Accountants use two primary accounting methods: the POC or percentage of competed project method and CCM or completed contract method for construction projects. Each method has its advantages and disadvantages. The choice depends on various factors, including the nature of the projects, the degree of completion certainty, and the impact on financial reporting.
A more pressing question is: how can these accounting methods be useful in resolving the common construction accounting problems that happen in between the beginning and ending of a project? More issues can come up before, during, and after every construction project. And often, it’s up to the accountants or CPAs how to fix them using either percentage of completion or completed contract method for construction.
Common Construction Accounting Problems Accountants Often Have to Deal With
Construction accounting comes with its own set of challenges due to the unique nature of the industry, which involves long-term projects, complex contracts, and various cost components. But even if accountants know how to keep track of construction projects, unpredictable issues may still arise. This happens usually during the “gap” between the beginning and end of the project.
For example, you discuss doing a home building project with a contractor in the month of September. And then, you decide to move forward with the project in October. The contractor would then collect a 40% deposit, some of which would be used to fund the materials needed for construction. This 40% would be income you just put on your books until the following year, considering that some materials can take as long as months to arrive.
This becomes an issue especially when it’s time to file your tax return. Without any expenses going against the 40% net income, this amount would be overstated. A worst-case scenario would be if the client cancels the project due to inability to complete the payment. It means you already paid the taxes on the 40% deposit, which in the end, needs to be returned to the client.
Aside from this, accountants in the construction sector often encounter the following problems:
Revenue Recognition and Percentage of Completion
Determining the appropriate time to recognize revenue can be challenging, especially when using methods like the Percentage of Completion. Estimating the percentage of work completed accurately is crucial for recognizing revenue appropriately.
“Earning” a liability
The initial deposit, say 40%, is money you have not really earned yet because you haven’t completed the work. You aren’t sure what will come out after cost of materials but also, what is the client changes their mind? That makes that percentage a liability instead of a profit.
In some cases, a client may back out of contract because of financial issues. This happens even while the project is ongoing, leaving you in a financially complicated position.
Cost Estimation and Overruns
Accurately estimating project costs is complex, and unexpected overruns can occur due to changes in project scope, unforeseen issues, or fluctuations in material and labor costs. That can lead to the need to increase your bidding due to the rising cost of materials, and this can happen really fast and anytime during the project.
Changes in project scope or specifications can complicate accounting processes. Accountants must carefully account for contract modifications to ensure accurate revenue and cost recognition.
Work-in-Progress (WIP) Calculations or Construction Project Cost Tracking
Maintaining accurate Work-in-Progress schedules is essential for recognizing revenue and profit correctly. Accountants may know how to keep track of construction projects, but errors can still occur. Errors or incomplete WIP calculations can lead to financial misstatements.
Complex Contracts and Terms
Construction contracts often have intricate terms and conditions. Interpreting and applying these terms correctly is crucial for proper accounting. Errors in contract interpretation can lead to disputes and financial discrepancies.
Managing the depreciation of construction equipment is challenging due to the varied and intensive use of machinery. Determining the useful life of equipment and applying appropriate depreciation methods is crucial.
Cash Flow Management
Construction projects often require substantial upfront investments. Poor cash flow management can lead to financial strain, affecting a contractor’s ability to meet obligations and complete projects on time.
Change Orders and Variations
Change orders and variations in project specifications can impact both costs and revenue. Properly documenting and accounting for these changes is crucial to avoid financial discrepancies.
Many construction projects involve subcontractors. Managing and accurately accounting for subcontractor costs, progress, and payments is essential to maintaining financial transparency.
Compliance with Accounting Standards
Staying compliant with accounting standards, such as Generally Accepted Accounting Principles (GAAP), is crucial. Failure to adhere to these standards can result in financial reporting issues and legal consequences.
Software and Technology Integration
Implementing and integrating construction accounting software can be challenging. Inadequate training or improper use of software may lead to data entry errors and reporting inaccuracies.
Changes in tax laws, accounting standards, or other regulations can impact construction accounting practices. Staying informed about regulatory updates and adjusting accounting processes accordingly is crucial.
Establishing and maintaining robust internal controls is essential for preventing fraud, errors, or mismanagement of funds. This includes segregation of duties, approval processes, and regular internal audits.
Completed Contract Method for Construction VS Percentage of Completed Project
Some accountants are more comfortable with percentage of completion method while others work better using completed contract method for construction. Several factors, such as the nature of the projects, the degree of completion certainty, and the impact on financial reporting, among others, affect an accountant’s choice of method. But speaking from experience, the completed contract method for construction proves to be a better approach than percentage of completion.
It’s an accountant’s and a bookkeeper’s job
To be able to come up with accurate projections, accountants and/or bookkeepers need to properly keep a record of the financials day in and day out. The process may require more work and day-to-day involvement, but it eliminates the need to project costs for a project since all expenses are already known upon project completion. This approach safeguards against the pitfalls of inaccurate estimates, potentially saving valuable resources.
Take note that the completed contract method is more of an accountant’s or a bookkeeper’s job rather than a CPA’s. The laborious record-keeping and day-to-day involvement are what set the boundaries. That said, a talented and involved bookkeeper/accountant would be your best option so that your CPA can focus on taxes.
Having a team of accountants, bookkeepers, and a CPA will give you the most accurate picture of your finances for your business and still able to prove your income without paying taxes on money that is still a liability.
What is a Completed Contract Method for Construction?
The completed contract method for construction is a revenue recognition approach applied in construction accounting to match costs and revenues accurately, providing a more realistic financial representation of long-term projects. Unlike the Percentage of Completion Method, which recognizes revenue as the project progresses, CCM delays revenue recognition until the project reaches substantial completion.
Advantages of Completed Contract Method for Construction
- Simplicity – The completed contract method for construction is straightforward and easy to apply, making it an attractive option for smaller contractors who may not have the resources to implement more complex accounting methods.
- Flexibility – With the completed contract method, you have the flexibility to defer the reporting of both income and expenses until the project reaches completion. By postponing income and expense reporting, completed contract method for construction can potentially yield tax advantages, contingent on the duration of the contractual engagement.
- Risk Mitigation – By deferring profit recognition until substantial completion, contractors can mitigate the impact of unforeseen circumstances that may arise during the course of a project. This aligns with the conservative accounting principle.
- Safeguard against cost fluctuations – In the construction industry, the cost of materials can change fast. It is because of this unpredictable market behavior that accountants and bookkeepers prefer thee completed contract method with long-term or short-term projects. It promotes an incentive for you to implement efficient time and cost-saving strategies in project completion. The compensation for the project remains stable, decoupled from the actual duration, encouraging streamlined efforts to enhance overall efficiency.
- Applicability to Certain Contracts – CCM is particularly well-suited for projects with extended timelines and significant uncertainties, where it might be challenging to reliably estimate the percentage of completion.
Disadvantages of Completed Contract Method for Construction
- Delayed revenue recognition – With completed contract method, the revenue recognition is deferred.
- Applicability – While the completed contract is the preferred method for accountants and bookkeepers, it is a less suitable approach for projects with well-defined timelines and clear milestones.
What is a Percentage of Completion Method for Construction Contracts?
Even though completed contract method for construction is simpler, the percentage of completion method for construction contracts is accepted as normal and used in the construction industry. This is because it recognizes revenue and costs on long-term projects. It allows for the recognition of revenue and expenses as a percentage of the project that is completed, providing a more accurate representation of a contractor’s financial performance over the duration of a project.
Advantages of Percentage of Completion Method
- Immediate Revenue Recognition – POC allows for recognizing revenue proportionate to the completion of the project. This can provide a more accurate representation of a contractor’s financial performance during the construction process.
- Timely Recognition of Profits – Profit recognition occurs as the project progresses, enabling a timelier reflection of profitability.
- Applicable to Long-Term Contracts – POC is particularly suitable for long-term construction projects with well-defined milestones and measurable progress.
Disadvantages of Percentage of Completion Method
- Estimation Challenges – Determining the percentage of completion can be subjective and may involve estimation uncertainties, especially when project milestones are not clearly defined. This complexity can lead to errors in financial reporting.
- Cash Flow Misalignment – The method may not align with the actual cash flows of a project. Recognizing revenue before receiving corresponding payments can create cash flow challenges, particularly for companies with tight liquidity.
- Potential for Overstating Revenue- If percentage of completion is overestimated, revenue and profit may be recognized prematurely, leading to financial misstatements.
- Industry and Project-Specific Challenges – Certain industries or types of projects, like construction, may be less suited for the POC method. The construction industry, specifically, has highly uncertain project scopes so you may find it difficult to accurately estimate completion percentages.
- Contractual Changes and Risk – Changes in project scope or unexpected risks can significantly impact the accuracy of estimates and disrupt the Percentage of Completion calculations. This can lead to adjustments in financial reporting, complicating the accounting process
How to Keep Track of Construction Projects
Keeping track of construction projects for accounting purposes is crucial for ensuring accurate financial reporting, monitoring project profitability, and complying with industry standards. Here are some essential steps to help you effectively manage construction project accounting:
Establish a Chart of Accounts
Develop a comprehensive chart of accounts tailored to the construction industry. This should include specific categories for project costs, such as labor, materials, subcontractor expenses, equipment, overhead, and indirect costs.
Use Construction Accounting Software
Implement specialized construction accounting software that is designed to handle the unique requirements of the industry. Such software often includes features for job costing, project tracking, and integration with other financial modules.
Assign Job Numbers or Codes
Assign unique job numbers or codes to each construction project. This facilitates easy identification and tracking of costs associated with specific projects in your accounting system.
Set Up Cost Codes
Establish a system of cost codes to categorize expenses within each project. This allows for detailed tracking of costs, making it easier to analyze and report on specific aspects of a project.
Implement the Percentage of Completion Method
Consider using the Percentage of Completion Method for revenue recognition, especially for long-term projects. This method recognizes revenue and expenses as a percentage of the project completed, providing a more accurate reflection of financial performance.
Regularly Update Work-in-Progress (WIP)
Maintain up-to-date Work-in-Progress schedules. This involves regularly updating the percentage of completion, calculating costs incurred to date, and assessing the overall financial health of each project.
Document Change Orders
Clearly document and track any changes in project scope or specifications through change orders. Ensure that these changes are properly accounted for to prevent discrepancies in revenue and costs.
Monitor Subcontractor Costs
Keep a close eye on subcontractor costs by verifying invoices, tracking progress, and ensuring that payments are in line with the terms of the subcontract agreements.
Regularly Reconcile Accounts
Conduct regular reconciliations of project-related accounts, including bank accounts, to identify any discrepancies or errors in financial records.
Implement Internal Controls
Establish internal controls to prevent fraud, errors, or mismanagement of funds. This may include segregation of duties, approval processes for expenses, and regular internal audits.
Budget vs. Actual Analysis
Compare actual project costs against the budget regularly. This analysis helps identify variances and allows for proactive decision-making to address potential issues.
Ensure Compliance with Regulatory Standards
Stay informed about accounting standards and regulatory requirements relevant to the construction industry. Ensure that your accounting practices align with these standards to avoid compliance issues.
Provide Training for Staff
Train accounting staff and project managers on the use of accounting software and proper procedures for recording project-related transactions. This helps ensure consistency and accuracy in data entry.
Generate regular financial reports that provide a snapshot of each project’s financial status. This may include income statements, balance sheets, and cash flow statements specific to each project.
Can an Accountant, a Bookkeeper, and CPA Offer Enough Financial Assistance to Make Your Business Life Easier and Less Risky?
Back to the previous scenario, paying tax return on the 40% deposit that you may eventually return to the client due to cancellation isn’t just. This is one of the risks that construction contractors have to take, given that the construction industry presents the most unpredictable dynamics. Because of the complicated numbers, who can you rely on: a bookkeeper, an accountant, or a CPA? The answer is all of them!
Bookkeepers and accountants prove to be invaluable in getting your finances in order. They are the forces that do the construction project cost tracking and take care of the accounting processes. Essentially, bookkeepers and accountants are the ones involved in the day-to-day financial activities. They are also the ones that tackle any mistakes no matter if percentage of completion or completed contract method for construction is used.
A CPA, on the other hand, can take care of the taxes and provide some insights to get your business running productively. Most CPAs do not really get the hang of accounting methods, such as completed contract, but it helps to have a power team that consists of an accountant, a bookkeeper, and a CPA to ensure your business’ growth.
Applying Percentage of Completion and Completed Contract Method for Construction Correctly Can Save Your Business
With all the possible issues that can come up during a project, you should know which accounting method would work best – percentage of completion or completed contract method for construction. A skilled accountant can help you mitigate the financial loss using the right financial strategy for construction company.
Having learned all the advantages and disadvantages of both accounting methods, the completed contract method for construction remains the best approach for accountants and bookkeepers. While the percentage of completion may apply to some construction projects, the completed contract method provides more security on your revenue. This is something that bookkeepers and accountants understand, which is also why they prefer this.
Addressing common construction accounting problems requires a combination of skilled accounting professionals, robust accounting software, and ongoing training to ensure accurate financial reporting and compliance with industry standards. Regular audits and reviews of accounting practices can also help identify and rectify potential issues before they escalate.
Bookkeeping Services Columbus can help business owners in the construction industry manage projects efficiently. Our team of financial experts will be there to take care of your books and other financial processes so you can focus on growing your company even more. You can learn more about how we can assist you by calling us at (614) 205-5676 or leaving us a message through our website.