Common (and Costly) Mistakes in Construction Accounting

We can now see the pandemic in the rear-view mirror, but the effects are still being felt in the construction industry. Sourcing materials, competing for labor and dealing with inflation are all creating pressure on construction firms in a competitive market. Following the right accounting practices and avoiding costly mistakes due to misguided financial practices can help alleviate some of the stress.

Which Accounting Method Is Best for Your Business?

An important back-office decision for construction firms is which method of accounting to use for tax reporting and financial statement preparation. There are many considerations to selecting a method of accounting for new construction firms, and some of those considerations are often at odds with each other. Managers need to be able to see actual performance to make management decisions, lenders want to see profitability and firms want to minimize the amount they pay to federal and state taxing authorities. Several combinations of accounting methods can be used for financial statement, tax and management reporting purposes.

Startup construction firms often adopt their accounting and tax reporting methods and systems based on short-term needs rather than long-term objectives. For instance, a startup firm might select a tax reporting method that minimizes tax burden and is less complex to minimize administrative, payroll and software costs. Though it is often overlooked but necessary for firm growth, companies will need to use more sophisticated methods of accounting and tax reporting to secure lending and bid on larger jobs. Taxing authorities, lenders and bonding agencies eventually will be likely to require a method of accounting called “Percentage of Completion” for reporting on larger and long-term jobs. As the firm grows, an early adoption of the required reporting can save time and avoid additional costs, positioning the firm to take advantage of timely opportunities.

For tax reporting, construction companies are often required to adopt the same method of accounting used for financial statement purposes. Under the applicable Financial Statements rule (I.R.C. § 451(b)(3) (Also Publication 538), a taxpayer “must recognize revenue no later than when the item of revenue is reported in your applicable financial statement.” There are some exceptions to this rule, specifically for smaller taxpayers and homebuilders. Generally, the method of accounting used for financial statement purposes may also be required for tax reporting.

As They Grow, Construction Firms Become Subject to Outside Users Requiring GAAP Financial Statements

As a firm grows, lenders, customers and bonding agencies are likely to request financial statements that have been reviewed or audited by an independent CPA. This usually means that the firm’s reviewed or audited financial statements need to be reported using Generally Accepted Accounting Principles (GAAP). Even though the construction industry is diverse and encompasses many different practice areas, typically across the industry a contractor bids for or negotiates a contract with its customer for each project. GAAP prefers the use of percentage-of-completion accounting method for recording revenue, as this method recognizes revenue over time as performance obligations are met. With this method revenue is calculated on a job-by-job basis.

These criteria need to be met in order to use the percentage of completion accounting method:

1. The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
2. The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced. 
3. The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date. 

Accounting Pitfalls to Avoid

Estimating job costs

A common mistake among construction firms is failure to properly estimate job costs. Proper and accurate job costing results in more accurate bidding, higher win rates and higher profitability. Using the percentage-of-completion correctly can help construction firms bid jobs more accurately. Properly allocating direct, and just as importantly, indirect costs, are a key component of the percentage-of-completion calculation. Of course, it takes an investment in people and systems for this to work. It is also critical to update the estimate over the life of the job to take into account any mid-course changes.

Anticipating reductions in depreciation for tax purposes

Construction companies typically continuously replenish machinery and equipment. For the past several years, construction businesses have become accustomed to utilizing 100% bonus depreciation for these purchases. Qualified property eligible for bonus depreciation includes depreciable assets with a recovery period of 20 years or less, such as vehicles, furniture, equipment and heavy machinery.

Over the next several years, however, the percentage of accelerated bonus depreciation available will decrease by 20 points each year, until it eventually phases out completely. Under IRC § 168(k) the allowable tax deductions for depreciation will decrease each year as follows:

Section 179 expensing is still available up to $1,160,000 (2023) on qualifying equipment, limited to equipment purchases up to $2,890,000 (2023).

Don’t Miss Out on Available Tax Deductions and Credits or Overpay the Taxes You Owe

Too many construction companies fail to maximize tax deductions and available tax credits. Tax credits available for commercial builders under Section 179D (§179D Energy efficient commercial buildings deduction) and home builders under Section 45L often go unnoticed.

The Research & Development (§41 credit for increasing research activities) tax credit incentivizes businesses to retain jobs within the U.S. and encourages R&D spending year over year. Many construction firms are engaged in activities and practices that qualify for these credits.

Tax credits available under the Inflation Reduction Act typically don’t apply to construction companies, but they may apply to their customers. Many construction companies see in these credits an opportunity to add a competitive advantage, and they are pivoting to meet the requirements.

When it comes to collection and remittance of sales taxes, requirements for construction firms are particularly burdensome. Providing both materials and services to a client creates an obligation to keep costs sufficiently separated in order to properly collect sales tax from customers (depending on the state you operate in). The company can be held responsible for the cost of the customer’s tax if the costs are not allocated and billed correctly. Construction companies must also ensure that they do not overpay sales tax on their taxable purchases. Most states do not have a process for automatically refunding overpaid sales tax. If tax is paid more than once on an item, the taxpayer must claim a refund of the overpayment.

By avoiding these common pitfalls, construction companies will be better positioned to take advantage of opportunities to succeed in a competitive industry. If you would like more information about how Weaver can set your firm up for success with strong accounting practices, please contact us today.

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