In the dynamic and ever-evolving construction industry, financial management is a critical aspect that can make or break a project. The complex nature of construction projects demands accurate tracking, allocation, and analysis of various costs and revenues associated with each undertaking. A single construction company works with multiple contractors and sub-constructors at a time, where management, as well as contractors, have to make difficult financial decisions on an everyday basis.
In such circumstances, construction accountants are the professionals who can help you navigate these complexities, providing crucial financial insights to stakeholders at every stage of the project’s life cycle, or you can simply invest in software and track the progress yourself. Either way, to be well-versed in financial management during a construction project you need to understand different accounting methods to gain a deeper understanding of the field.
Whether you want to establish a new construction business or want to kickstart an old company, here are some key financial aspects of construction accounting that you need to know.
Job costing is a fundamental concept in construction accounting. It involves tracking and allocating costs to specific construction projects, where each project is treated as a separate job, and expenses such as materials, labor, equipment, subcontractors, and overhead costs are allocated to that job.
At its core, construction accounting revolves around job costing. Each construction project is treated as an individual job, and costs related to materials, labor, subcontractors, equipment, and overhead are meticulously allocated to the respective job. This level of detail enables contractors to understand each project’s true cost and profitability, empowering them to make informed decisions and adjustments to ensure success. Job costing and job cost ledger if maintained regularly can create a powerful cycle where previous financial data and historically recorded costs lead to better financial decisions in future times.
Construction projects are usually invoiced in stages based on the percentage of completion. Progress billing helps contractors receive payment for the work they have completed at different stages of the project. It requires accurate tracking of project progress and costs.
Moreover, construction accountants must deal with unique billing practices prevalent in the industry. Since progress billing allows contractors to invoice clients at different stages of project completion, it requires precise monitoring of project milestones and costs incurred. Additionally, construction contracts often involve retainage, where a portion of a payment is withheld until the project’s completion, necessitating meticulous accounting to ensure the timely release of retained funds.
In construction contracts, clients often withhold a percentage of the payment as retainage until the project is complete. Construction accountants need to account for these withheld amounts separately and ensure they are released when the project meets the specified requirements.
Construction companies often have significant overhead costs related to administration, equipment, and facilities. Properly allocating these costs to specific projects is crucial to accurately determine the profitability of each project.
Job Profitability Analysis
Construction accountants analyze the profitability of each project by comparing the total revenues and expenses associated with it. This analysis helps construction companies make informed decisions and identify areas for cost optimization.
WIP (Work in Progress) Accounting
As construction projects can span several months or even years, it’s essential to account for the work in progress accurately. WIP accounting recognizes revenue and costs based on each project’s completion percentage.
Compliance and Regulations
Construction accountants must be well-versed in relevant accounting standards and tax regulations specific to the construction industry.
Cash Flow Management
Managing cash flow is vital in construction, as projects often involve substantial upfront costs. Proper accounting practices help monitor cash flow, ensuring that funds are available to cover expenses as they arise.
Construction accountants generate financial statements, including income statements, balance sheets, and cash flow statements, to provide a clear picture of a construction company’s financial health.
Specialized accounting software is commonly used in construction accounting to streamline processes, improve accuracy, and facilitate reporting.
Now that you are familiarized with different terms and concepts of financial accounting, the following are given 6 fundamental ways of doing construction accounting.
1. The Cash Method
The cash method tracks how much cash a contractor is spending and receiving. When using the cash method, contractors only record their expenses when they spend income on costs like materials or equipment and only record revenue when they receive payment from the client. The cash method because is usually the most preferred method as it gives you an easy way to manage the contracts without generating accounts payable or receivable.
2. The Completed Contract Method
The completed contract method is when contractors track their expenses throughout a construction project but don’t send an invoice until the project is complete. Contractors typically use this method on shorter projects with fewer variables as it allows them to send one invoice at the end instead of multiple different invoices throughout the process.
3. The Percentage of Completion
The percentage of completion method allows contractors to send invoices once they reach certain milestones in construction. For example, the builders might receive payment after finishing a house’s frame or installing the wiring in a building.
4. The Contract Retainage Method
Contract retainage refers to the right of a client to withhold a certain percentage of a contractor’s total payment until they’re satisfied with a construction project’s results. Under a retainage contract, clients can refuse to fulfill their obligation until they deem the construction satisfactory.
5. The Fixed Price Method
The contractor/s usually submits a fixed price of the project at the bidding stage. While this method allows the client to choose a contractor bid that is more favorable to the client’s financial convenience, it puts the contractor under obligation to complete the project in the stipulated time and cost.
6. The Accrual Method
In this type of method, the company/client recognizes contractors’ bills as soon as they are received. The clients whose contracts include retainage do not recognize the revenue until the project is fully completed.
Overall, construction accounting requires a deep understanding of accounting principles and the ability to adapt them to the unique characteristics of the construction industry. Construction accountants do play a crucial role in helping construction companies manage their finances efficiently and make informed business decisions. However, to make your project successful, it is essential to understand the concepts fully (as a contractor and as a client).