Understanding the Basics of Accounting in Construction Industry
Accounting is an important aspect of running a company, ensuring profitability and transparency. However, for the construction industry, the concept of accounting is little different and complex. In this blog, we will understand how accounting in construction industry is different from the regular practices, what the challenges are, and why it is crucial to seek professional help to improve your accounting system.
How Accounting in Construction is Different?
Accounting for construction industry is more intricate and challenging. Therefore, firms should have a different approach for accounts management. Here is how construction accounting is unique from that of regular businesses:
- Sales: Most companies have a product or service line of 1-5 categories. Thus, accounting for sales is less complicated. However, for construction companies, it is not so simple. They have a wide range of service categories – consulting, design, engineering, service work, materials, labour, etc. With such manifold business, accounting can be difficult.
- Expenses/Overhead: In general accounting, there is a transparency between overhead and cost of goods sold. In the construction industry, items that usually fall under the category of overhead would be considered as cost of goods sold because it is related to a client’s project directly.
- Cost of Goods Sold: In regular accounting practice, the cost of product sold is recorded simply. However, for the construction industry, maintaining cost of goods sold is difficult. Every job has both direct and indirect costs, falling under the purview of various categories. Recordkeeping can be elaborate and problematical.
- Break Even: For general businesses, break event point is calculated on the basis of where income cuts over expenses. For construction firms and contractors, calculating breakeven is easy said than done. There are so many categories of items that it becomes harder to achieve break even on a project. Moreover, there are hundreds of custom jobs, each having unique requirements and varied associated costs.
Common Accounting Mistakes
When construction companies adopt general accounting principles, the following errors can show up on their financial statements. It is important to avoid such accounting mistakes and use advanced software solution designed particularly for the construction industry.
1. Not Accounting Estimated Job Costs Properly
Estimated job cost is most vital for any construction project because contractors mostly use the percentage-of-completion approach to calculate revenues. However, mistakes occur in accounting estimated job costs due to poor forecasting/estimating, inappropriate accumulation of actual costs, or excluding revisions inaccurately in case of change orders.
To avoid this, it is vital to compare actual project cost to estimated costs on a monthly basis and make sure both includes the same elements. Future increase in wages and prices should also be taken into consideration, and likewise, monthly revisions should be made in the estimated cost.
2. Inaccurate Assignment of Overhead to Jobs
Most construction firms and subcontractors use overhead rate for allocation of indirect costs such as depreciation, utilities, etc. to individual jobs. This is generally calculated by using a fixed percentage that is multiplied by either material costs or direct labour costs. However, most often, the overhead rate is not tracked to determine whether it accurately represents the firm’s current overhead costs. This results into under-or-over allocation of costs.
Prevent this mistake by monitoring the overhead rate on an annual basis to ensure that the costs are input accurately and an appropriate method is used that considers important elements of construction labour, materials and activities.
3. Inappropriate Job Cost Cut-off
Most construction firms adopt the accrual accounting method in which costs and revenues incurred and earned are recorded in the period. However, cut-off mistakes arise as a result of excluding the costs incurred during the period being accounted. This often happens when certain invoices are received after the period and are not recorded in accounts payable closing process.
You can avoid this error by implementing a voucher system that records the costs as liabilities incurred in the period. You can then match the accrued costs with the received invoices, and make payments as shown in accounts payable.
4. Not Recording 100% of Loss Contracts in the Period
In construction industry, the percentage-of-completion method is popularly used for revenue calculation. This can lead to an accounting error when it is not considered whether the job that is estimated is a loss. A loss contract should be accounted fully when determining a loss. Prevent this by monitoring the job schedule in detail that comprises estimated cost, estimate job revenue, and estimated gross profit or loss. When you record estimated loss, an accrual of loss should also be accounted for.
Widely Used Construction Accounting Methods
Here is a quick glimpse of most commonly used accounting methods for construction industry:
- Percentage of Completion: Construction businesses widely use the percentage to completion method to calculate their gross profits in each period instead of doing it after job completion. It helps calculate the profit or loss of a construction project in progress.
- Job Costing: This is another standard practice of construction accounting wherein you have to allocate all direct and indirect revenues and costs to each contract or job. This simplifies the process of tax preparation and also provides contract profitability.
- Completed Contract: In this method, all job expenses are capitalised. This means recording the expenses as an asset to the balance sheet. Revenues received are moved as liabilities in the balance sheet. After completion of the contract, the expenses are revenues are moved from the balance sheet to the right income and expense accounts.
- Cash Basis: The simple accounting method is frequently used in the construction industry wherein revenues and expenses are recorded as and when received and paid.
Get Expert Advice for Accounting in Construction Business
Accounting for construction business can be most challenging and daunting. Additionally, it is a time-consuming process and creates backlogs.
Get expert help from chartered certified accountants who have vast knowledge and experience in accounting for construction industry. They use cutting-edge technology and keen expertise to save time on paperwork and accurate tracking and recordkeeping to ensure profitability.