If your construction company has a contract that rolls into a new year, you must accrue for the materials, revenue, and labor involved in the contract - even if you use cash basis accounting for your business. This means accounting for these elements to accurately reflect the work performed and expenses incurred, even if the cash transactions occur in different accounting periods.
You also have to choose an acceptable accrual method of accounting for the contract - completed contract method (CCM) or percentage-of-completion method (PCM). How do you do that?
At CSI Accounting & Payroll, we've worked with construction companies for over 50 years. We know the unique accounting needs of your industry, including determining the right accounting method for a construction contract.
This article will walk you through classifying your contracts and business to determine whether CCM or PCM is right for you.
Step 1: Classify the Contract as Short-Term or Long-Term
Do you have a short-term or long-term contract?
Long-Term Contract
A long-term contract is any contract that spans a year-end. Even if you have a contract that started in December but was not completed until the following January, you have a long-term contract.
Short-Term Contract
A short-term contract is any contract that is started and finished within one taxable year. This is regardless of the elapsed time of the project (i.e. 3 months versus 9 months). For short-term contracts, continue to use your business's accounting method – accrual or cash method.
Next Steps
If you have a short-term contract, you stop here. If you have a long-term contract, you must choose an accounting method based on the following steps.
Step 2: Classify Contracts as Home Construction or General Construction
Are you building homes or other types of buildings?
Home Construction Contracts
Aside from apartment buildings, the following buildings with four or fewer dwelling units are considered home construction contracts:
- Single-family homes
- Duplexes
- Triplexes
- Quadplexes
Additionally, to be considered a home construction contract, at least 80% of the estimated total contract costs must be for the construction, improvement, or rehabilitation of the units. This also includes things like plumbing, HVAC, or constructing an addition to a home.
General Construction Contracts
If the project doesn’t fall under the criteria for a home construction project above, it must be classified as a general construction contract.
Next Steps
If you have a home construction contract, you stop here. If you have a general construction contract, you must choose an accounting method based on the following steps.
Step 3: Classify Your Business as a Small or Large Contractor
Is your business a small or large contractor?
Small Contractor
If your average annual gross receipts for the last three tax years is less than $25 million, you are a small contractor.
Large Contractor
If your average annual gross receipts for the last three tax years is more than $25 million, you are a large contractor.
Large contractors must use the percentage-of-completion method (PCM) for long-term, general construction contracts. Under PCM, contract income is reported annually according to the percentage of the contract completed in that year.
For example, you sell a job for $400,000 that costs you $100,000 to do. At year-end, you've finished 25% of the job and would therefore document 25% of the job as being done. This would look like $100,000 in income (25% of the total $400,000 in income) and $25,000 in expenses (25% of the total $100,000 in expenses), as shown on your Income Statement.
Next Step
If you are a large contractor, you stop here and follow PCM as described above. If you are a small contractor, you must continue to the final step.
Step 4: Length of Contract
As a small contractor, you must separate your long-term general construction contracts into two categories based on their length.
Less Than Two Years
If a contract is reasonably likely to be completed within two years from the date work begins, then it can use the completed contract method (CCM). Under CCM, contract income is reported in full when the entire contract is completed.
For example, you sell a job for $400,000 that costs you $100,000 to do. At year-end, you've finished 25% of the job, but you would not recognize any income or expenses until the project is finished. When the project is finished in the future, you would record the entire $400,000 in income and $100,000 in expenses when the project is finished.
reasonably likely to be completed within two years from the date work begins.More Than Two Years
If a contract is estimated to take two years or more to complete, then you must use the large contractor method of percentage-of-completion method (PCM) as explained in step 3, even though you are a small contractor.
two years or more to completeGet Accrual Method Advice and More!
If you have a contract that rolls into a new year, you need to either use completed contract method (CCM) or percentage-of-completion method (PCM). After reading this article, you should be able to follow the steps to get to the right solution for you.
However, every situation is different. If you're still struggling with choosing the right method of accrual accounting for your construction contract, consider working with a monthly accountant who can answer your questions year-round and has extensive experience in the construction industry!
If you're considering working with a monthly accounting firm, why not consider CSI Accounting & Payroll? Click the button below for a free consultation to see if we can be a good fit for your business:
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