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Construction Accounting Methods – Why your Financial Statements Matter!
Are you like many construction industry companies? Do you feel your current internal financial statements are good enough for the day-to-day operational needs of your company? Are you aware of the reporting standards prescribed under GAAP (you know…. those Generally Accepted Accounting Principles in the US) and the different accounting methods that GAAP allows. If you are like most construction companies, you currently may be unaware that your accounting is not following the correct reporting standards and methods required by your industry, and this can cost you! Whether it’s missed opportunities or the additional cost of correcting your past financial statements, more and more interested parties- (i.e. regulatory and licensure agencies, surety and bonding companies, banking institutions and investors, and clients) are requiring properly presented financial statements with the correct accounting methods prescribed under GAAP accounting guidelines with job schedules and full note disclosures! So what does all this mean!?
Let’s start from the beginning. Like many construction industry companies, you probably maintain an in-house accounting system to manage your books and records. The documents you prepare through your in-house accounting system are called “internally prepared financial statements.” Most of the time, your internal financial reports are perfectly fine for the day-to-day operational needs of your company. And like most companies, you probably aren’t following the reporting methods and standards required under Generally Accepted Accounting Principles in the US (GAAP). And whether it’s the opportunity to bid on a multi-million dollar project or you simply just need a short-term operating loan, interested parties are going to ask for your financial statements! Additionally, they are going to want to see properly presented financial statements, and the right presentation and methods matter!
So what are the proper construction accounting methods? Most construction contracts are long-term in nature. Thus, the underlying accounting principle known as matching, where expenses follow revenues, would be violated if the revenue from the contract were recognized right when the contract starts. To meet the matching principal objectives, there are currently two methods of revenue recognition which are allowed under GAAP for construction contractors. One is percentage-of-completion method and the other is completed contract method.
Under the percentage-of-completion method, the construction contractor recognizes revenue over the life of the construction contract based on the degree of completion. Theoretically, you earn the revenue from the contract you perform throughout the various stages of the contract in increments. Thus, if you are 25% complete on the project, you should be recognizing 25% of the contract value and comparing the revenue earned to-date to the relevant costs you have incurred to-date to correctly monitor and report the financial progress of your current project.
Under the completed contract method, all revenues, costs, and income are recognized only at completion of the construction project, ordinarily at the end of the construction contract.
Naturally, the percentage-of-completion method reflects the most accurate progress of your current project, and is method most often preferred by outside interested parties. For example, your surety and client are going to want to know how the project on is performing, and they are going to want to see percentage-of-completion financial statements to be sure the job is progressing on schedule.
Whether you are a small business or large corporation, no company is exempt for these accounting reporting standards and methods. Often the stronger and more complete financial statements that you can submit to an interested party, the better chance you have of securing that once in a lifetime contract or to increase your available bonding capacity! Often these interested parties request a formal review or audit of your financial statements and ask for an opinion on from an outside accountant on whether or not they agree with the methods your in-house accounting personnel used to prepare your financial statements.
You may also face the additional burden of trying to grow your company while meeting working capital or net income requirements, all the while trying to minimize the impact on the owner’s personal taxes! In order to grow your company under these differing pressures, we suggest that you consider selecting the completed contract method for tax purposes (i.e. if contracts are less than two years in duration) and the percentage of completion method for financial statement purposes to navigate through these complex financial situations when considered in conjunction with the tax implications.
We know that adhering to proper accounting methods and standards for construction companies can be very cumbersome and time consuming. With pressures from regulatory agencies and surety companies, failure to perform proper GAAP accounting and financial statement presentation for your company’s financial statements can cost you missed opportunities and may eliminate you from bidding on a project that may take your company to the next level! It’s important not to trust just any accountant to achieve these objectives. Inquire of their relevant industry experience and also ask them for industry references!