If you are a small business owner in the construction industry, you may have heard of percentage-of-completion accounting. But what does it mean, and how does it affect your financial reporting and tax obligations? In this blog post, we will explain the basics of percentage-of-completion accounting, the challenges it poses, and some tips to help you handle it.
What does percentage-of-completion mean for construction companies?
Percentage-of-completion is a method of accounting that recognizes revenue and expenses based on the progress of a long-term contract. For example, if you have completed 25% of a long-term contract at the end of the year, you can recognize 25% of the contract revenue and expenses in that period.
This method is required by the IRS for most construction contracts, but there are exceptions for home construction contracts and small construction contracts completed within 2 years that meet the gross receipts test. The reason is that percentage-of-completion provides a more accurate picture of your business performance than other methods, such as completed contract or cash basis, which only recognize revenue and expenses when the contract is finished or when cash is received or paid.
However, percentage-of-completion also has some implications for your cash flow and tax liability. For instance, if you recognize revenue before you receive payment from your customer, you may have to pay taxes on income that you have not yet collected. Conversely, if you incur expenses before you bill your customer, you may have to wait until the contract is completed to fully deduct them from your taxable income. You should adjust your operations for these factors when using the percentage-of-completion method.
What makes accounting for percentage-of-completion complicated?
Percentage-of-completion accounting can be complex and time-consuming. Some of the challenges include:
Project cost tracking:
How do you keep track of all the direct and indirect costs associated with each contract, such as labor, materials, equipment, overhead, and subcontractors? You also need to allocate these costs to each stage of the project and update them regularly as the project progresses.
Which method are you using to measure the percentage-of-completion for each contract? There are different methods available, such as cost-to-cost method, simplified cost-to-cost method, 10% method, and capitalized-cost method. Each method has its advantages and disadvantages depending on the nature and scope of your project.
Assessing work progress:
How do you calculate how much work has been completed and estimate how much remains to be done for each contract? This can be difficult if your project involves intangible or qualitative aspects, such as design or engineering. You also need to account for changes in the contract scope, specifications, or schedule that may affect your progress.
Did you know you need to calculate the interest due to or from the taxpayer at the end of the contract? You do this by comparing the actual taxes paid each year, which were based on estimates, to what the taxes paid would have been using the actual costs and contract price. Check out IRS form 8697 for more information.
Percentage-of-completion accounting can be overwhelming for small business owners who do not have the resources or expertise to handle it properly. However, there are some options that can help you simplify it and avoid errors and penalties. Some of these options are:
Budgeting & forecasting:
Prepare a realistic budget and forecast for each contract that includes all the expected costs and revenues. Monitor your actual results against your budget and adjust your forecast as things change.
Simplified cost-to-cost method:
The cost-to-cost method calculates your percentage-of-completion by taking the costs incurred divided by the estimated costs to be incurred, including allocable indirect costs. The simplified method makes it easier by focusing on just direct material costs, direct labor costs, and depreciation.
You should carefully select and supervise your subcontractors to ensure that they deliver quality work on time and within budget. You should also verify their invoices and payments to quickly resolve any disputes and keep projects on track.
Whether you have a spreadsheet or industry-specific software, don’t reinvent the wheel on every job. Utilize templates that reduce the amount of time and energy it takes to quote, budget, track, and complete. If you can batch process or automate, even better.
Working with a qualified accountant:
Consult or engage with a qualified accountant to help you with calculations, accounting, and taxes, all in one! An accountant can help with both the technical and the touchy subjects, offering a hand in the work or an ear to your issues.
Working with Haworth & Company, Ltd.
At Haworth & Company, Ltd., we have over 30 years of experience providing accounting and tax services to small businesses in Minnesota. We understand the unique challenges and opportunities that construction companies face in their industries. We can help you with percentage-of-completion accounting, as well as bookkeeping, payroll, business consulting, tax planning, and more. Contact us today and see how we can help you.