Why do almost three out of five contracting companies have financial blind spots even with standard accounting systems in place?
The problem here is that there is a critical misconception that construction accounting is merely ordinary accounting with a project; it is a specialized profession created to suit an industry where costs change each day, revenues take months or years, and profitability is monitored on a job-by-job basis rather than monthly.
Construction has been among the most financially complicated industries in recent years. Projects are habitually associated with lengthy schedules, varied material costs, a labour-intensive sub-contractor model, and billing via milestones.
The data available from the industry last year indicates that construction businesses have net profit margins averaging less than 6%. Thus, there is not much room for accounting errors, missed cost tracking, or inaccurate revenue recognition. General accounting in this environment is hardly enough.
General accounting deals with the structured framework, including ledgers, financial statements, compliance, and reporting. Construction accounting, however, takes that framework a step further to reflect the economic realities of a project.
It brings in job costing, work-in-progress (WIP) reporting, progress billing, retainage tracking, and percentage-of-completion revenue recognition practices that are fundamentally necessary but not very common in conventional accounting models.
It is necessary to point out that construction accounting is not the rival of general accounting. It is a professional branch that was created to address industry-related issues. Similar to manufacturing, healthcare, or e-commerce accounting, construction accounting also changes the core principles depending on the unique needs of the operation, though, in this case, each project is a mini business.
The construction accounting environment is not an exception. The compliance rules, billing cycles, and reporting standards differ among contractors operating commercially and between the government and individual contractors. That is why a universal accounting method frequently leads to delayed information flow, cash flow, and loss of profits.
This is why construction accounting vs. general accounting is not really the question; it is why the construction business, which is based on general accounting, is usually unable to see real-time profitability, control costs, or predict cash flows correctly.
This blog dissects what actually makes construction accounting different, why the construction industry requires it, and how the approach to selecting the correct accounting method can be the difference between surviving construction projects and climbing the profit ladder.
What is Construction Accounting?
Construction accounting is a specialized method of accounting that addresses problems and concerns unique to the construction industry. Construction companies are project-based, meaning they are likely working on multiple projects at one time. Each of these projects has different contractual terms that must be met.
Plus, construction is a largely decentralized business landscape, with every project needing different materials from numerous suppliers. This means that financial data needs to be organized and processed separately. On top of that, this means the business has a wide range of short-term and long-term liabilities to manage. Collections and accounts receivable for construction accounting are also far more complex.
Why is There a Need for Construction Accounting?
The point is that while construction businesses have a lot of work a general accountant can address, this is not enough. Construction businesses need specialized accountants who know how things work. These professionals are used to working in high-stress environments and can navigate through the complexities that arise.
Adherence to the ASC606 Standard
Project-based industries such as the construction sector operate under the ASC 606 revenue recognition standard. This standard comes under the umbrella of GAAP and is the choice for most construction business owners. A construction account specialist will be expected to understand how ASC 606 compliance works and operate the accounting function accordingly.
Managing Individual Project Expenses
Under this standard, several processes need to be adjusted. Firms are typically working on multiple projects at once, which means managing various profit centers. Even under the same contract, mvariousprojects can need to be managed. Each of these projects, while attached to a single client, is treated as a different project with its own individual costs that need to be managed. This makes management much cleaner and allows for a clearer view of financial health and performance.
Revenue Recognition Strategy
Another distinction under this standard is revenue recognition. Before ASC 606, construction firms accepted payment under either the Contract Completion Method (CCM) or the Percentage Completion Method (PCM). They received payment at project completion or upon completion of a certain percentage of the project.
Under ASC606, revenue is now recognized as a performance obligation, with payment collected after certain pre-specified performance obligations are completed. These obligations are broadly understood as goods or services that can stand on their own and provide value to the client, separate from other goods or services in the contract.
Contractual Factors Unique to the Construction Industry
On top of all this, other contractual factors to be considered include retainage clauses, customer disputes, and off-sync billing. Let’s illustrate these nuances of construction accounting with one big example.
Construction firm A is contracted by Company B to build three apartment buildings for $10 million in two years. Firm A separates all three apartment buildings into individual projects, each with its own costs, such as labor and materials.
The firm also ensures that each building’s completion is considered a performance obligation. Since building 1 is twice the size of the others, it will cost $6 million, which will be collected upon completion. The other two will be worth $2 million each, and revenue will be recognized upon project completion.
In all this, Company B sets up a 20% retainage, meaning it will withhold 20% of the total payment until it is it is satisfied with the result. This means that firm A’s invoices throughout the contract will be based on a total cost of $8 million, with $2 million retained. Then, when Company B is satisfied, an invoice for the $2 million will be generated.
This will also mean that the revenue for each building will now be adjusted. Building 1 now costs $5 million, and the other two $1.5 Million each. This $2 million is not counted as accounts receivable and is instead recorded as a separate asset account in company A’s books. Company A will also need to adjust its cash flow projections to account for these changes and clauses.
As you can see, this is far more nuanced than general accounting and bookkeeping. Managing these many different moving parts is essential to construction accounting. At every step of the way, the contract needs to be consulted and compliance ensured.
Construction Accounting vs. General Accounting: Key Differences
What is the difference between construction accounting and regular accounting?
Let’s look at some ways construction accounting is distinct from general accounting. This should give you a feel for what we mean when we say it needs a unique skill set.
Management of Multiple Sales Categories
One of the defining characteristics of a construction firm is the diversity of services offered. Construction firms can be contracted for consulting, architectural design, engineering, labor procurement, and material procurement, among other services.
Often, multiple construction firms work on the same project, each contracted to provide one piece of the puzzle. For example, a firm may be contracted to design a project, but it may be too expensive on the construction front. A more affordable contractor will be contracted to build the project based on the designs of the other firm.
Other industries, such as software engineering, also have diverse channels, but construction accounting is among the most complex in this regard. The accounting professionals on board have their work cut out for them, managing multiple contracts and financial arrangements.
Complexity of Cost of Goods Sold (COGS)
When tracking all costs for a particular building project, all expenses are recorded as COGS. This includes everything from labor costs to material costs. In contrast, retail and other goods-selling businesses record costs per item sold. This depends on the method of inventory valuation they use.
Each specific expense of a unique project is recorded under COGS in construction rather than as a standard cost for all projects. One project may end up using expensive cement, for example, while another opts for something cheaper.
Labor may request different wages for different projects. Thus, no standardization is involved. Every project operates on its own cost basis, and accountants must manage all these varying expenses under COGS.
Dealing with Overhead
Another nuance of the construction sector is the blurriness of the line between COGS and overhead. Overhead is the cost of keeping the firm going and cannot be attributed to a specific business project. For example, if a bulldozer is used in construction, the driver’s wages and fuel consumed will be included in COGS.
However, depreciation of the equipment and its maintenance will be treated as overhead. This is because the fuel and labor consumed were for the project. The bulldozer is a company asset that can be used for multiple projects. Thus, the cost of maintaining it is overhead and not COGS.
Determining what is overhead and what is not is incredibly complex in construction. The example above shows that even operating a machine has overhead and COGS. Being able to categorize and record these expenses properly is part of what makes construction accountants different.
Challenged in Evaluating Financial Performance and Profitability
Another big roadblock for construction businesses is the difficulty in evaluating financial performance.
Unlike many other industries, the project-based nature makes things much harder. Broad trends cannot be analyzed, as every project costs differently. Pair this with the fact that construction projects are almost always long-term, sometimes lasting over 5 years. This means that profitability will be affected as market trends switch.
Costs of materials and wages will change, which means the project’s COGS and overhead will be affected. Then there are problems like weather, security, and the like that can affect costs.
The bottom line is that numerous factors constantly affect cost. Unlike retail, where prices are determined after the product is procured, construction is pre-decided. All of these things need to be considered when evaluating financial performance. Contracts must also be open to account for inflation and changing costs for very long projects.
This means accountants have to be deeply involved in the planning process. Regular reporting is a requirement to ensure things stay on track. Calculating the profitability of a construction business is an incredibly difficult task. Only experience can help you here. This is why construction firms need specialized accounting rather than general accounting.
Find Your Ideal Construction Accountant with Expertise Accelerated
If you want to learn more about construction accounting, especially the outsourced variety, we are here to help!
Expertise Accelerated connects US businesses of all stripes with their ideal accounting professionals. Through EA, US businesses can easily access the global pool of remote accounting talent. For construction accounting, you can provide us with your requirements, and we will handle the rest!
Think of EA as your one-stop shop for all things accounting. Need someone to manage bookkeeping? We have you covered. Need a hand optimizing your finances and improving profitability? No problem, we’re on the case.
Book a free consultation with EA CEO Haroon Jafree today and see who you work with. If nothing else, it should prove an informative and productive conversation. And should the stars align, you will find a stalwart aid to your construction accounting efforts in EA.
