Construction Accounting: How to Navigate the Industry’s Unique Challenges

The construction industry presents unique accounting challenges that other industries don’t encounter. Accounting for complex, long-term contracts requires specialized knowledge. Construction businesses must follow specific rules and generate unique reports. 

This article will explain the unique challenges of construction accounting and help you follow the industry’s reporting requirements. You’ll also learn recommended construction accounting best practices.

Challenges of Construction Accounting

Project-Based Contracts

Construction businesses work on a project-by-project basis. 

Unlike retailers selling a standardized product, construction companies set unique terms for every contract. Each construction project requires varying specifications for the following: 

• Job site location
• Architectural structure and components
• Work schedule, timeline, and completion date
• Materials and equipment inputs
• Wage and benefit requirements
• Vendor agreements
• Permits and safety specifications
• Additional terms, as applicable

Construction firms must create unique contracts for each customer and track each project separately.

Decentralized Project Locations

Every construction project takes place at a unique job site, often located far apart from one another. Construction companies transport machines, tools, and workers to various locations. Construction crews must travel to each job site. 

Accurate construction management requires tracking employees and equipment in varying locations, potentially across multiple cities and states. 

Complex, Long-Term Contracts

Construction contract timelines vary by project. 

Small projects, such as home renovations or restaurant remodels, could require 1-2 years or less. However, many construction projects take multiple years to complete. For example, residential apartment complexes and retail shopping centers could need numerous phases over several years.

Accounting for complex, long-term projects requires tracking each contract’s income and expenses over multiple years. 

We recommend consulting with industry professionals for help with complex accounting.

Irregular Costs and Unpredictable Profits

Construction companies incur varying costs throughout each project. Complex contracts require numerous inputs, making it difficult for accountants to accurately estimate each project’s total cost.

Consider the following examples of fluctuating costs involved in a construction project: 

• Labor costs
• Raw materials such as lumber or steel
• Fuel and transportation
• Repairs and maintenance of tools and equipment
• Administrative, back-office, and indirect costs
• Weather-related delays or damage
• Economic inflation or deflation

Numerous additional factors contribute to unpredictable profits. Accountants can reference historical data but must monitor direct costs throughout each project. 

Change Orders

Change orders refer to any change in a construction project's requirements. For example, a customer could extend the timeline, add components, or adjust the design. 

Due to the long-term nature of construction projects, change orders occur often. Construction accountants must update project estimates and recalculate project profitability after every change order.

Contract Retainage

Most construction contracts include a retainage provision. 

Retainage refers to a percentage of the total project cost the customer withholds from payment. Retainage often represents 5-10% of the contract total. After the project’s completion, the customer pays the retainage if satisfied with the construction. 

Contract retainage adds complexity to construction accounting. Companies must separately track and account for the retained fees.

Essential Construction Accounting Elements

In addition to the construction industry’s unique challenges, accountants must understand construction-specific accounting requirements. The following examples highlight several construction accounting considerations.

Job Costing

Construction firms must track each project's income and expenses separately. Job costing refers to accounting for each contract with separate records.

At the beginning of each project, the company should set up a job costing schedule with the expected project revenue and estimated costs. Construction companies must update the schedule throughout the project to reflect change orders or cost updates. 

Accurate job costing facilitates project management and helps accountants monitor profitability.

Accounting Method

Every company must choose an accounting method for bookkeeping and financial management. The two most common accounting methods are cash-basis accounting and accrual-basis accounting. 

Cash Basis Accounting

The cash method requires companies to record transactions upon receiving or spending cash. 

For example, a cash-basis construction company records income upon receiving payment from a customer. Likewise, the company records expenses when paying for tools or raw materials.

Accrual Basis Accounting

The accrual method requires companies to record transactions when they occur, regardless of cash flow. 

For example, a construction company records income and expenses throughout the project's life, even if the customer hasn’t paid a progress bill.

Accrual-basis construction businesses often follow specific rules for recognizing contract revenue. Keep reading to learn more about income recognition for contracts.

Contract Revenue Recognition

The Financial Accounting Standards Board (FASB) establishes reporting guidelines for businesses. Many companies must follow the FASB’s generally accepted accounting principles (GAAP) for financial statement reporting. 

The FASB publishes updates to the Accounting Standards Codification (ASC), an organized set of GAAP guidelines.

The FASB issued ASC 606 to establish rules for recognizing contract revenue. Accrual-basis construction companies can follow ASC 606 for accurate financial reporting. 

The American Institute of Certified Public Accountants (AIPCA) summarized the following steps for recognizing revenue in the construction industry:

1. Identify the contract with a customer.
2. Identify separate performance obligations.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. Recognize revenue as performance obligations are satisfied.

Construction firms often use one of the following revenue recognition methods to comply with ASC 606.

Percentage of Completion Method

The percentage of completion method recognizes revenue based on the construction project's progress. 

First, the company determines the project’s total income and expenses. Throughout the project, the company must estimate the percentage of project completion. The company recognizes revenue and expenses periodically by applying the completed percentage to the project totals. 

For example, imagine your company estimates a total project income of $1,000,000 and total expenses of $900,000. If your company has completed 10% of the project at the end of the year, the company should recognize $100,000 of income and $90,000 of expenses. 

The company should update its calculations for each financial report or after a change order. 

Completed Contract Method

The completed contract method requires the company to recognize income and expenses after finishing the project. 

For example, imagine signing a 6-month home renovation contract. Regardless of whether your customer pays a progress bill, your company can only recognize income and expenses after you’ve completed the project. 

Specific rules may apply depending on your company's size or the project's length. We recommend consulting professionals specializing in construction-industry accounting. 

Billing in Construction

Construction companies can choose from multiple methods for determining project fees. The best option for your company depends on the complexity and length of your projects.

Fixed Price

With a fixed-price billing arrangement, the construction company and the customer agree to a fixed project fee. Depending on the project length, your company could establish multiple phases, each with a fixed price. 

The company must bill the customer the fixed fee, even if the project incurs unexpected costs. 

Time and Materials

Time and materials billing requires the company to bill the customer based on the hours worked and materials used. Upon signing the contract, the company and its customer agree on a price for each input. 

The company must calculate labor hours and materials spent during each billing cycle to determine how much to bill the customer.

Unit Price

A unit price billing refers to fees calculated per unit installed. The contract includes a set price per unit, and the customer pays for the units needed. 

For example, a contract could establish $50 per square foot of tile installed, with the exact square footage determined at project completion. The construction company would charge the customer for the total square footage installed. 

Each pricing method has benefits and disadvantages. 1-800Accountant can help you determine the best method for your projects. 

Construction Payroll

Construction companies must follow numerous wage requirements for their employees and subcontractors. Consider the following rules that could apply. 

• Multi-state payroll: Your company must follow state and local minimum wage requirements. If your projects span multiple states, your accounting system should monitor each jurisdiction’s wage requirements.

• Prevailing wages: The U.S. Department of Labor imposes wage rate requirements for most construction contracts. Construction companies must pay workers the prevailing wage and benefits in each location. Prevailing wages depend on each worker’s skill level and type of work.

• Union rules: Labor unions enforce fair pay and work environment policies for their members. Many construction laborers join unions. Contractors must monitor the wage and condition requirements imposed by each labor union. 

Construction payroll is complicated, but you don’t have to figure it out alone. 1-800Accountant’s payroll services can support your company with accurate wage and tax calculations.

Construction-Specific Financial Statements

Most companies generate the following three statements for financial reporting: 

• Balance Sheet
• Profit or Loss Statement (Income Statement)
• Statement of Cash Flows

Construction companies often generate additional reports due to their contracts' long-term, complex nature. The following reports summarize ongoing project status and contract-by-contract financial data. 

Work in Progress (WIP) Schedule

A Work in Progress schedule summarizes all ongoing projects. The schedule reports progress billings, income earned, and expenses incurred to date. A WIP schedule helps your company monitor budgets and make financial decisions.

Construction in Progress (CIP) Report

A Construction in Progress Report is similar to a WIP schedule, but the CIP report summarizes revenues and expenses for a single project. The CIP report helps your company compare each project's actual income and costs to the estimates included in the contract.

Job Cost Sheets

Job cost sheets detail all expenses incurred on the project. These reports help construction companies keep comprehensive financial data for reference on future projects.

1-800Accountant’s Top Accounting Tips for Construction Companies

Choose the Right Accounting Method for Your Business

Your accounting method affects several aspects of your bookkeeping. Cash basis accounting is often simpler than accrual basis accounting, but restrictions apply to contract-based companies. 

Accrual basis accounting is often favorable for large companies with complex operations. Additionally, accrual-method companies can easily comply with revenue recognition rules. 

Follow ASC 606 Revenue Recognition Rules

Your financial reporting must adhere to the ASC 606 requirements for recognizing contract revenues. We recommend working with professional CPAs for help with complying.

Ensure Job Costing Accuracy

Implement construction accounting schedules, including WIP reports, CIP schedules, and job cost sheets. Your company will be able to track budget-to-actual for individual projects and monitor overall financial health. 

Avoid Common Construction Accounting Mistakes

Beware of the following mistakes as you set up your construction accounting processes:

1. Underestimating job costs
2. Delayed accounting for change orders
3. Disorganized income and expense tracking
4. Inaccurate overhead cost allocation

Have a Tax Strategy

Long-term construction jobs can complicate your income taxes. Your company could experience fluctuations in your income tax obligations due to your accounting method, billing cycles, and revenue recognition. 

Professional CPAs can help your company develop a tax strategy and better estimate your tax liability. 1-800Accountant’s Small Business Tax Services offer industry specialists to support your business.

Consider Construction Accounting Software

Implementing accounting software can relieve pressure on your back-office staff. Construction accounting rules are complex, but construction accounting software can help your company maintain your bookkeeping.

Hire Construction Accounting Experts at 1-800Accountant

Implementing tools and software can make your calculations more efficient but can’t replace professional advice. You can enjoy hands-on expertise and done-for-you services with 1-800Accountant’s bookkeeping services. 

1-800Accountant can support your business with real-time, accurate bookkeeping so you can gain confidence in your financial reporting. You can better understand your financial health and prepare for tax season.

Schedule a free call with 1-800Accountant to learn how professional CPAs can support your construction business.