Understanding your financial health is a critical component to any construction business. In construction accounting, there are two primary methods of tracking income and expenses: Accrual method and cash basis method. In this article, we’ll look at the pros and cons of these two accounting methods, and when to use each one.
The cash basis method of accounting is simple and straight-forward, meaning that you will track cash out and cash in. The accrual method requires a more robust accounting process and is based on the premises that work completed and forecasted is to be received and paid later.
Construction accounting is a tool to understand how much money you are receiving due to completed work, outstanding invoices, and work completed but unbilled. The accounting process allows you to understand how to manage your money, when and how soon to pay your invoices, and provides actionable insights that help you improve your cash flow.
Cash accounting for contractors
The cash method is the simplest, but least accurate accounting method that small contractors use for their bookkeeping. Many small contractors use this method, as it is as close to their “cash reality” as they can get.
The cash method is a simple way of tracking payments and expenditures by recording the flow of money. Using the cash method, you record revenue only when you receive a payment. Likewise, you record expenses only after you pay your vendor or supplier.
For example, if you are a homebuilder and you are paying an invoice for lumber, the moment you cut a check, it hits your book as a cash outlay. It doesn’t matter whether you actually took possession of the lumber yesterday or last month; you’re only looking at the moment the money left your account.
In the US, only contractors whose gross receipts are under $5 million can use cash basis accounting. The cash method of accounting is not recognized under Generally Accepted Accounting Principles (GAAP).
An example of cash accounting
If you are using the cash method in a construction project, it will look something like this.
Let’s say you are the owner of ABC Earthmovers and you completed one project in April. Let’s call that project “Johnson house.” You sent an invoice for $250,000, due 30 days from the invoice date. For the month of April, you record $0 of revenue for the period, since you haven’t received the cash yet.
However, you are still paying your employees ($45,000 that month), buying office supplies (pay FedEx and Office Max $4,000), and covering other costs during the month. You will record those as expenses in April – the month when you spent the money.
Assuming that you are paid on time in May, you’ll record the revenue for the project in that month. For this example, we’ll assume that your expenses are consistent from month-to-month.
April
| Job name | Revenue | Expenses | Net Profit |
|---|---|---|---|
| Johnson House | $0 | -$49,000 | -$49,000 |
May
| Job name | Revenue | Expenses | Net Profit |
|---|---|---|---|
| Johnson House | $250,000 | -$49,000 | $152,000 |
Using the cash method in this example, you didn’t recognize any revenue in April, when you actually completed the work. For that month, you had a loss of $49k. However, your profit goes back up in May, when you record that income. After subtracting expenses, our total profit for this period would be $152,000.
Advantages of the Cash Method
- Useful for small companies that get paid in cash.
- Simple and straightforward to use.
- Easy bookkeeping; doesn’t require accounting expertise.
- Allows you to defer taxes until a future period (when cash is recorded).
Limitations of the Cash Method
If your construction business were as simplified as the example above, the cash method may work well for you. But construction projects are never that simple! You probably have multiple projects happening at once, with a variety of customers and vendors. All of them want to pay (or be paid) at different times. Using the cash method, it can be hard to track when everything is due.
A cash method has some notable disadvantages:
- Not everyone can use it; cash basis accounting is limited to contractors whose revenue is under $5m per year.
- You may struggle to get financing or loans without GAAP approved method.
- Not helpful for decision-making; it’s difficult to see trends.
- Provides no visibility into accrued work, as it is only used to record transactions once payment is received or issued.
- Accounts payable and receivable can fall through the cracks.
- Doesn’t provide an accurate picture of a contractor’s financial health.
Accrual accounting for contractors
When using the accrual based method, you record the revenue or expenses during the period the work is performed – whether or not you received or paid any money during that period. The accrual based method is a way to track the money you will receive in the future for each project. In this process, you don’t need to wait to actually get paid or issue the check to your supplier. The moment you send your invoice or pay application to the GC, you record the revenue. Under accrual basis accounting, you effectively assume that work is acceptable to the other party and that you will receive the payment due.
An example of accrual accounting
The accrual based example is treated differently. For this example, we are using the same numbers as we did for the cash example above. ABC Earthmovers completed one project in the month of April. The work performed during that month was worth $250,000, all labor and rentals included.
As soon as you submit your first pay application (App #1) in April, you record the revenue of $250,000 – even though you haven’t received it yet. You will record that amount in accounts receivable (A/R).
During the next billing cycle in May, you send another pay application (App #2), and record the revenue.
April
| Job name | Revenue | Expenses | Net Profit |
|---|---|---|---|
| Johnson House | $250,000 | -$49,000 | $201,000 |
May
| Job name | Revenue | Expenses | Net Profit |
|---|---|---|---|
| Johnson House | $250,000 | -$49,000 | $402,000 |
It may look, at first glance, like the accrual method resulted in a larger net profit than the cash basis method above. But these are two different accounting methods for the exact same business. Their financial position is exactly the same – they only appear different because income and expenses were recorded at a different time.
Advantages of the accrual method
- Better for capital-heavy industry with long delays between work and payment.
- Good tool for financial management; easier to analyze patterns.
- GAAP-approved accounting method.
- Much more accurate reflection of a company’s financial health.
Limitations of Accrual Method
- Not helpful to companies that get paid in cash, soon after the work is done.
- This method does not accurately reflect your cash position. Requires additional preparation of cash flow statements.
- More difficult to maintain; requires constant attention to journal entries.
- You are liable for taxes on income before you actually receive the money.
- Requires more robust knowledge of accounting.
Cash vs. Accrual: Choosing Your Best Option
Not sure which way to go? Here are some questions to consider.
Do you:
- Earn revenue under $5 million per year?
- Work exclusively on short-term projects?
- Get paid immediately, or soon after you finish a project?
- Know nothing about accounting?
- Only want to pay taxes after you have the cash in hand?
If you answered “Yes” to all of the above questions, then you may benefit from the cash method. However, if you answered “No” to even one question, then the accrual method will be your best bet.
Contract accounting methods for contractors
Contractors don’t just need to know what their money is doing over a specific period. You also need to understand the financial health of each construction project (or contract) that you take on. There are two project-based accounting methods for contracts: Completed contract method and percentage of completion (PoC).
Completed Contract Method
The completed contract method defers all revenue, expenses, and gross profits until substantial completion of the project. This is a more straightforward and conservative approach than PoC accounting, though both will yield the same results. The primary difference is that, using completed contract, you will only recognize revenue at the end of a project.
If this sounds strikingly similar to the cash method we talked about above, it’s because they are nearly identical in practice. They both record revenue and expenses after the fact. However, cash basis accounting only records income or expenses after the cash moves. Completed contract accounting records income and expenses after the contract is finished – whether cash has moved or not. Just like cash accounting, completed contract method is not recognized by GAAP. The IRS doesn’t allow completed contract accounting on long-term projects, or those of a particular dollar value.
Percentage of Completion (PoC) Method
The percentage of completion method is the most commonly used accounting method by contractors, and is similar to accrual accounting. PoC works by recording revenues and expenses as the work is in progress. Most construction companies (along with accounting firms, banks, and the IRS) prefer this method, since it provides a more accurate picture of the financial health of individual projects. PoC accounting is especially useful on jobs with a long timeline.
Learn more
- Financial statements every contractor should know
- Accounting reports that help contractors spot cash flow problems