The Complete Guide to Construction Accounting
If you're in the construction industry, you know that accounting and financial management can be more complex than in other industries. In this guide, we’ll review construction accounting processes and how they differ from standard accounting processes. You'll also read about specific elements of construction accounting that are unique to the industry and how construction accounting software can empower construction firms to manage their finances more effectively.
What is Construction Accounting?
Construction accounting is a specialized form of accounting that helps contractors track, manage, and report their financial data more accurately than standard accounting. Standard accounting is great for many businesses, but most construction firms need something more robust.
The main difference between construction accounting and standard accounting is that construction accounting must consider the unique features of construction projects. For example, construction accounting must track progress payments, retainage, change orders, and other project-specific financial data. This data must be accurately tracked and reported to manage construction projects effectively and to determine their profitability. This, in turn, impacts the profitability of the construction business.
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Key Aspects of Construction Accounting That Make It Unique
1. Job Costing
Job costing is important for construction accounting because contractors need to track the costs of their projects accurately to make a profit. There are many different elements that go into job costing, such as labor costs, materials costs, equipment costs, and overhead costs.
The details included in job costing allow a construction business to calculate how much it costs to complete a specific job or project. This information can then be used to set prices for future jobs and help make decisions about whether a project is worth undertaking.
In standard accounting, all financial transactions are recorded in the general ledger. The general ledger includes all income and expense accounts for a business, but it is not tied to a project. This is where job costing comes in. In construction accounting, transactions are not only recorded in the general ledger but also in a job costing system; it is crucial that they are in balance so that you have accurate reporting.
With job costing, each project is given its own set of work breakdown structures (WBS) that encompass the income and expenses tracked through the various phases of the project. This allows project managers and contractors to see exactly how much is being spent on each scope and the entire project. Job costing also allows contractors to easily adjust projects when necessary. This helps them better understand business cash flow as well as make changes to maximize the profitability of a particular job.
2. Sales and Costs of Sales Categories
Construction accounting includes several sales and expense categories not found in a standard accounting chart of accounts. This is due to the level of detail at which construction projects must be tracked.
A chart of accounts is a listing of all the accounts used by a business to record transactions in its general ledger. Additional types of revenue/sales categories in the construction industry may include:
- New Construction Income
- Remodel/Renovation Income
- Service Income
- Rental Income
These additional income categories allow the contractor to have a better idea of the type of revenue the project is bringing in and enables them to determine where they see the most profit. Income and expenses should be tracked separately for each job. When it comes to cost categories, these are broken down into direct costs, indirect costs, and committed costs.
- Direct costs are costs that can be directly traced to a specific project, such as material, labor, equipment rentals, and subcontractor costs.
- Indirect costs are overhead costs that are allocated to a specific project, like staff salaries and administrative costs. A common indirect cost in the construction industry is equipment usage, where the cost of using a contractor's owned equipment must be allocated to each job that it is used on. This cost should be allocated to jobs based on some standard rate such as a daily internal rental rate or a per hour of usage rate. To calculate this rate, you can divide the number of equipment hours used on a project by the equipment hours incurred by the company for the period in which the indirect costs are being allocated
- Committed costs occur when a company agrees to buy something via a purchase order or contract. For example, if a general contractor has agreed to hire an electrician for a project and they've signed the contract stating the amount of work and dollars to be billed, this is a committed cost. Other examples include unposted payroll, purchase orders in which you are waiting for delivery or the bill for the materials has not been paid yet, and open contract or subcontractor agreements.
3. Revenue Recognition
Revenue recognition is important for construction accounting because revenue from construction projects is recognized based on the amount of work that has been completed and not the amount that has been billed. Unlike standard accounting, construction accounting has several different ways to recognize revenue.
To comply with revenue recognition principles, contractors must carefully track the progress of each project. This information is used to determine how much revenue has been earned and when it should be reported.
For each project, at a minimum, the construction contract should specify the price, project schedule, the payment schedule, and the scope of work to be performed.
5 Steps to Recognizing Revenue in a Construction Firm
Overall, there are five essential steps to recognizing revenue in the construction industry:
- Identify the contract with a customer: While most contracts are written they can also be verbal or implied, and should outline important topics like scope, fee, fee terms and conditions, and any other rights you or your customer agree upon.
- Identify the scope of work: The scope of work is the agreed upon services to complete a project or series of projects between a business and a customer, otherwise known as a performance obligation.
- Complete your take-off and mark-up price: Take-off is when you determine the quantity of materials needed to complete a job. Your mark-up price is the difference between the cost of materials or services and the price you would charge for them.
- Allocate the transaction price to each performance obligation: Each individual performance obligation identified in the scope of work is assigned a price.
- Recognize revenue: Revenue recognition should occur when (or as) each performance obligation is satisfied.
With standard accounting, revenue is recognized when the service is performed, but in the construction industry, things aren't that straightforward. There are two ways to recognize revenue in the construction industry: the cash method and the accrual method. Under the accrual method, there is also the completed contract method and the percentage of completion method. The most common way to recognize construction revenue is the percentage of completion method, because in construction, revenues and costs can be reasonably estimated.
- Cash Method: Under the cash method of revenue recognition, revenue is recognized when cash is received, and expenses are recognized when they are paid. This means that if a construction project is completed in December, but the customer doesn't pay until January, the revenue from that job would be reported in January. Expenses would be reported when they are paid for. If they are purchased with cash before the job is completed, this could cause a mismatch between the reporting of revenue and the reporting of expenses.
- Accrual Method: Under the accrual method, revenue is recognized when the service is performed, and expenses are recognized when they are incurred (but not necessarily paid for). This means that if a construction project is completed in December, but the customer doesn't pay until January, the revenue from that job would be reported in December when the customer is billed for the job.
The main benefit of using the accrual method is that it provides a more accurate picture of a construction company's financial health. This can give construction firms a better idea of their true profitability and help them make more informed decisions about job costing and which projects they should take on.
- Percentage of Completion Method: The percentage of completion method is another type of accrual method used for revenue recognition in the construction industry. Under this method, revenue is recognized as a construction project progresses. This gives the contractor an opportunity to recognize income as a percentage of total income as it relates to the amount of the job completed.
The main benefit of using the percentage of completion method is that it provides the most accurate picture of a construction company's financial health. This is because revenue is recognized as the project progresses rather than when the customer pays. This can give construction firms a better idea of their business finances and help them make more informed decisions.
ASC 606 Standards
Businesses in the construction industry also need to be aware of ASC 606. This is a revenue recognition standard affecting businesses that enter into contracts with customers. These standards help companies report and track their income from construction projects. The goal of these guidelines is to create a more accurate picture of a company's financial situation and to ensure businesses across the construction industry are reporting revenue consistently in a standardized way.
4. Mobile Workforce
Dealing with a mobile workforce is one of the biggest challenges in construction. Unlike other industries, in the construction industry, the work takes place at the job site. It can be challenging to keep track of labor costs when a construction company has employees who work at multiple job sites. To comply with payroll regulations, it's important for construction companies to track employees who work on multiple jobs and locations each day.
If you have a mobile workforce, it's important to track income and expenses on a per-job basis. This includes payroll expenses. Payroll in the accounting industry is made even more complex by variables such as:
- Changing jobs and worker classes
- Different pay rates based on job and/or type of work
- Fringe benefits
- Wage and payroll regulations
- Federal, state, and local taxes based on the location of the job
When choosing payroll software for your construction business, it's important to consider your company's specific needs. This includes:
- Supporting local, state, and federal payroll regulations
- Tracking employee time and expenses across multiple job sites
- Generating accurate and detailed reports for each job site
Due to COVID-19, more construction office staff are now working remotely. Having field applications and cloud technologies that enable your workforce to do their job on the go and from multiple locations is important for all construction firms.
5. Payroll Requirements
There are many different payroll requirements in the construction industry, depending on the type of job and the worker classification. For example, hourly workers must be paid for all hours worked, including overtime.
If you're a construction company owner, it's important to understand the specific payroll requirements for the construction industry. This will help ensure you're compliant with all labor laws and avoid penalties for non-compliance. Managing payroll, including tracking employee time, managing project finances, and generating accurate reports, are important steps to helping you make informed decisions about your business.
There are also many fringe benefits that construction workers are entitled to, including health insurance, vacation pay, and retirement benefits. Some benefits are taxable, and others are not. Along with wages, this information is reported on W-2s and 1099s for your employees and subcontractors at the end of the year. With accounting software designed for the construction industry, construction firms can more easily manage their own payroll.
The Davis-Bacon Act of 1931 requires that workers on federally funded projects be paid the "prevailing wage." The prevailing wage is determined by the U.S. Department of Labor and is based on the wages paid to workers in the same occupation in the area where the project is located.
For construction companies, it's important to understand the prevailing wage requirement for the areas where you have ongoing jobs. Staying up to date on this will ensure you are paying your employees what they are entitled to while maintaining compliance with all labor laws.
When it comes to unions and payroll, there are other regulations and deductions you need to watch out for. Unions place specific requirements on pay rates as well as deductions for things like union dues and fringe benefits like pension and health insurance payments. Depending on the union, deductions can also include things like political contributions and annuity funds. You will want to make sure you are in compliance with union requirements when preparing your payroll.
It is important for your construction accounting software to tie tax rates to your job sites, so that every federal, state, and local tax rate is taken into account, ensuring the accuracy of your workers’ paychecks. This can be a complex and time-consuming task if your payroll software isn't up to the task.
In the construction industry, retainage is the percentage of each progress payment that is withheld by the client until the project is completed. Percentages typically range between 5% and 10% of the progress billing/payment. The purpose of retainage is to ensure that the contractor completes the project as agreed.
Retainage provides a financial incentive for contractors to complete projects as agreed. It also protects against substandard work and incomplete projects. If a contractor does not complete the project or delivers substandard work, the customer can use retainage withheld to cover the cost of repairs or completion of the project by others.
The impact of retainage is far reaching. Contractors hold retainage on their subcontractors, thereby impacting construction firms as well as the people they work with. Wages, insurance, and equipment expenses all need to be paid, which can be difficult if retainage is putting a strain on cash flow.
You can avoid potential disputes with customers and ensure you receive all the retainage due to you by maintaining effective communication with your customers, completing a job as specified in the contract, and tracking payments and retainage. Tracking retainage and progress payments will also help identify any cash flow problems.
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Common Reports in Construction Accounting
Many accounting reports are required to analyze your construction business's financial health. Some of these reports, such as the trial balance, aged accounts receivable, aged accounts payable, profit and loss statement, the balance sheet, and the cash flow report, are borrowed from standard accounting. Other reports, such as the job cost report, job profitability report, earned value, work in progress, and estimates vs. actuals are project-based and are specific to the construction industry.
- Trial Balance: The trial balance is a list of all your construction company's general ledger accounts and their balances. It also acts as a check to make sure the debits and credits in your general ledger accounts balance.
- Aged Accounts Receivable: The aged accounts receivable report shows all unpaid invoices grouped by how many days they are past due. This report is used to track outstanding invoices and manage collections.
This report allows you to prioritize which invoices to collect first, lets you know which customers are consistently late in paying their invoices, and helps you monitor how retainage is impacting incoming cash flow.
- Aged Accounts Payable: The accounts payable aging report shows all unpaid bills, grouped by how many days they are past due. This report is used to track outstanding bills, manage vendor payments, and monitor retainage.
Both the aged accounts receivable and the aged accounts payable reports can help you manage your business's cash flow. The aged accounts payable report helps you manage your business's cash flow by showing you all unpaid bills, grouped by how many days they are past due. This allows you to prioritize which bills to pay first.
- Profit and Loss Statement: The profit and loss statement shows your construction company's income and expenses for a period of time, such as one month or one year. This report is used to track your company's financial performance during this period. You can then compare profit and loss statements over time to see how your company is doing from year to year.
- Balance Sheet: The balance sheet shows your construction company's assets, liabilities, and equity at any specific point in time—commonly month-end or fiscal year-end. This report is used to track your company's financial position (also known as net worth).
- Job Cash Flow Statement: The job cash flow statement shows your construction company's cash inflows and outflows throughout a specific project's lifecycle allowing you to proactively understand the cash needs to ensure you have the allocated cash for each phase of the project. The job cash flow statement will allow you to create a payment schedule throughout the project.
- Job Cost Report: The job cost report shows the costs incurred on a specific project. This report is used to track project expenses and check that projects are profitable. The information on a job cost report can also be used to make decisions about future projects.
Additionally, the job cost report can help you identify areas where cost savings could be achieved. The report measures project performance against the original estimates and current costs, allowing you to adjust for future projects.
- Job Profitability Report: The job profitability report shows the profit or loss for a specific project. This report is used to track project profitability and identify problem projects.
This report is a project performance tool that shows the direct and indirect costs, revenue, and profit or loss for a specific project. This report can be used to track project profitability, as well as identify problems with certain projects. Additionally, this report can help you make more informed decisions about pricing for future projects.
- Work-in-Progress (WIP) Report: The WIP report is a project management and accounting tool that shows the status of a construction project and evaluates if a project is on budget and whether it is over or under billed. The WIP report calculates the value of work completed and how much revenue should be recognized based on the completion status of the project.
This report is also important in helping a contractor understand their cash flow for each job. A job that is overbilled will typically produce positive cash flow, and a job that is underbilled will produce negative cash flow. The over and under billings need to be reflected in the contractor's financials as a liability (over billings) or asset (under billings) on the balance sheet and an adjustment to revenue on the profit and loss statement.
- Estimates vs. Actuals Report: The estimates vs. actuals report is a detailed report comparing the estimated costs of a project to the actual costs incurred. This report is used to track project cost and potential overruns to identify problem areas, allowing you to make adjustments during the project as well as providing historical information when pricing future projects.
A number of things can impact construction cost estimates, such as increasing material costs and labor rates from the time the estimate was created to the time the project is underway. The scope of the project can also affect the estimated costs of a job.
Benefits of Using Construction Accounting Software
Accounting software that is designed for the specific needs of construction firms can make your job a whole lot easier. Using tailored construction accounting software allows you to gain a greater understanding of your business and reap benefits like the ones listed below.
For example, a concept unique to the construction industry is WIP. Without the right software, construction firms are not able to precisely manage WIP and prepare accurate financial statements since standard accounting software is not built to support WIP. These accurate reports will help you understand the financial success of your business and your jobs more, and it will be easier for you to receive financial assistance, such as a bond for a job or line of credit.
Accounts receivable and accounts payable automation can digitally transform a company’s cash flow. Solutions like Deltek Payments can benefit your company by establishing a modern experience, increasing security and control, and reducing excessive operational costs like managing payments manually.
How Deltek Supports the Construction Industry
Deltek ComputerEase is the leading construction software provider of job costing accounting, project management, and payroll services—delivering solutions that help customers connect and automate the project lifecycle that fuels their business. Deltek ComputerEase’s dedicated team is committed to providing service excellence and product innovation, adapting to the evolving construction compliance requirements.
If you are currently using a generic accounting solution that’s built for standard accounting processes, you will undoubtedly benefit from switching to a dedicated construction accounting solution. Contact us today to learn how Deltek ComputerEase can help you to boost your profitability.