WHICH METHOD OF ACCOUNTING IS RIGHT FOR YOUR CONSTRUCTION COMPANY?
by Megan McDonald
For construction companies and contractors, there are more options available for accounting methods than other business entities due to the nature of construction activities and the timing of profit at different points during a construction contract. Methods include cash and accrual, and more specifically, accrual methods include percentage of completion and completed contract method. But which method is right for your company? The answer to that will mostly depend on your size in revenue, but in this article, we will highlight some of the important aspects of each.
Under the cash method, revenue is recognized upon receipt and expenses are recognized when paid. The cash method can be used by a small contractor for both short-term and long-term contracts as long as the average gross receipts do not exceed $5 million and sales revenue from merchandise does not exceed 10 to 15 percent of the gross income. Many small construction companies opt to use the cash method for their short-term contracts and an accrual method for their long term contracts. There is a rule in cash basis that is often overlooked- if a business receives a check at the end of the year but does not deposit it until the next year, the business must report the income in the first year, when the money changes hands.
Under the accrual method, income is recognized when earned and expenses when incurred. If a contractor is unable to use the cash method based on gross receipts, they must choose between the percentage of completion method or the completed contract method of accrual accounting.
Percentage of Completion Method
If a contractor’s average annual gross receipts exceed $10 million then the Internal Revenue Service will consider that a large contractor. Large contractors must use the percentage of completion method, which is a type of accrual accounting. The percentage of completion method involves estimating the finish date of the contract and recognizing income based on the work completed. The contractor will need to have an idea of when the contract will be completed to determine a percentage of how much was completed at year end when it comes to tax time. Using this method, the contractor reports income earned as well as expenses related to those jobs rather than deferring those. The main tax advantage to the percentage of completion method is that it allows you to report your expenses each year against the income rather than all at once as the completed contract method. According to the IRS, this method is preferred by most banks and bonding companies.
Completed Contract Method
Completed contract method allows taxpayers to defer the taxes in the year in which the contract is completed. However, the expenses directly related to the jobs are also deferred until the end when the contract is completed. Completed contract is an available option to smaller contractors (under $10 million in average gross receipts over the last 3 years) or if the project has at least 80 percent of costs arising from construction of residential homes and buildings with no more than four dwelling units. The downside of the completed contract method is a contractor could end up completing several jobs in one year which could result in an unexpected jump in the contractor’s tax bracket.
As a taxpayer in the construction industry, there are various accounting methods to choose from that will have an impact on tax-related cash flow over the life of your business. It is important for contractors to be aware of the methods and together with their tax advisors, determine which method best suits their business need and growth goals.
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