from various places. Measuring these against revenues received by way of a controlled billing system providing different methods of revenue recognition is the type of detailed control and reporting often required by growing businesses.
The Cash vs Accrual Method
Many contractors like cash method offered in entry level products like QuickBooks for its simplicity, but it can also be the most inaccurate way of revenue recognition. Money is reported as income when received and as an expense when spent. Transactions are recorded only when the money goes in or out of an account therefore, control over the sub-ledger entries and as to which fiscal period or even fiscal year becomes difficult for companies managing long-term projects. There are no Accounts Payable and Accounts Receivable when the Cash Method is used and hence no clear picture of the receivable assets and vendor liabilities. A cost incurred in December 2019 and paid in January 2020 is recorded as an expense for the fiscal year 2020. Likewise, payment received in 2020 for a project completed in 2019 is recorded as revenue in the 2020 Fiscal year. Without careful management, cash accounting can lead to inaccurate reporting of the financial condition of the business.
The Accrual Method
The accrual method includes accounts receivables and payables, and so provides a more accurate perspective on the financial conditions of the company. The firm records revenue or expenses when a transaction occurs rather than when payment is received or made. An invoice billed in 2019 but yet to receive payment will be recorded as a receivable and is accounted for and taxed in the fiscal year of 2019. Likewise, a bill in 2019 is reported and recorded as a liability on the day it's received, even if the payment would be made in 2020. The accrual method can often not be the most reliable method for contractors as it still doesn't precisely account for the unfinished part of the project.
Percentage of Completion Method
The percentage of completion method recognizes revenues and expenses as a portion of the work completed to date. The earned and unearned portions of a job are tracked separately. For example, a project lasting between 2019 and 2020, all costs incurred, and invoices made for the portion of the job completed in 2019 are reported and accounted for the fiscal year 2019. If any payments received for the part of the job to be done in 2020, this is tracked separately and accounted only after finishing that part of the job. The Percentage of Completion Method is the most commonly used for construction businesses due to matching that replicates the project’s timeline.
Completed Contract Method
The completed contract method can be used by contractors only when not exceeding a specific annual revenue and the contract can be completed within a specified period. Here, every expense and income are tracked but are accounted only on completing the project. For example, take a project that is managed between 2019 and 2020, all transactions made in the course of the job are accounted only on completing the project in 2020. This method can be suitable to postpone tax liabilities, but when several contracts finish all at once, there will be an extraordinary increase in revenue. The resulting balance sheet fluctuations can make managing the business challenging.
To make the math simple, let's consider a $100 job that's 30% complete. An upfront payment of $30 is received, and an invoice for another $30 is yet to be paid by the client. $5 in cost has been paid, and a $20 bill from the subcontractor is received. The project was sold with a 50% gross profit.
Gross Profit $25.00
Transactions are accounted for only the received and paid payments.
Gross Profit $35.00
Transactions are accounted for the all the completed and yet to be completed payments.
The Percent of Completion Method
Gross Profit $15.00
The transaction is accounted only for the percentage of the project completed, and the accurate cost is calculated with a 50% profit margin.
Completed Contract Method
Gross Profit $0.00
No transaction is accounted for because the project is not over yet.
Revenue calculation for construction businesses is different than for other businesses. It is therefore imperative to have an accountant who understands construction projects and select an accounting software solution that provides multiple revenue recognition methods. Adagio Construction is one such accounting software, empowering mid-market construction accountants with all the features they need.
Many vertical market software solutions have automated and simplified their customers' unique requirements, including the construction industry. However, the accounting needs remain complex, and the requirements for construction accounting reporting can be challenging compared to other sectors. These businesses are not just going to calculate debits and credits but also need the proper tools and techniques to address their complex accounting needs.
So, whether you are on a quest for a better solution or you already have one you're happy with, make sure you have the means necessary to manage these four critical aspects of construction accounting.
1. Revenue Recognition
Unlike many businesses, the cost and revenue calculations are not easy in the construction industry. Small companies may choose a revenue recognition method referred to as the Cash basis, where the money is counted as income when received and expensed when spent. In the construction world, Cash basis accounting would leave you broke; it's the most ineffective method of accounting for construction because the money received is typically much later than when the money spent.
Sole proprietors, new businesses or businesses with no inventory use the cash basis method for its simplicity; however, most businesses use the Accrual Method. Accrual basis accounting applies the matching principle, matching revenue with expenses in the time in which the income earned and the expenses occurred. This method is more complicated than cash basis accounting but provides a significantly better view of the financial affairs of the business.
Percentage Completion Method recognizes revenue and expenses over a period, considering the percentage of the project completed to date. The deposits on the yet-to-complete part of the job are tracked separately as a liability until earned. This method is preferred to account for long-term projects.
The income isn't reported until the entire job is finished in the Completed Contract Method. Income and expenses are tracked, and invoices are made throughout the contract period. But, the profit is recognized when payments are made towards the project, or once the project is completed.
What should you look for?
Accounting software that solves construction accounting difficulties should have multiple revenue recognition methods for the business to choose from; Adagio Accounting has five revenue recognition methods available.
2. Job Costing
A project can often have many stages of work, many contractors, subcontractors, and several temporary employees. These temporary workforces will work on the project for a day or maybe a week, whenever needed and often don't get paid using your payroll system. It's vital to be able to account for multiple vendors on a job to ensure you have control over allocating the correct budget to the right phase, job and client.
Tracking accurate costs, types of expenses and production activities by project is the key to managing projects efficiently.
Job costing is like General Ledger for a project, tracking cost types, cost activities, and project completion. Cost activities may be associated with different levels or phases of a project, such as roofing, painting. Comparing estimated costs to actual expenses provides insights for future projects and services and helps businesses to ensure ongoing profitability.
What should you look for?
Detailed and project-specific accounting software that manages all associated costs efficiently and with accurate job costing and tracking capabilities.
3. Reporting and Job Tracking
Usually, construction companies deal with multiple projects in different locations at the same time. Tracking every project smoothly and efficiently can be a challenge considering that some projects may take years to finish.
Misplacing a record or failure to report an expense can impact the profitability of the project and also the business. Every single spending on a project should be reported and tracked daily to manage costs as they incur. Active job Tracking systems enable firms to compare actual costs to estimated expenses, providing valuable insights for future projects.
Getting all the expenses to the accounting department as quickly and accurately as possible is vital. Failing to do so results in backlogs, missed opportunities and can impact decision making.
What should you look for?
Solutions that allow a business mobile access to the accounting details and cloud-based reporting can be an added advantage for construction companies feeling the weight of managing their complex needs.
4. Cash Flow Management
When it comes to a construction business, maintaining a positive Cash Flow is vital. According to a U.S. bank study, 82% of businesses fail due to poor cash flow management or poor understanding of how cash flow contributes to a business. Budgeted spending, periodic invoicing, updated payables, updated receivables, and accessing accurate financial reports helps in controlling positive cash flow.
What should you look for?
A software with robust invoicing functions that integrate to accounts receivable and the general ledger.
Tracking cash flow and profit margin in a construction business is often different than in other industries. Comprehensive accounting software with robust revenue recognition and expense tracking methods, made for construction businesses, is essential for you to be a successful contractor.