Construction accounting vs. general accounting is not exactly the type of comparison people might think it is. Working in a construction company is different from working in any other business.
It is helpful to distinguish what makes construction accounting different from regular accounting. However, it must be clarified that these two are not directly comparable.
Construction accounting is more of a subset of general accounting. Think of general accounting as an umbrella term, with various niches of accounting coming under that umbrella. These niches all align with the basic principles of general accounting. The difference is in their unique practices and concerns based on their industry. Construction accounting is different from e-commerce accounting, for example. It is also distinct from accounting in the manufacturing industry.
Even within construction accounting, you have distinctions like private contractors and government construction. Rather than construction accounting vs. general accounting, the question should be about what makes construction accounting different from general accounting.
With that premise set, let’s answer what makes construction accounting different. Some of you may also be wondering why there would be a need for construction accounting. Is general accounting not solid enough for the construction industry? This blog post will answer all these questions and more, so strap in!
Table of Contents
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 need to be fulfilled. 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 separately organized and processed. On top of that, this means the business has a wide variety of short-term and long-term liabilities that need to be juggled. 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 like the construction sector operate on the ASC606 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 know how ASC606 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 multiple profit centers. Even under the same contract, multiple projects 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 a clearer look at financial health and performance.
Revenue Recognition Strategy
Another distinction under this standard is revenue recognition. Before ASC606, construction firms either accepted payment on a Contract Completion Method (CCM) or a Percentage Completion Method (PCM) basis. They accepted payment at project completion or upon completion of a certain percentage of the project. Under ASC606, the revenue is now recognized as a performance obligation, where payment is collected after certain pre-specified performance obligations are completed. These obligations are broadly understood as goods or services that can stand independently and provide value to the client while separate from other goods or services in the contract.
Contractual Factors Unique to the Construction Industry
On top of all this, other contractual factors are to be considered, such as retainage clauses, customer disputes, and off-sync billing times. 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 with their separate 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 cost, which means it will withhold 20% of the total payment until 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 of accounts. 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. Every step of the way, the contract needs to be consulted, and compliance needs to be 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 designing, engineering, labor procurement, material procurement, etc. Many times, multiple construction firms are working 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 then to build the project based on the designs of the other firm.
Other industries, like software engineering, also have such diverse channels, but construction accounting is one of 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 of the costs of a particular building project, all expenses are recorded as the COGS. This includes everything from labor costs to material costs. In contrast, retail and other goods-selling businesses record costs based on each item sold. This depends on the method of inventory valuation they use.
Every specific expense of a unique project is recorded under the COGS in construction rather than a standard cost for all projects. One project may end up using expensive cement, for example, while another opts for something cheaper. Labor may ask for varying wages on different projects. Thus, there is no standardization involved. Every project operates on its individual costing, and accountants must manage all these varying expenses under the COGS.
Dealing with Overhead
Another nuance of the construction sector is the blurriness of the line between COGS and overhead. Overhead is the cost to keep the firm going and cannot be attached to a specific business project. For example, if a bulldozer is used in construction, the wages of the driver and the fuel consumed will come under COGS. However, the depreciation of the equipment and its maintenance will come under 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 these expenses and record them 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 is cost differently. Pair this up with the fact that construction projects are almost always long-term, sometimes extending for 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 are going to 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. All of this is to say that 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!
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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.