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A Crash Course in Construction Accounting: Basic Concepts and Terms

7 minutes read - April 29, 2022 - by Yondu Team
The methods and processes of construction accounting are different from other industries. Read this guide to learn more about accounting for construction.
crash course in construction accounting

Despite their significant differences, the construction, retail, and manufacturing sectors seem similar and sometimes interchanged by someone unfamiliar with said industries. Not only do they vary in concept—manufacturing makes products, retail sells goods or services, and construction builds establishments—but they also differ in cash cycles, upfront costs, and accounting processes. 

Compared to the retail and manufacturing industries, the construction industry takes longer to convert its inputs into cash. It also has higher upfront costs, as before construction can even begin, there are already fees, taxes, and land acquisition costs to pay. The work-in-progress is different, too, because the prices and timetables are distinct.

With these differences, it makes sense that the construction accounting methods and processes are unlike other sectors’.

If you want to learn more, or have had some trouble navigating accounting for construction, this article can serve as your crash course about the topic and show you how ERP software can address some of your issues.

What is Construction Accounting?

Construction accounting is a branch of accounting that financially tracks a construction job’s progress. It’s an essential element in construction retention payments, bidding, invoicing, and project management. 

Construction accounting management involves monitoring revenue and costs. There are two main types of expenses under this branch: 

  • Direct – consultancy fees, materials, architectural fees, and labor
  • Indirect – insurance, supervision and inspection costs, and equipment rental

The usual construction accounting process starts by recording revenue and comparing the expected project value to the estimated percentage of project completion. Then, as time goes on, the client will receive completion invoices.

Next, they’ll make payments once the job is done. If the project is up to their satisfaction, the construction retainer, usually 5% of the contract value, is paid last because they keep the contractors until the project is finished. 

In terms of accounting methods, construction has many unique ways of financial reporting. These methods are critical in construction management and taxation.

How is Construction Accounting Different from General Accounting?

Usually, you are taught regular or general accounting as it is the most common type of accounting. On the other hand, while it shares general accounting’s basic principles, construction accounting has specific differences. 

1. Limited volume of sales

The construction industry may have a greater range in service categories, but it can also rake in limited sales, especially for construction firms with large-scale projects. For instance, companies that deal with municipal or commercial buildings may only get a few contracts every year. Hence, your chart of accounts will look different than that of high-volume retail or manufacturing businesses.

2. Change orders are common

For longer construction projects, change orders are quite common. Accurate documentation of the financial impact these changes bring to the project is essential to ensure that the project stays on track. It’s best to have an expert who can handle these changes efficiently, or else there will be problems with the project’s finances and contract.

3. Each project is different

In construction, every project is different, with an assortment of associated costs and complex requirements. For example, material costs and labor can greatly differ depending on the type of building and its location.

In general accounting for retail and manufacturing, break-even points are easy to calculate since income and expenses relate directly. You cannot say the same for construction projects whose variables change by the day. 

4. The Cost of Goods Sold (COGS) is irregular

Unlike construction accounting, general accounting can easily record the sold product costs. It’s not that simple for construction accounting because of the direct and indirect costs. You have to classify each job into a category (materials, labor, insurance, etc.). 

There’s a clear distinction between COGS and overhead costs in general accounting. Meanwhile, some expenses considered overhead in regular accounting are COGS in construction accounting because these costs are directly connected to the client’s project.  

5. Profit and loss are harder to forecast

Due to different factors such as the abovementioned, it’s more difficult to gauge whether a construction project will be profitable or not than projects in manufacturing or retail. Fluctuating expenses, unique challenges, and change orders are the major components that affect the construction project forecast.

This is the reason accurate accounting is crucial in construction. It can help determine whether a project will lose money, make a profit, or break even. 

The Fundamentals of Construction Accounting

Construction accounting is a specialized practice with unique concepts and particular building industry requirements. From estimates to payroll, these fundamentals vary based on the project type and risks involved. Check out the said fundamentals below. 

1. Job Costing

In other industries, a general ledger (G/L) will suffice. They can simply track transactions that influence the company’s whole financial state. For construction projects, you track and report transactions for each specific job. This is because construction production is decentralized, and its accounting is project-centered. The tracking of production activities and project costs is called job costing. 

Together with a G/L, job costing is essential in construction accounting. G/L overlooks costs for the whole company while job costing tracks on a project level. Additionally, a G/L consists of accounts payable and materials expenses. On the other hand, job costing involves cost types, individual projects, and cost activities (e.g., framing, foundation).

2. Construction Billing

Construction production has several billing methods and styles because most projects are flexible and long-term. Some of the most common billing formats are:

  • Fixed price – It refers to a detailed estimate of the project’s overall costs. The construction company completes the project following the established price regardless of time and materials. If unforeseen problems arise, price changes may be allowed.
  • Time and materials – The contract price is based on the materials’ costs and the per-hour labor rate. You may give a standard markup to the materials and labor time to generate a profit and cover overhead costs.
  • Unit price – You bill clients at a fixed price-per-unit rate. You’ll often see this when you provide repetitive items at an expected cost, but the number of required items is unforeseeable. 

3. Revenue Recognition

You can determine the project’s income through revenue recognition. Since construction contracts usually have delayed payments and are long-term, revenue recognition helps establish what you should officially record as revenue. It’s an essential aspect of construction accounting because you don’t typically complete, bill, and collect a contract in a month.

Construction managers bill clients on a percentage-of-completion basis; hence, it is important to determine which milestones are reportable.

4. Contract Retainage

The client can withhold a retainage or a certain amount of the contract price for a specific period or until they are satisfied with the completed work. Retainage serves as the contractor’s financial incentive to finish the project to the client’s liking. It also protects the clients in case any issues surface. 

Usually, the retainage amount is recorded as receivables, but if the client has the right to hold on to it for more than a year, it’s classified as long-term receivables. Most contractors work with low-profit margins; hence, retainage can represent a significant amount of the project’s profits. In turn, you may also withhold retainage from your subcontractors. 

5. Payroll

The construction industry has a more complex and unique payroll than other sectors. In addition to minimum wage requirements and the local market rate, you must also consider the specific rules of union labor and public projects. Here are some aspects of construction payroll you need to take into account:

  • Prevailing wage – For public projects, you must pay each type of worker based on a government-defined minimum wage. Prevailing wage is called such because, according to surveys, it’s the rate people of the same role are paid to work in each region. 
  • Union payroll – The construction industry is largely made up of unions. Wages are decided through collective bargaining agreements, and you need to report them to each union to verify your company’s compliance. 
  • Compliance reporting – Following local tax requirements, you also must track and report employment regulations compliance to local and national agencies. 

Common Methods Used in Construction Accounting

Construction accounting has several methods. You need to choose the right one so that your company can optimize its tax reporting and accurately distribute indirect and direct project costs. This is heavily important when working on long-term projects. 

1. Cash Method

This method is easier than the other methods in this list because you only have to record the revenue when it’s received and the expenses when you’ve paid vendors. However, since the cash cycle for construction projects is long, it can skew the balance sheet towards the red and may not offer accurate financial reporting, unlike the other methods.  

2. Accrual Method

You’ll recognize expenses when they’re “incurred” and income when they’re “earned” in this method. Compared to the cash method, it paints an accurate picture of your company’s financial standing because you record a transaction in the period you encountered it. 

3. Percentage of Completion Method (PCM)

With the percentage of completion method, you bill the client in every stage of work performed and record the expenses and earned revenue. Using this method to record costs and income, you can easily match the work performed, which most lenders and banks prefer. Additionally, you can generate accurate estimates with PCM, hence why many companies prefer this method.

4. Completed Contract Method (CCM)

The completed-contract method is best for projects that don’t take more than a year to finish. Using this method, you’ll only recognize revenue, profit, and expenses once a project is completed. If you want to postpone income to a future period, you can use CCM.

You can take advantage of CCM as an accounting method if you’re a contractor who builds new, move-in-ready homes and only recognizes revenue on a house once it’s sold. 

Maximize Cash Flow and Profitability with Yondu

Construction accounting has been adapted to the complex needs and processes of the industry, which is why it’s distinct from regular business accounting. If you’re new to it, you need to take on specialized skills and learnings to navigate this accounting type and make your financial reporting easier. 

Take control of your construction projects using a cloud enterprise resource planning (ERP) system. Aside from your accounting processes, you can also manage your project’s supply monitoring, schedule, decision-making processes, and communication flow on this platform. It’s organized, efficient, and productive, thanks to automation. 

As the leading IT company in the Philippines, Yondu serves as Acumatica’s partner in the country. Acumatica is a cloud ERP with a Construction Management module fully integrated within its system. With this and other useful modules like Inventory Management and Finance, you can further drive your construction business growth.

Aside from Acumatica, Yondu also develops customized construction management software based on your business model and process. You don’t have to skip on the benefits of construction ERP just because Acumatica doesn’t fit your business’ needs. With Yondu’s personalized approach, you can take your business to the next level on your terms. 

Increase your profitability and collaboration and choose an ERP solution that’s right for your business. Schedule a consultation with Yondu’s ERP experts today.

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