Generally, a contractor’s chart of accounts for their accounting system is significantly different than other businesses and is oriented towards the method of accounting selected by the contractor. This article will explain some of the differences and why they are important.
Two of the differences explored below are:
- Completed contract vs. Percentage of Completion
- Cash vs Accrual
Completed Contract
The completed contract method of accounting accumulates all job costs to a current asset account on the Balance Sheet called Construction in Process and is similar to inventory for a retail business. With contracts having a longer term than one year, it is customary for the customer to make deposits on the contract and these payments are considered liabilities on the Balance Sheet.
When the project is completed the Construction in Process (asset) and the Deposit (liability) accounts are cleared of the actual costs and monies received to the income statement. The deposits are moved to revenue and the CIP is moved to expenses to calculate profit or loss on the job. This method focuses on when the project is completed.
When President Trump signed the “Tax Cuts and Jobs Act” it greatly expanded the availability of the completed contract method from $10 million to $25 million average receipts test. If you have not been using the Completed Contract method, and you fall under the new $25M threshold, switching may offer you the ability to plan better for taxes based on cash received and expenses deducted, and offers you an easier way to account for your projects.
Percentage of Completion Method
This method is somewhat similar to completed contract except it posts the costs and the revenue associated with those costs to the Income Statement every accounting cycle. The accounts follow the flow of how a percentage of completion method works. The key is that the percentage of completion method accumulates all items to the Balance Sheet during the interim accounting period and then using a process, transfers the cost and revenues earned to the income statement at the end of the cycle. Typically this is done when the work in progress schedule or job schedule is completed.
Under this method there is an accounts receivable account whereby the customer simply fronts money during the construction process. With the percentage of completion method, the customer is legally obligated to pay as the project goes through stages of construction. With the completed contract method, the contract states that the legal obligation is fulfilled once the project is done. The percentage of completion method is different because it often takes more than a year to complete the work, therefore the contractor wants to recognize his earnings as he progresses. Therefore the contract and the corresponding accounting is designed with this in mind. As the contractor invoices the customer for services and costs rendered, the customer owes the contractor this amount. So one key difference between the two methods is that invoicing occurs with the percentage of completion method, whereas with the completed contract method, invoicing does not exist. The customer merely fronts money in accordance with the contract.
Another difference between the two methods relates to the end result. With the completed contract method, the project is accepted by the customer at the end of the project. With the percentage of completion method, the customer often accepts the project in incremental steps. As an incentive to finish the job there may be a retainage withheld from payments that is paid once the contract is complete.
A third difference relates with customer deposits account. Under the completed contract method, the account also includes customer payments. Under that method, in addition to initial deposit the customer often has to prepay for any change orders or upgrades requested. Under the percentage of completion method, any change orders or upgrades are simply invoiced to the customer as that work is done. It isn’t customary for a customer to make a deposit for the project with percentage of completion method. However, there may be a mobilization aspect in the contract, thus the requirement for a deposit.
The most interesting account with the percentage of completion method relates to progress billings. With the completed contract method, there are no progress billings but rather deposits as the project progresses. With the percentage of completion method, the customer pays off the invoice as progress billings during the interim time period, thereby recognizing the net profit on a job as it progresses toward completion. Once the accounting cycle closes, the contractor will transfer the entire amount to the income statement that is in the progress billings.
Cash Basis Accounting
The cash basis of accounting recognizes revenues when cash is received, and expenses when they are paid. This method does not recognize accounts receivable or accounts payable.
Many small companies opt to use the cash basis of accounting because it is simple to maintain and matches what is in the bank account. It’s easy to determine when a transaction has occurred and there is no need to track receivables or payables.
The cash method is also beneficial in terms of tracking how much cash the business actually has at any given time and since transactions aren’t recorded until the cash is received or paid, the business’s income isn’t taxed until it’s in the bank. In reference to the two methods of accounting for projects discussed above, either can be used under the cash basis of accounting.
Accrual basis Accounting
Accrual accounting is a method of accounting where revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. For example, you would record revenue when you bill for it, rather than when you get paid.
The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
The downside is that accrual accounting doesn’t provide any awareness of cash flow; a business can appear to be very profitable while in reality it has empty bank accounts. Accrual basis accounting without careful monitoring of cash flow can have potentially devastating consequences.
When President Trump signed the “Tax Cuts and Jobs Act” it greatly expanded the availability of the cash basis of accounting method from $5 million to $25 million for the three prior tax years. Switching methods does offer you the ability to plan for taxes based on cash received and expenses deducted.
In looking at the options discussed above, most contractors use the accrual method of accounting and the percentage completion method of recording jobs, as lenders and bonding agencies generally prefer it. But the option for using the cash method and completed contract for tax purposes only, could offer significant tax planning opportunities. We would love to explore these options with you – give us a call today.