Construction companies face an imposingly complex choice when it comes to their accounting methods. Because no two projects are ever alike, and your earnings may fluctuate from year to year, it’s important to know your options.
The IRS has stated that contractors must select an accounting method that clearly reflects their income. You may choose from four approaches:
- The cash method. A cash method taxpayer recognizes income when it’s received. But a taxpayer may not use the cash method if its total merchandise purchases for the year are substantial compared to its gross receipts. Thus, most contractors can’t use it because merchandise includes any item physically incorporated in a product, including all building materials.
- The accrual method. With this approach, a taxpayer recognizes income and expenses when the underlying service or event occurs, which isn’t necessarily when cash changes hands. A major benefit of this method is that it provides a more accurate matching of revenue and expenses as both are recorded when incurred, not necessarily when paid. This method can also allow additional tax-planning opportunities through year-end accruals.
- The accrual-excluding-retentions method. This seldom-used method is similar to the accrual method except that revenue from retainages isn’t recognized until the contractor is entitled to receive it.
- A hybrid method. Another rarely used approach, this combines the cash and accrual methods. For example, the cash method is used for receipts and expenses and the accrual method is used for accounts receivable and payable.
Along with selecting an overall approach, you must choose an additional a c c o u n t i n g method if you have long-term contracts. A contract is considered long-term if it isn’t completed in the same year it’s started, regardless of the time you take to actually complete the job.
You need to pick an accounting method in the first year of the contract. The two most common approaches are:
- The percentage- of-completion method. Here you report income according to the percentage of the contract completed during the year. This percentage is calculated by comparing expenses allocated to the contract and incurred during the year with the estimated total contract costs.
- The completed-contract method. Under this approach, income isn’t reported until you complete a contract, even though you may receive payments in years before completion. Thus, it is advantageous because you can defer taxes.
You cannot, however, include the cost of supplies or materials you allocated to the contract but never used as an allocable contract expense. These supplies must remain on the books as an asset until they are used in a project. At that time, they may be deducted.
Whether you can use the completed- contract method depends on the size of your company as measured by gross receipts. Larger construction businesses (those with gross receipts over $10 million) must always use the percentage-of-completion method, while smaller ones must do so only for contracts that will take longer than two years to complete.
Construction companies with gross receipts under $10 million may use the completed-contract method for contracts they’ll complete in less than two years.
As you can see, choosing the right accounting method depends on a variety of factors. Complicating matters, you may want – or be required – to change methods as your business grows. Thus, this is a decision you’ll need to revisit regularly.