Construction Accounting: A Comprehensive Guide for Contractors

The construction industry is a complex and dynamic sector that requires careful management of finances to ensure profitability. Construction accounting is the process of managing financial transactions specific to construction projects. It involves tracking costs, revenue, and profits for each project to provide accurate financial statements and ensure the project's success.

In this article, we’ll explore the basics of construction accounting, including job costing, contract revenue recognition, and accounting methods. We’ll also discuss best practices and explain how construction accountants can help contractors manage their finances.

Understanding Construction Accounting

Construction accounting is a specialized branch of accounting that deals with the unique financial aspects of construction projects. The goal is to ensure the project is completed within budget, on time, and with a reasonable profit margin.

One of the key elements of construction accounting is job costing, which tracks the costs of each project and assigns those expenses to specific jobs. This allows contractors to determine the profitability of each job and make informed decisions about future projects.

Another important aspect of construction accounting is revenue recognition. Construction projects can span months or even years, so careful management is necessary to ensure revenue is recognized appropriately over the life span of the project. The two primary methods of revenue recognition in construction accounting are the completed contract method and the percentage of completion method (which we dig into below).

Construction accounting software is an essential tool for managing the finances of construction projects. It enables contractors to track expenses, manage job costing, and monitor revenue recognition. Many construction-specific accounting software packages are available, so contractors should choose a solution that meets their specific needs.

Financial management is a critical component of construction accounting. Contractors must manage cash flow, monitor income statements, and maintain a healthy balance sheet to ensure the financial health of their business. Accrual accounting, which we’ll discuss later on, is the preferred method for construction companies, as it provides a more accurate picture of the company's financial health.

Key Concepts in Construction Accounting

The unique financial management needs of construction firms require a different approach to accounting. Here are some key concepts in construction accounting to further your understanding.

Job Costing

Job costing is the process of tracking all expenses associated with a specific construction project. This includes direct costs like materials, labor, and equipment, as well as indirect ones like overhead expenses. Job costing helps contractors determine the profitability of each project and make informed decisions about future projects.

Revenue Recognition

Revenue recognition is the process of totaling revenue earned on a construction project. There are three main methods of revenue recognition in construction accounting: the cash method, the completed contract method, and the percentage of completion method. Each approach has its advantages and disadvantages, and contractors must choose the method that best suits their needs.

Retainage

Retainage is a common practice in the construction industry where a portion of the contract price is held back by the owner or general contractor as a form of security until the project is completed. Contractors must account for retainage in their financial statements and manage the cash flow implications of retainage.

Change Orders

Change orders are modifications to the original contract that arise during the construction process. They can have a significant impact on the profitability of a project, so contractors must track and manage them carefully. This includes accounting for the costs associated with change orders and updating the job cost ledger accordingly.

Accounting Methods in Construction

1. Completed Contract Method

The completed contract method is popular for exempt construction contracts. Revenue and costs on contracts are not recognized until the contract is completed (or over 95% complete) and can be used for its intended purpose. This method usually results in the largest deferral and is suitable for contractors who work on long-term projects that take more than one accounting period to complete.

2. Percentage of Completion Method

The percentage of completion method recognizes revenue and expenses as work is completed on a project. It’s another good fit for contractors who work on long-term projects that take more than one accounting period to complete. The percentage of completion is calculated by dividing the total cost incurred to date by the estimated total cost of the project. 

3. Cash Method

In the cash method, expenses and revenues are accounted for as and when they’re paid and received, respectively. This approach is recommended for contractors who work on small projects and don’t have a large inventory of materials. It’s a simple method of accounting, as it only requires the recording of cash transactions.

4. Accrual Method

The accrual method recognizes revenue and expenses as they’re earned and incurred, respectively. It’s a good option for contractors who work on larger projects and have a large inventory of materials. This approach provides a more accurate picture of a contractor's financial position than the cash method.

Construction Accounting Software

Construction accounting software helps contractors and construction professionals manage their finances and projects more efficiently. It’s specially designed to handle the unique aspects of the construction industry, such as job costing and retainage. Here are some of the top construction accounting software options available in 2023.

1. Sage

Sage is a popular choice for construction accounting software. It offers a range of features, including comprehensive accounting capabilities, project management tools, and reporting capabilities. Sage is also known for its ease of use and excellent customer service.

One of its standout features is its mobile app, which allows users to manage their finances and projects on the go. Sage is also cloud-based, meaning users can access their data from anywhere with an Internet connection.

2. QuickBooks

QuickBooks is another popular choice for construction accounting software. It offers a range of features, including job costing, project management, and reporting capabilities. This software is also known for its ease of use and affordability.

3. Foundation

Foundation is a comprehensive construction accounting software that offers a range of features, including enterprise resource planning, project management, and reporting capabilities.

Construction Payroll Accounting

Construction payroll accounting entails calculating and processing employee paychecks, ensuring compliance with labor laws, and managing various deductions, fringe benefits, and union requirements.

Prevailing Wages

Prevailing wages are the minimum wages that contractors must pay their employees for work on public projects. They’re set by the government and vary depending on the location and type of work. Contractors must comply with prevailing wage laws to avoid penalties and legal issues.

Fringe Benefits

Fringe benefits are non-wage compensation that employers provide to their employees, such as health insurance, retirement plans, and paid time off. These benefits are crucial to attract and retain skilled workers in the construction industry. Contractors must properly calculate and report fringe benefits to ensure compliance with labor laws.

Deductions

Deductions are specified amounts that employers withhold from their employees' paychecks, such as taxes, social security, and health insurance premiums. Contractors must accurately calculate and report deductions to prevent legal problems and abide by labor laws.

Union Requirements

Union requirements are rules and regulations that contractors must follow when working with unionized employees. These may include paying union dues, providing pension benefits, and following specific work rules. Contractors must carefully follow union requirements to circumvent legal hassles and maintain positive relationships with unions.

Financial Management in Construction

Financial management is foundational in construction management, as it deals with allocating and accounting for financial resources to cut project costs, maximize profits, and ensure the long-term financial health of the company. It takes into account every process, from small purchases to structural changes on a business level.

Bidding and Estimates

Bidding and estimating are essential to win profitable projects. Contractors must create accurate and competitive bids and estimates to ensure profitability. They have to consider various factors, such as cost of labor, materials, equipment, and overhead expenses. Accuracy in this area requires proper tracking of costs, both direct and indirect.

Cash Flow Management

Cash flow management ensures construction companies have enough money to cover their expenses and liabilities. They do so by tracking their accounts payable and receivable, managing their profit margins, and monitoring their cash reserves. Proper cash flow management can help construction companies survive economic downturns, unexpected expenses, and other contingencies.

Budgeting and Operations

Budgeting and operations enable construction companies to manage their resources effectively. They have to create budgets that accurately reflect their expenses and revenues to ensure profitability. Monitoring their operations also entails tracking costs, overseeing their financing, and keeping an eye on their contingencies. Proper budgeting and operations ensures resources are utilized correctly and drives long-term financial health.

Project Finances

Construction companies must manage their project finances by keeping track of their costs, revenues, and liabilities. Project financial management can prevent cost overruns, delays, and other contingencies that could affect a company’s profitability.

Contract Types in Construction Accounting

When it comes to construction accounting, understanding the different types of contracts is mandatory. Two common types are cost-plus and unit-price contracts.

Cost-Plus Contracts

In a cost-plus contract, the contractor is reimbursed for all costs incurred during the construction process. Additionally, the contractor is paid a fee for their services, which is typically a percentage of the total cost of the project.

Cost-plus contracts are common in projects where the scope of work isn’t well defined or when changes are expected during the construction process. They provide flexibility for the contractor and the owner, but they also require careful cost tracking and accounting to ensure all expenses are properly documented and reimbursed.

Unit-Price Contracts

A unit price contract pays the contractor based on the quantity of work completed. The unit price is usually determined by a specific unit of measure, such as square footage or linear feet. The contractor’s total payment is calculated by multiplying the unit price by the quantity of work completed.

Unit price contracts are common in projects where the scope of work is well defined and the quantity of work can be accurately estimated. They provide a clear payment structure for both the contractor and the owner but also necessitate close monitoring and accounting of the quantity of work completed.

In addition to these types of contracts, construction accounting also manages contract claims. These are disputes that arise between the contractor and the owner regarding the terms of a contract and can involve issues such as delays, changes in scope, or payment disputes.

Accounts Management in Construction Accounting

Accounts management is a vital component of construction accounting that deals with the management of financial transactions. It contributes to the success of a construction firm by ensuring the firm's financial transactions are recorded accurately and efficiently.

Accounts Receivable

Accounts receivable refers to the money that a client owes to the construction firm for services rendered. Construction companies typically invoice their clients for their services, and accounts receivable tracks the payments due.

Staying on top of accounts receivable ensures the company receives payment promptly. Delayed payments can affect cash flow, which, in turn, can lead to financial difficulties. To manage accounts receivable, construction firms must track the payments due from clients, send timely reminders for payment, and follow up with clients who haven’t paid.

Accounts Payable

Similar to the previous term, accounts payable is the money a construction firm owes its suppliers for goods or services received. 

To manage accounts payable, companies must track the payments due to suppliers, verify invoices are accurate, and pay suppliers on time. Delayed payments to suppliers can hurt a company’s credit and make it difficult to obtain credit in the future.

General Ledger

The general ledger is the central component of accounts management in construction accounting. It’s a record of all the financial transactions of a construction firm and includes all their accounts, such as accounts receivable, accounts payable, and others.

Construction firms must manage their general ledger efficiently so that all financial transactions are recorded accurately. The general ledger helps produce financial statements, which are essential for decision-making and compliance purposes.

Final Thoughts

Many resources are available to learn more about construction accounting, including webinars, online courses, and books. These resources are crafted to help contractors improve their accounting skills and stay up to date on the latest industry trends.

It’s important for construction professionals to be familiar with the different methods of revenue recognition, including the cash method, the completed contract method, and the percentage of completion method. Armed with this knowledge, contractors can accurately report their revenue and avoid potential legal issues.