Construction and contracting involves some specific bookkeeping concepts and requirements not often encountered by firms in other industries. For example, construction firms and contractors have to account for revenues and expenses associated with specific jobs – at a variety of different locations. While a retailer may be able to recognize revenues and expenses all in a steady stream, the rules are different for contractors.
Not every bookkeeper is up on the latest tax and accounting rules, requirements and best practices for construction firms in Canada. It’s important that your bookkeeper, accountant and CFO are all on the same sheet of music so you can minimize your overall tax burden and maximize your company’s cash flow, net of taxes.
Accounting Methods for Contracting Firms
Most Canadian businesses must use the accrual accounting method. But for contractors with multiple projects at any given time, it’s usually better to use the percentage completion method. Under this method, contractors don’t recognize revenue and expenses as soon as they link the contract, as is done under the accrual method. Instead, under the percentage completion method, contractors recognize the revenue and expenses on their books in stages as the project is completed.
For contracting companies, this usually provides a much more accurate picture of the financial health of the company than using the accrual method.
If it is not possible to estimate the percentage of completion of a project, you can consider using the completed contract method: all revenues and expenses are recognized on the books only when the construction project is done.
Who can use the completed contract method?
The completed contract method of accounting is best suited for smaller contractors and those whose projects are normally completed within less than one year. This defers all income tax due to the completion of the contract.
For most applications, the percentage completion method is preferable, though it requires more ongoing bookkeeping work. The percentage completion method is best when firms are growing and taking on – or expect to take on – larger and more complex projects over time.
Accounting for Credit and Debt
Contractors frequently rely on loans and access to lines of credit in order to buy supplies and pay workers until the client pays. Contractors and their bookkeepers need to know specifically how to record credit transactions.
Under Generally Accepted Accounting Principles (GAAP), any debt taken out is booked as a liability on the balance sheet.
It’s a current liability if the balance is due within a year, or within the business’s normal accounting/operating cycle (if longer than one year). The liability is booked as long-term debt if the terms stretch longer than one year.
You must disclose all short-term/current debt and long-term debt on your income statement. Any principal payments due over the next five years must be notated as such on your income statement as well. If anything on your balance sheet is serving as collateral for the loan, you must disclose that on your company balance sheet.
It’s important to account for holdbacks correctly. You need to create a separate accounts receivable account for holdbacks – one that allows for project allocations. When you issue new project invoices, your need to create two line items:
- Amounts owed
- The amount of the holdback
The 2nd line item needs to be a negative number on your books. So the two numbers net out against each other. Your bookkeeping or accounting professional should know how to do this.
All business owners and managers should carefully monitor their cash flow statements and balance sheets. But there are three more reports that construction industry businesses and contractors should monitor on a daily basis:
- Progress invoicing
- Job costing
- Job profitability
As you can tell, each of these reports reflect the profitability (or lack thereof) down to the contract/job level. This way, managers can tell which projects are approaching or entering unprofitability – and can take action before too much damage is done.
Also check out key factors that any contracting business should consider as they review their bookkeeping processes. Contractors and their company bookkeepers alike can use this guide to ensure they are thinking through the various scenarios and complexities when it comes to setting up a construction bookkeeping system.
5 Standard Practices
Below are 5 tips that should be standard practice for bookkeepers of contracting businesses.
The complexity of contracting businesses is rooted in classes. Because each new project assumes costs pertaining to the specific project for the contracting business, a multitude of classes is a requirement, not an option in our view. Classes need to be oriented in such a way that the relevant costs can be directly linked to specific projects, expensing materials by the specific job in question. This complexity is exacerbated when trying to decipher where overhead expenses (as opposed to cost of goods sold expenses) should be posted to. Therefore, after having done bookkeeping for a construction company for some time, a library of expense categories will begin to emerge.
2. Review Key Construction Reports Regularly
Further to above, classes also play a vital role in producing reports for managers. Revenue and profit estimates are based off reports that are generated by either the accountant or bookkeeper and need to accurately display the costs of jobs and projects. Namely, the trinity of construction reports for management are progress invoicing, job costing, and job profitability. Within these reports are significant sub-reports such (e.g. job costs by vendor) which are also extremely helpful for construction managers. A contracting business cannot operate (for very long) without these reports. Incorrect class specifications will not only lead to incorrect books, but potential losses for your client. Having an organized set of classes will enable you to provide meaningful results for decision making to your client. This is easier said than done as construction projections are almost always one-of-a kind custom jobs and report generation is limited by the software you elect to use (more on that below).
3. Understand Holdbacks
A common mistake that inexperienced construction bookkeepers make is the fact that they don’t know what to do with the holdbacks that are accrued. Often times, they can be found in a mystery AR accounts with no indication of what it is or what it’s there for. First, to account for a holdback a holdback receivable asset account needs to be created, and it needs to be able to allow project allocations. For this reason, when new invoices for a project are issued, two line items are needed: one of the amounts owing and an additional line item on the invoice as a negative amount for the amount/percentage of the holdback. Bookkeepers need to specify the holdback receivable account and allocate the amount to the appropriate project. When the client has signed off on the job, you can add back the holdback as a positive amount (again, specifying the holdback receivable account) and allocate the amount to the project. To ensure that the holdback invoice amount is received, bookkeepers can create an AR Aging Summary report (or Customer Aged report for Sage). For a full guide on holdbacks for tax purposes, you can check out our guide on GST/HST and the Construction Industry.
4. Choose the Right Software
Given that the multiple classes are required, we recommend QuickBooks Desktop for construction businesses. QuickBooks Online, though more accessible, has the pitfall of not allowing the bookkeeper to create complex classes and reports that may be required for contracting companies. QuickBooks Online, on the other hand, has a limited number of job costing reports, report filters, and WIP reports. Again, as a bookkeeper with complex projects, reports on jobs classes need to be able to be filtered to be able to make meaningful decisions. Additionally, though specific contracting software such as Sage 100 Contractor or Sage 300 CRE exist for larger construction companies, between Sage 50 and QuickBooks Desktop, QuickBooks Desktop is still our recommendation for small to medium sized businesses. One of that greatest shortcomings of Sage 50 is again, the limited amount of customizable fields within reports (not the case with advanced Sage software such as Sage 300 CRE).
One of the most overlooked components of bookkeeping for contracting businesses is the training involved with contracting business managers. Classes and reports won’t be useful if the information about expenses aren’t accurate. Additionally, contractors generally aren’t the savviest when it comes to bookkeeping/accounting. More often than not, part of your duties will require that the bookkeeper train managers to communicate in a way that jobs and projects accurately reflect what is supposed to be recorded in the books. Proper bookkeeping in construction is limited by the quality of information that the bookkeeper receives. Garbage in equals garbage out, as they say.
The first step is breaking old habits that contracting business managers may have. For construction companies seeking a bookkeeper, they will most likely have a spreadsheet that poorly resembles a project job-costing report. As a bookkeeper, you will need to show and demonstrate that there are reporting tools that make spreadsheets obsolete.
Second, you’ll need to train managers to send information for any expense so it can be allocated appropriately. Receipts and bills need to come with descriptions so bookkeepers know what project it was used for and under which class.
This article is only intended for bookkeepers who are considering or have newly signed on contracting businesses. Different constructions companies will have different needs but the above serve as guidelines as to what the bookkeeping job will entail. Bookkeeping for such businesses are more nuanced and complex but these are the bare minimums that should be considered when first taking on a contracting client.