DOC Accounting for Construction Contracts Construction Tax Tips Anna Achieng

Turner, Inc. began work on a $7,000,000 contract in 2017 to construct an office building. During 2017, Turner, Inc. incurred costs of $1,700,000, billed its customers for $1,200,000, and collected $960,000. At December 31, 2017, the estimated additional costs to complete the project total $3,300,000. Prepare Turner’s 2017 journal entries using the percentage-of-completion method. Beyond GAAP considerations, contractors need to consider tax rules when deciding which accounting method is right for them, using the guidelines of Internal Revenue Code section 460 . IRC 460 provides industry-specific tax rules and includes several exceptions.

• The company will report its revenue of $1 million to recognize the two payments for $500,000 that the customer made at the end of the six-month and one-year milestones.
• NetSuite has packaged the experience gained from tens of thousands of worldwide deployments over two decades into a set of leading practices that pave a clear path to success and are proven to deliver rapid business value.
• The most effective construction companies are proactive rather than reactive.
• As you can see, choosing the right accounting method depends on a variety of factors.
• To illustrate the difference between the two methods, consider a contractor has accepted a contract to build a 5-story office building.
• Using CCM accounting, revenue and expenses are not recognized on a company’s income statement even if cash payments were issued or received during the contract period.

On ascertaining the percentage of the total project cost incurred, the same percentage is applied to contract revenue to recognize the income. Under this method, the revenues and expenses are recognized only to the extent the project completes. To ascertain the percentage of completed work, one may have to rely on certifications by external competent parties such as architects, valuers, or other qualified persons. Under TCJA, the threshold for using the cash method of accounting and the completed contract method of accounting for long-term projects significantly changed, allowing more contractors flexibility. The Tax Cuts and Jobs Act changed tax planning for many business owners in the construction industry.

What is the Right Construction Accounting Methods?

But the final standard, unlike the earlier drafts, is a standard the construction industry can work with. Moreover, SOP 81-1 does not excuse the unsophisticated contractor from being required to employ its methodolgy for the recognition of revenue construction bookkeeping on long-term construction contracts. The main advantage of EPCM is that income is reported over the life of the contract and any losses will be recognized based on the percentage of the contract completed, called the completion factor.

• Accounting method decisions are multi factorial, so businesses should discuss these options with their CPAs.
• Based on your reading and outside research, communicate your own understanding of the requirements.
• Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
• The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost.
• Accrual excluding retainage is similar to accrual; however, it has the advantage of not recognizing retainage until it is received.

From change orders and retainage to weather delays and customer disputes, there are many reasons construction projects cannot be billed on a traditional production timeline. The varying construction accounting methods take those factors into account to minimize interruptions to cash flow. The accrual basis method determines cash flow based on the matching principle. Promised payments are considered as revenue even if the corresponding invoice has not been paid. This method allows construction companies to know what their accounts receivable should be once payments are completed. A contractor’s tax return can have more than one method of accounting at the same time.

Completed Contract Method (CCM)

In the accrual method, expenses are recognized when “incurred,” and incomes are recognized when they are “earned.” It gives better clarity of the project’s financial status than the cash method. Because the PCM is the method that must be used for alternative minimum tax calculations, businesses subject to the AMT may not see a tax benefit from switching to the completed contract method. Prior to 2018, businesses were only able to use the cash method of accounting if their average annual gross receipts for the past three years were $10 million or less. The threshold was raised to $25 million, adjusted for inflation annually.

• The Percentage of Completion Capitalized Cost Method can be used on residential contracts.
• This equity may be held by the owner or shareholders depending on the business structure.
• One potential downside of the percentage of completion method is that businesses may incidentally underpay or overpay for taxes depending on how accurately they estimate costs.
• Even when they are not collectible within the “current” timeframe of 12 months, retainage accounts are typically shown as current accounts and current liabilities, respectively.
• If a business has multiple projects that are completed within the same year, or if their taxes come due in the same year that working capital is earmarked for another project, the company’s working capital may be at capacity.
• Further, construction doesn’t happen in a warehouse or on an assembly line — it occurs on various job sites.

In this type of accounting, the costs are allocated to the specific project-related. The allocated costs include various costs such as material, labor, architectural fees, consultancy fees, and so on. Apart from these costs, indirect expenses are also allocated to the projects. In most cases, contractors prefer the completed contract method because it lets them defer taxable income for longer, but there are a few downsides to switching from PCM to completed contract method.

Controlling costs with construction accounting

With project completion delayed, the final invoice reflecting the accurate job costing won’t be sent until the next fiscal quarter which will have a higher tax rate. The new revenue standard requires that entities present either a contract asset or a contract liability. A contract asset is created when an entity satisfies a performance obligation by delivering the promised good or service and has earned a right to consideration from the customer. Alternatively, when the customer performs by prepaying its promised consideration the entity has a contract liability. Also, since the contractor has a history of executing unpriced change orders, the contractor might conclude that it expects the price of the change order to be approved.

For 2022, taxpayers with three-year average annual gross receipts of $27 million or less are not required to use the PCM when accounting for long-term contracts that are estimated to last up to two years. Except for home construction contracts, the PCM method must be used for all current CCM contracts to determine any alternative minimum tax liability, and the lookback method must be applied to determine any overpayment or underpayment of interest. There is also a percentage of completion-capitalized cost method that can be used for residential apartment contracts, where at least 80% of the total contract cost is attributed to the construction of the buildings.

Company

Long-term contacts are the contracts that are to be completed in more than five years. It includes a lengthy process and requires a lot of time to complete. Long-term contracts require proper planning of strategies to complete the project in a specified time. Accounting ratios are calculations that a construction business can use to get an overview of its financial health.

• The ASC 606 set by the Financial Accounting Standards Board provides revenue recognition guidance for any revenue gained from customer contracts.
• Payment is made based on completing project milestones or predetermined dates, i.e. a weekly or monthly schedule.
• The first exemption available to taxpayers is the “small contractor’s exemption.” To qualify for this exemption, the taxpayer’s AAGR for the past three years must be below $10 million.
• Revenues, expenses, and gross profit are recognized each accounting period based on an estimate of the percentage of completion of the project.
• To help organize each project, contractors use job costing, a process where revenue and expenses for each project are segregated into distinct profit centers.

Individual companies, industry associations, governmental agencies, practicing accountants, academicians, professional accounting organizations, and public opinion. Companies will be more likely to comply with GAAP and the time to research accounting issues will be substantially reduced. Def.) Is a schedule explaining any differences between the bank’s and the company’s records of cash. If the difference results only from transactions not yet recorded by the bank, the company’s record of cash is considered correct. B.) The Net Method is more theoretically correct because it “values the receivable at its Net Realizable Value.” It provides a better assessment of “revenue recognized” from the sale of the product. B.) Trade discounts are NOT recorded in the accounts because the price finally quoted is generally an accurate representation of the “Fair Market Value” of the product on that date.

With the cash method, a company recognizes revenues when it receives payment and recognizes expenses when it pays bills. Calculating profit is simple, since profit is just cash received minus cash disbursed. Job costing is a form of project-based accounting that helps construction companies keep track of the expenses for a specific job or project. Different accounting methods are necessary to address all these potential issues to better streamline tax reporting and maintain compliance with financial reporting agencies. While it makes sense to only record revenue or expenses after a transaction is complete, the cash method of accounting can be difficult to maintain if there are unanticipated payment delays or disputes.