Construction Accounting 101: Choose the Right Method

Taxpayers are typically required by the appropriate taxation authority to consistently use the method of accounting that accurately captures the entity’s true income. Consistency is essential since the swapping of accounting methods can potentially create loopholes that a company can use to manipulate its revenue and reduce tax burdens. In general, cash accounting is allowed for sole proprietorships and small businesses, whereas large businesses will typically use accrual accounting when preparing its tax returns. When using the percentage of completion method, it’s important for contractors to revise their estimates anytime changes occur on the job.

• For replacements, the old cost of the asset is written off from the company’s books and the cost of the new replacement is recorded/recognized.
• These should not be capitalized if they do not contribute to bringing the asset into the location and condition necessary for it to be capable of operating in the manner intended by management.
• Next, let’s look at how retention is recorded from an accounting perspective.
• For buildings, I recommend using the address or a parcel number for unique identification.
• See PPE 1.4 for additional information on maintenance activities.

Accrual accounting records revenues and expenses when they occur. Under cash accounting, income and expenses are recorded when cash is received and paid. In contrast, accrual accounting does not directly consider when cash is received or paid.

What Is Underbilling? | Construction Industry Accounting

A reporting entity may conduct feasibility studies and other activities related to asset selection. The reporting entity may incur costs to obtain an option to acquire one or more items of PP&E during this stage. Some of these costs may be incurred in one or more of the stages of a project. Therefore, the assessment of probability of a project when the costs are incurred is key to the capitalization decision. Fixed assets are property that a company owns which have a useful life of greater than one year. Examples of fixed assets include land, buildings, machinery, & some office equipment.

Change is permitted only if this results in a more appropriate presentation. IAS 40 notes that this is highly unlikely for a change from a fair value model to a cost model. In May 2008, construction bookkeeping as part of its Annual improvements project, the IASB expanded the scope of IAS 40 to include property under construction or development for future use as an investment property.

IFRS Sustainability Disclosure Standards (in progress)

This difference requires a unique set of controls surrounding materials, labor and work in process. Careful supply chain management and labor oversight are necessary to keep projects moving along. Care should be taken to distinguish capitalizable improvements from non-capitalizable maintenance cost. Normal, regularly recurring repairs and maintenance to keep property in an efficient operating condition should not be capitalized. Repairs or replacements that have an effect on a capital asset’s functionality or materially extend a capital asset’s expected useful life should be capitalized.

The practice of retainage, aka retention, has a tremendous impact on the construction industry. Let’s look at an example of recording and paying retention payable. For instance, assume you pay $5,000 cash to a design firm for product drawings. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

Tax

When you sell the $100 product for cash, you would record a bookkeeping entry for a cash transaction and credit the sales revenue account for the sale. This transaction transfers the $100 from expenses to revenue, which finishes the inventory bookkeeping process for the item. If your business manufactures products instead of offering services, you’ll need to keep accounting records of your inventory transactions. Some companies buy finished goods at wholesale prices and resell them at retail. This means the contractor can recognize half of the total revenue for the project. If the contract is for $120,000, the contractor would record revenue of $60,000 for the period, which would be reflected in their income statement.

And, the accountant can create the best tax strategy for your business. DateAccountNotesDebitCreditXX/XX/XXXXStartup ExpensesPayments for startup costs50,000Cash50,000It is important to document your startup costs well. You need accurate records because taxes for startup costs are more complicated than accounting for them. When you incur startup costs, you must accurately record the corresponding ledger entries in your accounting books.

Accounting for Buildings & Improvements

Lastly, the nature of construction is that the product is built over time — the majority of projects last more than a year. Production cycles of less than a year are considered short-term. The long-term nature of the construction business causes accounting and tax challenges when it comes to fiscal period cut-offs. It also exacerbates the disparity between when revenue is earned and when it is billed, which in turn impacts cash flow. Common industry practices like change orders and retainage — not to mention disputes — lead to unique accounting and tax complications. Our firm instituted a weekly job review and estimated cost to complete process for one of our remodeling company clients.