Construction accounting explained: 6 methods & how to use them

Underbilling. Inaccurate estimating. Mistaking expense allocations and ending up working on a project that’s actually costing you money, instead of earning you profit.

These common financial mistakes can be a construction company’s worst nightmare. Sadly, mistakes like these are common in the construction industry. They can add up fast, leading to long-term financial struggles and business viability.

As the economic forecast begins to show more promise for builders who can react quickly to market changes, construction companies should be strengthening their accounting processes. That way, if there’s an opportunity to capitalize on a market opportunity – like a change in supplies price or a new service offering – you’ll be able to take on the challenge knowing your finances are in a healthy place.

Construction accounting is a complex area of the business. In this blog, we’re simplifying accounting in construction by telling you exactly what it is, how it works and how you can incorporate it into your business based on what makes the most sense for you.

What is construction accounting?

Construction accounting is a specialized form of accounting used to track, record and manage revenue, expenses and profitability for a construction business. The aim is to better track and improve construction cash flow.

How accounting for construction companies is different from other industries

Typical financial accounting mainly focuses on the management of financial statements, balance sheets, cash flow statements and retained earnings. In many industries, these functions can be easily recorded and closed over short-term periods. The type of accounting work completed can also look very similar month to month, as the types of goods or services being provided are similar, if not carbon copies of work completed in previous fiscal periods.

The construction industry is different.

The majority of construction work is project-based

For custom home builders, every project is different, which means every accounting cycle can change. Even construction companies who specialize in mass production homes or spec housing experience need to consider different variables with each product, from differences in land grading to materials requested by home buyers.

The work is decentralized

It’s common for construction companies to build more than one project at a time. While some job sites are bundled together within the same division, others can be separated by entire neighborhoods. For businesses who serve even larger residential markets, projects can even span cities or states.

That means the resources used to support each project, including everything from equipment used to the construction workers tasked with working the sites, are constantly on the move. If equipment isn’t shared between sites, the company must lease or purchase even more resources to outfit each location.

Construction accounting is responsible for tracking and managing the expenses of each job site, then tallying those accounts as a whole to get a big-picture view of what’s needed financially to keep each project on track.

Construction projects usually involve long-term contracts

With the nature of housing projects, there’s often a long lead time between when a contract is signed and the construction project is completed. This complicates the accounting process, as it sometimes takes years until you have revenue in hand from a project.

While there are accounting methods used to help allocate revenue based on the amount of work completed over the life of a contract, the process is less straightforward than accounting for faster projects.  

The costs are constantly changing

Labor costs tend to be the biggest expense for many construction companies. Behind that, materials (including supplies and equipment) are a close runner-up.

Given the time of year, how many projects your company is running and what the supply pipeline looks like, these expenses can change quickly.

A project-heavy period could mean you have to employ a larger workforce (or pay more in overtime) just to stay on top of project timelines. Any disruption in the supply chain – like the lumber surge in 2021, for example – can result in higher-than-normal material costs and can quickly impact your estimated budgets.

Accounting often falls to business owners or other roles

Many construction companies, especially small businesses, are working with small accounting departments, or absorb accounting responsibilities into other roles.

Between overseeing multiple projects, client expectations and managing your team, even the most financially savvy contractors can struggle to balance their books.

Given the complexities of construction accounting and the other labor-intensive demands of a home building or renovation project, construction companies require easy-to-use accounting tools that can simplify and streamline the process.

6 key construction accounting principles

There are many different accounting principles unique to the construction industry. Here are some of the biggest concepts you’ll need to understand to get your books in order.

1. Job costing

Job costing is the practice of accounting for your company’s true costs at the project level. While many construction companies track expenses like materials and supplies by project, a portion of other expenses should be tracked per project, as well. Portions of payroll, workers compensation, taxes and other expenses should be included in each project’s budget. That way, you can gain a true understanding of whether a job is profitable or not.

2. Revenue recognition

Revenue recognition is defined by when a construction contractor is paid versus when they can record the revenue of that payment on their books.

Depending on the project’s contract, revenue is usually recognized in two ways:

1. At the completion of a contract and a homeowner fulfills their payment
2. Periodically throughout a contract, based on when the home builder meets obligations or milestones of the project timeline

In some cases, especially large-scale home renovation projects, a larger deposit might be required up front. In this case, a contractor might have to recognize that revenue over the course of several months, rather than a lump sum payment in advance. 

3. Retainage

Retainage occurs in construction when a portion of a payment is held back – or retained – from a payment until the project is complete. Retainage has a direct impact on revenue recognition.

For example, let’s say a $350,000 project contract calls for 10 payments throughout the timeline. These payments are subject to the builder meeting certain obligations, at which point the payment received would be recognized as revenue in each installment.

However, if a 5% retainage was negotiated into the contract, the construction company would only receive 10 payments of $33,250. After the entire project is completed, then the home buyer would be on the hook for paying the retainage balance of $17,500. Then the construction company would be able to recognize the remaining balance as revenue.

4. Billing

While revenue recognition and retainage impact when a company can record revenue, billing refers to when a home buyer receives invoices.

Billing in construction is less straightforward than other industries, where money is exchanged for goods and services. Home buyers can be billed by lump sum, time and materials, unit price or other variables. Bills can also be impacted by construction change orders or issues that might come up during the project.

5. Payroll

Payroll accounting focuses only on employee-related expenses. Direct costs included in this category include employee wages, benefits and payroll taxes. Indirect costs might include training expenses, personal safety equipment and other incentives you might offer your staff like retention bonuses.

6. Reporting

Construction accounting should include at least four basic types of reports: a balance sheet, income statement, cash flow report and retained earnings report – sometimes called a work in progress report.

In addition to these basic reports, construction reporting could include other documents to help support your compliance. These can vary to include things like union reports and workers compensation, to contract reporting supporting ASC 606 (the standard used to accurately recognize revenue).

6 common construction accounting methods

Although it may seem like there should be one right approach when it comes to construction accounting, in reality construction companies may choose from several different methods of accounting. There are advantages and disadvantages to each approach.

1. Cash method

The cash method of accounting is straightforward. You recognize revenue when cash is in hand and record expenses as you spend it. Still, there’s some limitations and risks when accounting with cash, especially when it comes to tax reporting and IRS requirements.

2. Accrual method

In accrual-basis accounting, revenue and expenses are recognized in the period earned or spent, instead of when they’re paid or received. Many businesses find this method difficult, as long-term construction contracts spill across more than one fiscal period. This can result in lots of journal entry adjustments and back-office work. However, this approach does give contractors very accurate pictures of financial health.

3. Fixed price method

Fixed price method is also straightforward in that the contractor and home buyer agree on a price for the project before any work is underway. This offers advantages in construction budgeting and helps attract customers who might be wary of market changes. Disadvantages can include losses for things like supply costs as prices change based on market demands and the supply chain.

4. Time and materials method

In many ways, the time and materials accounting is the opposite of the fixed price method. In this model, the contractor and home buyer agree to settle costs as the project progresses. This may mean home buyers spend more (or less) on material and supply costs based on their dynamic market price. Still, this approach can make it harder to predict expense and profits.

5. Completed contract method

The completed contract method requires all work from the construction company to be completed before revenue or expenses can be deferred. Although there are some tax benefits to this approach, contractors must be able to cash flow projects, as revenue can’t be recognized as taxable income until the project is finished.

6. Percentage of completion method

Different from the completed contract approach, the percentage of completion method allows revenue to be recognized periodically over the lifespan of a project. With this method, construction contractors can gain real-time understanding of a project’s profitability because of insight into periodic costs and revenue. Still, the end result can turn out very different from initial project estimates, which can impact client satisfaction.

Construction accounting best practices

For any industry, accurately reporting accounting and financials can seem like a daunting task. There are best practices construction companies may follow to help ensure compliant – and painless – construction accounting.

1. Estimate job costing as accurately as possible

Job costing sounds complex, but there are accounting software tools to make it more manageable. The key is to keep it simple when establishing a list of cost codes.

Think about what costs you really need to see on a budget. These should be “buckets” or “groups” of the different types of costs on any given job. If you see you’re overspending within any one of these general areas, it will be easy enough to drill down to the specific material, subcontractor or labor cost that’s putting you over budget.

2. Pick your accounting method based on your revenue

While some accounting methods may seem to have more benefits than others, you may have less choice in how you approach your accounting than you might think.

The Internal Revenue Service requires contractors who exceed $10 million in gross receipts to use a percentage of completion method in their accounting practices. Contractors who report less in gross receipts may be able to pick other approaches based on what can provide the most benefit per contract.

For example, a contractor may choose to use cash-basis accounting in a short-term contract and accrual accounting in a longer-term one.

3. Research compliance laws and track liability risks

The last thing you want is to be facing a fine because of accounting negligence, or be on the hook for a large sum if there’s a breach in contract between a contractor and home buyer.

When in doubt, it may be best to turn to a legal expert to help you navigate the details of compliance requirements from entities like the IRS.

4. Regularly track labor costs

As the largest expense on your books, labor costs should be diligently tracked and reconciled. Labor costs have the ability to impact schedules, project timelines, budgets and, ultimately, the total profitability of your contract.

Track labor budgets and identify exceptions like overtime before they occur to help keep your accounting ledger in the black.

Reconciling these expenses often can also help ease work around year-end accounting, when your business is hurrying to close your fiscal year while still delivering on active projects.

5. Hire onsite accounting consulting

From the sheer size of this article, you can see how complicated construction accounting is. So, why not bring in an expert?

Construction companies can use onsite consultants to help monitor your accounting needs. Together with your team, a consultant can work to develop an action plan to meet your specific pain points and goals based on the type of contracts you’re working on.

From there, they can help implement the best workflow to start creating contracts, establishing a base budget and tracking the true costs of a job. By using expert knowledge, your team can ensure accounting practices are compliant, understandable and easy to stick to based on the resources and accounting staff your construction company has available.

6. Use construction accounting software

Even without an onsite consultant, gone are the days when construction contractors had to do everything all by themselves (or in a spreadsheet).

Construction accounting software helps companies manage budgets and cash flow to help support a financially healthy business. It can easily create and send invoices to customers based on invoicing processes and billing methods you’ve established. From there, the invoices are automatically tracked in the system against the contract price, factoring for the true costs of a job. This gives you a quick, easy and accurate look at your gross profit at any given time.

Construction software can also support reporting. Between estimates, bills and purchase orders, builders can look at the estimated costs of a job, the actual costs and the receivables to run a variety of financial reports.

In addition to being able to build a contract or budget, construction accounting software provides simple tools to allow you to accurately track labor as well as subcontractor and supplier invoices for a job.

These tools provide a place to keep track of invoices and run separate reports on material or labor costs. These entries will automatically update the budget as opposed to manual entry, which leaves room for a larger margin for error.

Buildertrend helps you manage all things accounting

As the leading provider of construction budgeting software, Buildertrend is committed to helping you stay on top of your bottom line. Buildertrend’s financial tools offer intuitive solutions and integrations – like our QuickBooks integration – to help you work simpler, especially when working with complex accounting rules.

Plus, we have our own team of highly specialized consultants who are able to meet you in your office to ensure your accounting processes are supported. 

Are you ready to get your accounting processes in shape? Schedule a demo today.

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Get answers to the most common construction accounting questions.