Construction Accounting Guide: Key Elements and Methods - Firstbit Blog
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What You Need to Know About Construction Accounting

What You Need to Know About Construction Accounting

If you’ve ever had the chance to study basic accounting and finance in your academic career, you’ll know that accounting principles are more or less the same across all industries. When it comes to the construction industry, many of the same accounting principles still apply. However, it’s the continually adjusting and project-based nature of the construction industry that has given rise to the need for a separate branch of accounting that accommodates the specific requirements of the industry.

This article serves as your guide to construction accounting, detailing what it is, its characteristics, different methods used, and finally, the nuances of construction accounting in the UAE.
Contents

What is Construction Accounting?

Construction accounting is a specialized form of accounting tailored to the construction industry. It addresses the unique financial and operational aspects of construction projects, such as long contract durations, irregular billing schedules, and project-based workflows.

This type of accounting involves specific methods for financial reporting and tax rules compliance to manage the complexities of tracking costs, revenues, and profits over the specific life of construction projects.

Characteristics of Construction Accounting

The following are the primary characteristics of construction accounting that make it different from regular accounting:

Project-Based Accounting

Construction operates on a project-based production method. Each project involves a diverse range of processes, materials, and equipment, and each of these has its own costs that need to be tracked and managed.

Construction accounting is the practice of managing these financial aspects, with its key characteristic being its project-based nature. This means that financial tracking, budgeting, and reporting are tailored to each specific project, allowing for detailed oversight and management of resources, expenses, and revenues. This project-centric approach ensures that each construction project is financially viable and accurately accounted for from start to finish.

Special software for effective accounting practices helps construction firms manage project budgets, track cash flow, identify cost overruns, and ensure profitability amidst the complexities of project-based production. It can be an industry-specific accounting software or even an ERP system as a complex solution.
Improve your construction accounting with FirstBit

Decentralized Production

In construction, work happens on different sites, so companies need to move people and equipment between locations. They have to keep track of transportation costs and set up equipment at new sites. They also have to follow local rules and pay local wages, which can vary. Additionally, in construction, instead of buying vehicles, many companies lease them, which affects their finances.

Contractors must maintain precise records of mobilization costs in order to provide clients with invoices that reflect the full amount of expenses incurred. Another issue here is that contractors may not retain large amounts of inventory due to the unpredictable nature of production. This can lead to fluctuating costs and availability of production inputs, requiring meticulous tracking and special construction accounting methods that account for the variations due to decentralized production.

Long-Term Contracts

Long-term contracts in the construction industry can significantly impact cash flow due to the extended duration of these contracts and the associated revenue recognition methods.

Contractual agreements for projects often span several years, incorporating staggered payments throughout their duration. Additionally, retention withholding or the occurrence of disputes can even prolong the payment process.
It is imperative for contractors to employ meticulous tracking and reporting methods, alongside effective strategies for collection and cash flow management, to navigate the complexities.

Changing Direct and Indirect Expenses

The costs for a construction project can be hard to predict because they can go up and down. Labor and materials can get more expensive while a project is going on. It's especially hard for contractors to know how much materials will cost ahead of time. Other costs like administrative fees and insurance can also change during a long project, giving rise to the need for a special type of accounting method.

Construction Accounting Framework

The construction accounting framework helps manage the money of construction projects in a specific way. It keeps careful track of costs and income, and also handles contracts and rules to give a full picture of finances for those involved. Let's examine it more closely.

Job Costing

You may be curious as to why the General Ledger (GL) alone is not sufficient for your construction accounting processes. While the GL can indeed address some of your accounting requirements, it is important to note that for proper construction accounting, job costing is essential.

Construction accounting is focused on individual projects and production is spread out, so contractors must have a method to monitor and document transactions for each job.

Job costing is an accounting method that focuses on tracing and assigning costs directly to specific projects, contracts, or jobs. This method is particularly useful for one-of-a-kind or personalized projects that need detailed cost tracking and analysis on a project-by-project basis.
For instance, a construction firm engaged in multiple simultaneous custom home renovation projects would utilize job costing to effectively monitor and record expenditures related to materials, labor, equipment, subcontractor services, and project-specific overhead costs.
Costs typically fall into three categories:
Labor
Materials
Overhead
In construction accounting, general ledgers utilize the double entry accounting system where every debit in one account must have a corresponding credit in another account.

Job Costing and GL work in conjunction to give a comprehensive view of construction finances at both project and company levels. Monitoring both financial indicators is crucial for a complete understanding of your construction company's financial well-being.

Contract Revenue Recognition

In construction accounting, revenue recognition is about figuring out when a contractor earns money from a project and when they should record costs. Since payments for construction projects are usually spread out over time, contractors may not receive all the money at once. They need to decide on a method for recognizing revenue to determine when to report income and expenses.

Some common methods include cash-basis, completed contract, and percentage of completion. In the UAE, contract revenue recognition also involves specific guidelines such as IFRS 15 and ASC 606.

IFRS 15, also known as "Revenue from Contracts with Customers," is a comprehensive standard that establishes the principles for reporting information about revenue and cash flows arising from contracts with customers.

ASC 606 is another standard for how companies show revenue from contracts with customers. It says that revenue should be recognized when customers get control of goods or services. Companies must also give more information about their revenue. The goal of this rule is to make financial statements clearer and give better information about how a company is doing financially.

These standards require detailed disclosure of contracts, major judgments, and assets related to contract costs.

The process typically includes five steps:
Identifying the contract with the customer.
Identifying separate performance obligations in the contract.
Determining the transaction price.
Allocating the transaction price to separate performance obligations.
Recognizing revenue when each obligation is satisfied.
IFRS 15 and ASC 606 emphasize recognizing revenue when goods or services are transferred to customers, ensuring consistency and comparability in financial statements.
Comply UAE specific guidelines with FirstBit ERP

Contract Retention

Retention refers to withholding a portion of the project price until its completion or for a specified duration. This practice aims to incentivize contractors to finish the project satisfactorily, and safeguards owners in case issues arise.
In the UAE construction industry, it is common for employers to retain 10% of the contract price, although this percentage may vary depending on the nature of the project. Typically, the employer retains 10% of each interim payment, with 5% released upon completion of taking over and the remaining 5% after the defects liability period expires.
Construction accounting allows managing retention smoothly in construction projects. By accurately tracking and documenting retention amounts, accounting ensures compliance with contractual agreements and regulatory requirements.

Accounting is important for keeping track of money set aside for retention. Good accounting practices help manage cash flow and reduce financial risks. By analyzing the impact of retention on project profits, contractors can make better decisions about paying subcontractors and managing project finances.

Key Elements of Accounting in the Construction Industry

While various methods exist for construction accounting, they generally exhibit common traits. Adhering to these basic principles enables detailed tracking of project expenses.

Cash Method

The cash method is an easy way for construction businesses to keep track of their finances by recording revenue when payments are received and expenses when they are paid. This method does not involve dealing with accounts payable or receivable.

However, the cash method may not be suitable for all construction businesses, especially those with annual revenues that exceed a certain limit set by regulations. In such cases, they may need to switch to accrual methods (more on this below), which track expenses when they are incurred and revenue when it is earned, providing a more comprehensive view of the company's financial situation.

Advantages:

Offers straightforward revenue recognition based on actual cash flow
Logged upon payment receipt reflects current cash position
Expenses recognized upon payment eliminate accounts payable or receivable

Disadvantages:

Often restricted to lower-revenue construction businesses
Exceeding revenue thresholds requires adopting accrual methods, leading to complex tax consequences

Accrual Method

The accrual method of accounting allows construction companies to have a more forward-thinking approach to their finances. This method involves recognizing revenues and expenses as soon as bills are sent and received.

For instance, if a construction company sends out a bill for payment, they will record it as revenue even if they have not actually received the payment yet. Similarly, when they receive a bill from a vendor or supplier, it will be recorded as an expense even if they have not sent out the payment yet.

It is important to note that construction companies with contracts that include retainage typically do not recognize that revenue until a project is fully completed. This is usually when they have the right to receive that payment for the first time.

Advantages:

Provides a forward-looking view of finances
Enables proactive decision-making based on anticipated cash flow

Disadvantages:

May result in paying taxes on unrealized profit
Revenue can be mitigated by evenly distributing profit in contracts

Percentage of Completion Method

The Percentage of Completion Method (PCM) is a popular tool used by construction companies to track revenue and expenses throughout a project. Lenders and guarantors often require its use to assess the financial status of the company. PCM involves estimating the total costs and revenues for a project, allowing for a comparison between projected and actual progress.

Keeping accurate journal entries is important to reconcile any differences between PCM calculations and actual expenses in construction accounting.

Advantages:

Splits up the expenses and income for each specific period depending on the progress of the project

Disadvantages:

Requires a lot of estimation leading to errors and uncertainties in financial statements

Completed Contract Method

Under the completed contract method (CCM), revenue and expenses from a contract are only accounted for once the project is finished. This means that profits are only acknowledged once the entire project is done, resulting in all financial impacts being recorded in just one income statement entry. As a result, you may delay recognizing taxable revenue until the following tax year if the project goes beyond the current fiscal period.

Advantages:

Appropriate accounting method for short-term projects
The postponement of tax payments. Without revenue, there is no profit and therefore no tax liability

Disadvantages:

CCM is not GAAP- or tax-compliant for most long-term contracts (which is the majority of construction projects)
Company's income or results are not steady

Construction Accounting with FirstBit ERP

Using specialized accounting software for construction can help companies work better, save time, and get things right. FirstBit ERP system can be a smart move for you in construction accounting. It contains:
Automation of time-consuming tasks. FirstBit accounting module automates tasks like invoicing, tracking payments, and generating reports, saving time and allowing you to focus on core operations.
Improved productivity. FirstBit makes work more efficient by simplifying tasks and giving instant access to financial information. This helps you make smarter decisions and use resources more effectively, leading to improved productivity.