Accounting isn’t the flashiest topic out there, but it’s an important one for your construction business. The way a company accounts for income and expenses will help shape the financial picture on any given day of the year. This is not a cash management topic, but rather a revenue recognition topic. Federal, state and local tax agencies will tax companies based on this method. Let’s review the most common methods of accounting, and how to choose the right method for your construction business.
[Related: 3 tax breaks every builder should maximize this year]
Cash accounting is very simple. Income is recognized when it’s received and expenses are recognized when they are paid. In other words, it’s about real-time impact, and when transactions hit the bank account.
Example: Let’s say your business signed a rental agreement for an office space on January 1 for 12 months. The rent will be $1,000 per month ($12,000 annually), which is paid in advance on January 1. The cash accounting method would require an accounting for the $12,000 of rent on January 1 since it comes out of the bank account that day.
Cash accounting is ideal for small businesses. It’s simple, and builders who use the cash method won’t need sophisticated software. They can also use this simple method for their tax benefit. By asking customers to hold payment on December invoices until January, or by paying expenses early that aren’t really due until January, they are effectively deferring income, which will lower profits and taxes in the current year.
The downside is that revenue delays from projects can be lengthy, making financial statements hardly useful. They won’t be an active reflection of today’s financial picture of the business like the accrual method will provide.
Pro Tip: Use the cash method for tax purposes, but an accrual method for internal bookkeeping to allow financial statements to help steer the company.
With accrual accounting, income is recognized when earned regardless of when money is received. Expenses are recognized when they are incurred, not when those expenses are actually paid. The idea here is to match income and expenses with the period of work they represent.
Example: Consider our prepaid rental agreement. Accrual accounting would require an accounting of the $12,000 rent over the life of the rental agreement. While $12,000 would be taken out of the bank account on January 1, $1,000 of rental expense would hit the financial statements in each respective month of rent.
Accrual accounting is great for larger companies that need accurate financial statements to help make informed business decisions. The downside is that a builder might end up paying taxes on income that hasn’t been received yet. Also, the company’s cash position will not be as clear because income and expenses are being accrued at different times.
For those that elect accrual accounting, the added benefit is the ability to select an additional method for short-term projects, long-term projects or even a different method for both. Here are two additional methods that can be used:
- Percentage of completion method. Recognize revenue and expenses based on a project’s progress and in proportion to when the contract should be completed.
- Completed contract method. Recognize income and expenses once the project is completed.
The great debate
As always, you should consult with a CPA or a licensed tax professional about your unique business situations. However, for small businesses, the cash method is a great option for its ease of use. For larger companies that need a more accurate view of their business on a day-to-day or month-to-month basis, the accrual method will be superior to cash accounting.
Still confused about which method is right for your business? The IRS has already determined that builders who exceed $5 million in gross receipts are required to use an accrual method. Otherwise, take your pick of the methods above based on pros and cons of each.
Jacob Merkley is a licensed Enrolled Agent and is the founding partner of Western Tax Alliance, a tax resolution firm based in Las Vegas that is dedicated to serving the construction industry. He can be reached at [email protected] or 602-649-4779.