Four Accounting Methods Can Work for Builders
At the most basic level of application, accounting is pretty simple. It matches the revenue from the sale of an item with the costs associated with producing and delivering the item — all within the same accounting period. This matching process is fairly straightforward in most industries. In the building and remodeling industries, accounting can get a little more complicated because the item sold (a home or project) usually does not exist at the time of sale (contract). And the ultimate cost is not known until the job is done.
There are two major accounting methods:
And two subsets of the accrual method
- Percentage of completion
- Completed-contract method
You can use any of these accounting methods to recognize income, costs and profits on construction contracts. Some work well for tax purposes or for making a pitch to a lender or investor. Others do a better job of helping you make smart decisions about your business.
Here is an explanation of each:
- Cash method. Under this method, income is recognized as cash is received and expenses are recognized as cash is disbursed.
- Pro: The cash method may be beneficial for filing tax returns, when your responsibility is to report to Uncle Sam the amount of income actually received.
- Con: The cash method may not give you useful information for managing your business. Since transactions aren’t entered until cash is received or disbursed and bills usually aren’t paid as soon as they are received, cash-method accounting information often isn’t timely.
- Accrual method. Under this method, income is recognized when it is earned — typically when you prepare the invoice — and expenses are recorded when they are incurred — when you receive invoices. This method works well for time-and-material or cost-plus type contracts.
- Pro: The accrual method provides more timely accounting information than the cash method does.
- Con: It may not give a true picture of a company’s financial position. For example, to maximize cash flow on a remodeling project, it is common practice to “front-end load” construction billings. This results in billing amounts unrelated to actual costs incurred.
- Completed-contract method. Contractors who use this method don’t record revenue and expenses until contracts are complete and homes are closed. Costs incurred during construction are considered assets — work in progress — while customer payments are recorded as liabilities.
- Pro: The completed-contract method may be good for tax purposes because it enables a builder to defer paying taxes on a project’s profit until the job is completed.
- Con: For management purposes, this method does not give builders and remodelers tools they need to run their businesses.
- Percentage-of-completion method. This method recognizes gross profit, cost and revenue throughout the life of each contract based on periodic progress measurements. It may give most builders the best picture of how their businesses are performing.
- Pro: The percentage-of-completion method is most desirable for remodeling projects because it more accurately matches costs with revenues — and therefore profit — for a given period. Successfully using the percentage-of-completion method relies on an accurate estimate, as well as job-cost systems that provide precise and current records of expenses to date.
Let’s say that ABC Builders is working on a $500,000 home that will have costs totaling $400,000. The following transactions occur during the first month of the project:
- ABC pays $10,000 for permits and other start-up costs.
- ABC receives a $10,000 invoice from the excavation company.
- ABC receives $60,000 in progress payments (or draws) from the customer.
If the above transactions were the only ones ABC Builders had for the month, the company’s income statements under each accounting method would look like this:
Under the accrual method, revenue earned equals the amount invoiced on the first progress billing ($60,000). Under the percentage-of-completion method, revenue is computed with the following formulas:
- Calculate what percentage of the job is complete:
Costs to Date/Total Estimated Costs = Percent Complete
$20,000/$400,000 = 5% Complete
- Calculate the amount of revenue to be earned:
Contract Amount x Percent Complete = Revenue Earned
$500,000 x 5% = $25,000
Examining the four income statements, you can see that the percentage-of-completion method best reflects the company’s revenue, costs and gross profit for the period. If ABC’s president received an accrual basis statement, he may think the company is really prospering because ABC has already earned $40,000 of gross profit even though the job is just 5% complete.
However, this statement doesn’t give a true picture of the company’s profitability as of the end of the month. Because the job was only 5% complete, ABC earned only 5% ($20,000) of the total projected gross profit ($100,000) during that period.
So which accounting method should you use? That depends on what you build. Most builders use completed-contract accrual, but more and more custom and small-volume builders who primarily build pre-sold homes use the percentage-of-completion accrual method.
Steve Maltzman is a CPA and president of Steve Maltzman & Associates. The company provides financial and business management services for builders and remodelers. Maltzman is also past chairman of NAHB’s Business Management & Information Technology Committee. Maltzman can be reached at 909-420-0200, via e-mail or through the Web at www.smacfo.com.
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