This article is part of a larger series on Accounting Software.
Construction accounting is a unique form of bookkeeping and financial management with many distinctive features, such as job costing and change orders. This can leave many contractors and construction companies struggling to find the right accounting methods to keep up with their different projects, decentralized work, and irregular costs.
To help simplify the construction accounting processes, we present construction accounting tips and best practices. These include using time tracking solutions with geofencing, classifying workers correctly, selecting the right payroll provider, and backing up records digitally.
1. Use Job Costing
Because a construction company can work on many projects at the same time, it’s critical to attribute expenses to each job to control costs accurately and measure a project’s profitability. All direct and indirect expenses must be allocated to the proper job to ensure that the company’s financial records are accurate. This must occur during the project―not after―and expenses must be submitted daily.
Expenses should be categorized the same way as in the estimate you provided for project managers to determine whether the job is proceeding as planned. The construction company should also have a standard formula for allocating indirect expenses, such as administrative overhead, to each project. You can use job costing features in the software, such as QuickBooks Contractor.
When job costing is done correctly, it produces actionable data that offer project managers and supervisors with a “scorecard” to review how their crews are performing. It also helps them potentially make adjustments, help protect narrow profit margins, and target the right projects.
2. Consider Completed Contract Accounting for Taxes
The completed contract method (CCM) involves reporting all project revenue, expenses, and profit only once a contract is completed in full, although payments may be received during the duration of a project. While this approach is often the most preferred method in the construction industry, it’s best suited for short-term contracts under two years.
Contractors will often use this method if it’s impossible to calculate the percentage of completion for a project or if they want to defer revenue to a future period—but it also has particular restrictions by the IRS.
To be eligible, contractors can’t exceed a certain average annual revenue and their contracts must be completed within a set timeframe. It’s also important to note that because revenue isn’t properly matched with costs, completed contract accounting doesn’t comply with generally accepted accounting principles (GAAP).
3. Use Time Tracking Software With Geofencing
A construction company’s labor force can include a combination of salaried employees, union and non-union workers, and independent contractors. Tracking the labor hours and costs on multiple projects can become challenging, so to automate the process and reduce human error and oversight, it’s important to take advantage of web-based tools and mobile apps.
Not only is it essential to use some form of time tracking software, but it’s also a good idea to invest in an app with geofencing. This reminds your employees to clock in and out and allows you to monitor your employees’ locations as they travel while at work.
4. Manage Change Orders
Construction projects can often undergo changes from the original plan for which a quote, estimate, or bid was provided to the customer. These adjustments can cut into or eliminate project profits if the original bid isn’t adjusted for the additional cost.
The use of Change Orders to document changes to the original bid can avoid disputes with customers—and the original contract or bid should spell out exactly how to handle change orders. Contractors should also establish a standard change order process with full documentation of the work and cost required for each requested change.
5. Use Construction-Specific Accounting Software
Construction accounting software helps automate standard processes like job costing and estimate comparisons and also enables contractors to better track a project’s profitability. Sage 100 Contractor is one of our best construction accounting software, specifically because of its enterprise resource planning (ERP) features, which include project management, remote time tracking by employees, and equipment management. It’s a full accounting software package, with a job costing capability that allows you to generate cost reports and check job cost journals, labor journals, and billing summaries.
You can review other great options in our guide to the best small business accounting software.
6. Correctly Classify Workers as Employees or Independent Contractors
There are rules you must follow in making the classification of an independent contractor vs employee, and the courts have provided a list of factors that must be considered in determining if a worker is classified as a 1099 or W-2. The focus of the factors is to determine the amount of control the company has over the worker—the more control the company has over the worker, the more likely they’re an employee. The IRS groups the factors into three categories: behavioral control, financial control, and the relationship of the parties.
Also, there’s a big difference between how independent contractors and employees are treated for tax purposes. Your construction company must pay social security tax, workers’ compensation, federal unemployment tax, and perhaps other local tax on the wages of employees. However, when you pay independent contractors, you don’t have to worry about those expenses.
If the IRS finds you have misclassified employees as independent contractors, you’ll be required to pay all employment taxes (both your 7.65% and the employee’s 7.65%) for prior periods where the worker was misclassified. Whether the worker paid these taxes in the form of self-employment tax has no bearing on your tax obligation. This massive tax assessment is enough to destroy many businesses.
7. Choose the Right Payroll Provider
With the rigorous reporting requirements in the construction industry, companies may find that payroll can be a complex process. This can apply in instances such as prevailing wage requirements, certified payroll reporting, multiple pay rates, multiple states, and multiple localities.
Construction companies can also face many payroll reporting requirements, even if they don’t have to file certified payroll. These can include union reports, workers’ compensation, new hire reporting, and equal employment opportunity (EEO) minority compliance.
Because there are so many variables that factor into processing payroll for a construction company, it’s important to select the right construction payroll provider. The ability to manage multiple pay rates is key for processing payroll as are multistate, union-specific, and job costing tools.
8. Track Business Expenses
Tracking business expenses can be tricky, as it includes tracking materials and labor too. If you’re paying for these expenses with a credit card, it’s imperative that you use one that’s only for business. You’ll need to track payroll, subcontractor fees, equipment, and material purchases, ensuring that the date, description, and payment made are indicated for each transaction.
It’s also important to categorize these expenses by service and individual job so that you can track how much money came in as well as how much you spent on expenses easily. You may want to use a digital expense tracker app to automate this process for you.
9. Reconcile Bank & Supplier Statements
Each month, your bank and suppliers will send a statement for each of your accounts, which you’ll need to reconcile to ensure that it matches up with your own accounting system, invoices, and payments. After checking for any discrepancies, you may need to contact your bank to discuss any issues that come up.
While reconciling your accounts, you may also want to review whether you’ve had any unexpected expenses, which will impact a project’s profit forecast by raising the predicted job costing. You’ll want to ensure that this is accounted for and that you have a plan in place so that you don’t lose profitability and compromise your profit margin.
Check out our recommendations for the best bank reconciliation software.
10. Improve Inventory Tracking
Keeping an accurate inventory of materials makes it easier to see where your resources are being used so that you can budget accordingly. It isn’t unusual for a job to require more labor or materials than originally anticipated, and if you’re constantly taking materials from inventory, you can quickly go over budget on a project and find yourself in short supply on others.
Automating inventory management is the key to increased efficiency and eliminating time-consuming manual tasks. Since contractors deal with an array of construction materials―from raw materials and consumables to prefabricated products―and are often managing multiple construction sites at any given time, the need to streamline storage locations, work orders, and purchase orders (POs) using an inventory management system is crucial.
Our guide to the best inventory management software offers detailed insights into the pricing, features, and overall platform usability of the leading providers.
How Construction Accounting Is Unique
Construction accounting differs from regular business accounting in several ways. In addition to the standard accounts receivable (A/R), accounts payable (A/P), and payroll transactions, construction companies deal with job costing, change orders, progress billings, and customer deposits. Here’s a summary of its three most distinct traits:
- Project-based: Whether related to production, billing, or labor, construction companies operate their business primarily around projects. Therefore, contractors must treat every construction project as a unique, short-term profit center. To control costs and bid successfully, it’s crucial to track accurate costs for each project individually.
- Decentralized production: Construction projects primarily happen on different job sites as opposed to a fixed location. Both equipment use and labor frequently move from site to site, which can result in mobilization costs. It also means that equipment and labor costs must always be tracked to each job site along with the correct wage rate.
- Long-term contracts: In construction, production contracts can last years and have multiple, extended payments over that time. Contract terms frequently allow 30, 60, or 90 days or more to pay invoices. As a result, revenue recognition and cash management carry special considerations in construction.
Frequently Asked Questions (FAQs)
How do you account for construction projects?
Revenue from construction projects can be recognized using either the completed contract or percentage completion methods. Completed contract is usually favorable for tax purposes, but there are limitations on when it can be used.
What is an Employee vs Independent Contractor?
Employees (W-2 workers) are usually paid salaries or hourly rates by companies, which pay payroll taxes on their workers’ earnings. Meanwhile, independent contractors (1099 workers) are paid hourly or flat rates and are responsible for paying their payroll taxes. Our guide to W-2 vs 1099 workers discusses the differences between classifications in detail.
Accounting for construction companies comes with its challenges and requires a unique approach and a comprehensive understanding of all the factors that go into the process. By following our suggested construction accounting best practices, you’ll ensure that your company will maintain accurate records and have a better handle on your financial situation.