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Understanding the Unique Demands of Construction Accounting

Understanding the Unique Demands of Construction Accounting

Accounting plays a critical role in the construction industry by providing the financial structure necessary to manage complex, high-risk projects. Unlike general business accounting, which focuses on routine business transactions, construction accounting is project-specific, focusing on the financial performance of each job and ensuring it is carefully managed from start to finish. Due to this project-specific approach, there are distinct challenges presented such as long-term timelines, complex costing structures and contractual requirements.

Key Challenges of Construction Accounting

Construction accounting addresses the unique financial and operational needs of the construction industry. Below are several challenges that construction companies face, which contribute to the complexity of their accounting.

Understanding Risks – The construction industry presents a unique set of risks that must be carefully managed, including inaccurate cost estimates, cash flow shortfalls and out-of-scope work.

  • Inaccurate Cost Estimates: These often result from poor forecasting, leading to underbidding and flawed budgets that result in cost overruns. Accurate estimates should be comprehensive, accounting for all anticipated costs to complete a project, such as materials, equipment hours, labor and potential price increases due to market or supply chain fluctuations.
  • Cash Flow Shortfalls: To avoid cash flow issues, it’s important to incorporate a  payment schedule into the cost estimate that aligns with agreed-upon terms (specific dates or project milestones). This ensures routine expenses like payroll, interest and equipment rental can be met without disruption.
  • Out-of-Scope Work: Scope issues frequently arise from unforeseen challenges such as adverse weather, labor shortages or material unavailability. To manage these risks, it’s recommended to plan labor schedules carefully, track and accumulate uninstalled materials and seek timely change orders when additional work is required.

Project-Based Accounting – In construction, project-based accounting is a financial management approach that focuses on tracking the costs, revenue and profitability of individual projects, rather than just the overall finances of a company. Each project has different contractual terms that need to be fulfilled, so financial data needs to be separately organized and processed by each individual project. Tracking financial data by project helps companies understand how one project affects the broader performance of the business.

Contract Changes – Since construction projects often extend over long durations, they are more prone to delays and contract changes that can impact both timelines and budgets. To maintain consistent income and manage cash flow effectively, contractors typically rely on progress-based payment schedules throughout the duration of a project, allowing contractors to be paid a fixed amount of money for completing a specific project or task. Again, it is recommended to seek change orders to contracts on specific projects to ensure timely payment from customers.

Fluctuating Costs – Construction projects can often incur changes to indirect and direct costs, making it a challenge to estimate overall project expenses. Direct cost changes, like fluctuating material prices and labor shortages, can negatively affect the budget and the overall profitability of a project. Indirect costs, such as overhead and insurance, which are generally not tied to one specific project, can also vary during the course of a project. These indirect costs also create the added challenge of determining when to recognize revenue and costs because the costs are not directly tied to a project.

Financial Performance – Because each project has its own unique costs and risks,determining profitability can be difficult. In addition, unpredictable challenges, like weather, labor shortages and inflation, can negatively impact the budget of any project. To help with monitoring possible budgetary overruns, accountants must be heavily involved in regular financial reporting and cost monitoring for projects in order to better forecast whether a project will be profitable, break even or incur a loss.

Understanding Users of Construction Financial Reporting – Construction financial data and statements are often prepared for internal stakeholders, such as company owners, project managers and other key decision-makers, as well as external users like creditors, bonding and surety companies, government officials and current or potential customers. Given the significant reliance placed on the accuracy of this information, especially due to sensitive project-specific estimates, it is essential to implement and maintain robust internal controls. Strong internal controls help ensure the reliability and integrity of financial reporting. Construction companies should regularly review and monitor all key control areas that impact financial accounting and reporting to uphold transparency and accuracy.     

Best Practices for Construction Accounting

Adopting the following best practices for construction accounting can help ensure accuracy, profitability and compliance.

  • Use Job Costing Systems – Accurate job costing helps construction companies develop realistic budgets and report on profitability with greater precision. Creating a standardized job cost sheet that breaks expenses into categories like labor, materials, equipment and subcontracting, can provide insights for better budgeting, forecasting and profitability analysis. Implementing accounting software for job costing can streamline this process for each project, ensuring accurate cost estimates.
  • Apply Revenue Recognition Standard – Under Generally Accepted Accounting Principles (GAAP), construction companies must recognize revenue when it is earned through either the cash basis or accrual method. The method a construction company uses depends on the size of the business, duration and type of projects the company works on.
    • Cash Basis Accounting: In this simple approach to recognizing contract revenue, revenue is recorded when the business receives payment, and expenses are recorded when they are paid. This method provides a clear picture of the company’s actual cash flow and works best for small contractors and short-term projects.
    • Accrual Basis Accounting: Under the accrual-based approach, businesses record revenue when it is earned and expenses when they are incurred, regardless of when cash is received or paid. This method provides a more accurate long-term view of profitability, which is beneficial for complex, long-term projects and larger construction companies.
  • Ensure Compliance with Employment and Tax Regulations – In addition to meeting federal, state and local tax obligations, contractors must actively monitor and stay compliant with employment and safety regulations enforced by agencies such as the Occupational Safety and Health Administration (OSHA) and the Equal Employment Opportunity Commission (EEOC), as well as state and local agencies. Regulatory changes mean that construction companies and contractors must stay up to date on employment laws and changing tax codes in order to remain compliant. Finding an accounting partner, as well as an employment attorney, can help with navigating the evolving compliance environment.
  • Use Specialized Financial Reporting – In construction accounting, Work-in-Progress (WIP) and Construction-in-Progress (CIP) reports are used to track ongoing project finances.
    • WIP Report: This report provides a snapshot of the financial health of active construction projects by detailing costs incurred to date (for the year-to-date and project-to-date), estimated costs to complete, billed revenue and recognized income. It helps identify potential budget overruns or underruns and supports informed financial decision-making throughout the project lifecycle.
    • CIP Report: A CIP report tracks financial activity for projects in progress, detailing ongoing costs such as labor, materials and overhead, along with cumulative revenue recognition. This helps construction companies assess the financial health of a project, identify potential risks early and maintain consistent profit margins across multiple projects.

Understanding how to manage and analyze these reports is key to providing an accurate picture of the company’s project and, by extension, overall performance.

In an industry that is both complex and dynamic, adopting these specialized best practices is critical. Leveraging specialized construction accounting tools and involving experienced accounting professionals in both planning and execution ensures that financial performance is closely monitored, and profitability remains on track. If you have any questions regarding accounting in the construction industry, please contact a Brown Plus advisor.

Posted In: Construction | Insights

About the Author - Alex Craver, CPA

Alex is an Audit Manager at Brown Plus and a key member of the Brown Plus Attest and Auditing Practice. In this role, he is primarily responsible for managing engagements and overseeing resource management to ensure efficiency and high-quality service to his clients.

With over 10 years of experience in public accounting, Alex brings expertise working with clients across a wide range of industries, including construction, manufacturing and distribution, real estate and property development, engineering, unions, foundations and more. In addition to leading attest engagements and mentoring team members, he is a trusted business advisor who regularly consults on internal control assessments, cash flow planning, mergers and acquisitions (M&A), product profitability analysis, forecasting and other strategic financial matters.

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