A Guide to Construction Accounting Methods
Financial statements allow construction companies to demonstrate their financial health and positions for a variety of reasons — an important one being obtaining a surety bond.
However, not all financial statements are created equal in the eyes of the surety bond underwriter.
There are several accounting methods out there, and each one can make data for the same accounting period look different. That means the actual financial performance of a construction company could differ from what the data shows.
Below, we’ll cover these accounting methods and further explain which one you should use for your construction company.
What is a Long-Term Contract?
Many contractors may think a long-term contract is any contract lasting longer than twelve months.
For financial statement reporting purposes, this is not true. Long-term contracts are defined as any contract that straddles two tax years.
If a contract starts in October and is completed in March of the following year, its life is six months. However, this contract is considered long-term for financial reporting purposes since it straddles two tax years — even though its duration is less than twelve months.
The Four Accounting Methods And Their Uses
All companies must choose an accounting method to use when keeping their books and compiling financial statements.
Under the cash basis of accounting, you record revenue only when they have physically received payment, and expenses only when they have paid the money. Therefore, under the cash method, your net cash flows should roughly match the difference between revenues and expenses.
This is the simplest accounting method, but few construction companies qualify. Still, firms may use it internally, separate from the method used to prepare financial statements for the underwriter.
Under the accrual basis of accounting, you record revenue when services have been rendered, and expenses when they have been incurred.
Your net cash flows may not be the same as the difference between your revenues and expenses — you might recognize revenue on your income statement in one accounting period after completing a project milestone, but not receive payment for that revenue until later.
Similarly, you might incur expenses on credit in one accounting period, but not pay off that credit bill until the next accounting period.
The next two methods are variants of the accrual basis.
Completed Contract Method
The Completed Contract method is a form of accrual accounting that recognizes contract revenue and expenses only when the project is finished.
That means you only record your revenues, expenses, and profits on the income statement at the end. Any income statements created during the project will not have any revenue or expense numbers.
Percentage of Completion
The percentage of completion method allows you to recognize revenue as you earn it and expenses as you incur them throughout a project.
Expenses in each accounting period are compared to the total estimated costs to determine how much revenue to recognize each period.
Which Construction Accounting Method Should You Use For Long-Term Contracts?
Underwriters want to see construction companies use a method compliant with Generally Accepted Accounting Principles (GAAP).
For small construction companies, that means the percentage of completion accounting method.
Cash basis isn’t GAAP-compliant. It doesn’t record accounts receivables or retention.
This understates revenue, net income, working capital, and net equity compared to the accrual method.
Cash basis also does not record Accounts Payables, understating expenses and subsequently overstating net income, working capital, and net equity.
The completed contract method is only used when project estimates to completion are unreliable, so the bond underwriter may be unsure if company management can oversee a contract.
Therefore, that means accrual with percentage completion is the best method. If you don’t use this method, you risk rejection or delays when trying to secure bonds for upcoming projects.