A complete guide to construction accounting
A complete guide to construction accounting
If you run a small construction business, you know a thing or two about accounting complexities. Tracking profit and loss and managing cash flow matter to all types of businesses, but construction accounting has its own nuances that go beyond these basic accounting principles.
Understanding and taking control of construction financial management is crucial to building a healthy business. It’s also key to driving sustainable growth in the future.
In this article, we’ll talk about what sets construction accounting apart. We’ll also offer a comprehensive guide to successful construction accounting, including the three areas to focus on to help you grow and run a successful construction business.
Top Tip: Before you explore the specifics of construction accounting, you first need to understand the fundamentals of small business accounting. To learn how to track and organise business expenses so you can make informed decisions, read our complete guide to small business accounting 💡
Table of contents
- How is construction accounting different?
- The foundations of successful construction accounting
- What you should know about finance and cash flow management
- What you should know about project management
- What you should know about compliance
- Simplifying your job with accounting software
- Wrapping up
How is construction accounting different?
The nature of the construction industry can make financial management a little tricky. Several characteristics distinguish construction accounting from standard bookkeeping. Namely:
A project-based model
Construction firms and contractors generally work project to project, often on more than one at a time. And each job is unique in its planning and execution. That can mean erratic timelines and unpredictable cash flow.
Projects may be paid for with an up-front deposit, settled on completion or not settled until weeks or months after they’re finished. For this reason, you should calculate profit and loss (P&L) separately for each job. And you need to be prepared to handle the irregular cash flow in a way that sustains your business.
As a construction company, it’s likely that you don’t account only for your direct employees when it comes to payroll. You also work with various contractors on any given job, and they’re probably also employed on other companies’ projects. The hours of work on the job are variable, so construction payroll may look different from week to week. Your accounting practices need to make allowances for this.
A wide range of service offerings
Unlike many small businesses, construction offers a broad spectrum of services. Projects may vary from refinishing an office interior to constructing a building from the ground up. And the services required to complete a project can range from design and consulting to engineering and product sourcing. This can make tracking expenses and calculating profits on each service more difficult.
These characteristics mean the way you track and report numbers is often more fluid than with traditional accounting. It can be hard to know where to start and how to ensure you’re covering all your bases. The key lies in understanding the foundations of construction accounting and implementing an accounting system that supports each.
The foundations of successful construction accounting
Essential construction accounting needs to happen on two levels: the project level and the business level. These types of accounting occur simultaneously, so it’s important to be aware of your project-level finances and your business-level finances constantly.
Thorough bookkeeping practices will help keep you profitable. If you can track and analyse the numbers accurately, you can use them to manage and predict cash flow and plan for future growth. To cover your project and business-level finances, you’ll need to know about three facets of construction accounting:
- Finance management
- Project management
Let’s explore each of these in greater detail.
What you should know about finance and cash flow management
As mentioned earlier, when you work on a project-by-project basis, cash flow isn’t always predictable. You need to be able to manage money coming in and money going out so that you can stay solvent. That means you need to track your income and expenditures overall and by project.
You also need these numbers to create valid estimates around project timelines, costs and scope. Accurate estimation hinges on detailed data that’s easy to access, organise and understand.
The key to effective financial management is to run financial reports regularly. Here are several types of reports you should be aware of:
1. Accounts payable & accounts receivable reports
Accounts payable reports explain who you owe money to, such as suppliers and other third parties. Accounts receivable reports describe money owed to you, like any outstanding invoices you have sent to clients.
Checking both types of reports regularly is crucial to helping your business grow. You need to know what you owe to get an accurate idea of your actual financial standing. On the flip side, you need to know when money is owed to you and collect outstanding balances promptly to keep the lights on and your employees paid.
Top Tip: A proper invoicing process will help you organise your payment requests, ensure you get paid on time and improve your cash flow. Learn how to create an effective approach in our guide to streamlining your invoice process 📌
2. General ledger
Early on, you may be able to track all your business expenses in a simple spreadsheet. But as your business matures, your accounts will get more complicated, and you’ll need a more comprehensive accounting system. You’ll want to start using what’s known as a general ledger.
A general ledger is a record of day-to-day transactions and should include things like accounts payable, accounts receivable and business expenses.
Within your ledger, you should include the details of each transaction, including the date, a clear description of the transaction and a record of the attached expenses. Some of the common expenses you’ll track in construction include:
- Employee payroll
- Subcontractor expenses
- Tools and equipment
- Travel expenses (including fuel and mileage)
- Equipment maintenance
- Office utilities
- Union and association membership fees
- Bank fees
Your general ledger is instrumental in helping you (or your accountant) prepare financial reports and documents.
3. Job costing reports
Because construction accounting is highly project-focused, you need a system that lets you track, organise and report transactions for individual jobs. You do this with job costing.
Job costing is a detailed record of all the costs and income related to each construction job. That means tracking and recording everything from billing to purchase orders to quantity totals. It takes into account both direct and indirect project costs.
Job costing helps you understand the true costs and net profit of each type of project. And you need that information so you can see which jobs are profitable, where you may be spending more than you need to and where you may be losing money.
These reports help you create estimates for upcoming projects and determine which jobs to pursue. The information you gather from job costing is vital to setting client expectations and creating a useful business growth strategy.
Top Tip: Job costing is a way of making sure you don’t leave profitability up to chance. Learn more about how to dig into the underlying costs of a project to produce a clear financial picture in our guide to job costing 🎯
What you should know about project management
Changes happen frequently in construction projects, and you should be prepared to manage them to maintain control of your project-level and business-level finances.
Changes related to design, materials or deadlines can disrupt even the best-laid project plans. Having a firm grasp of the following accounting concepts will help you anticipate and quickly address any challenges that come up.
1. Change clauses in contracts
A critical part of managing change is anticipating it. Each job has a contract detailing commitments on both sides. It’s important that you understand the basics of contracts and include change clauses.
Change clauses are provisions in a contract that outline what happens in the event of some change to the terms of the agreement. They provide a built-in way for both parties to agree on how they’ll handle changes before the project starts.
A change clause should include information on when either party can change the set scope of the project and how they’ll report and manage costs. It should also specify that they’ll communicate these changes in writing through what’s known as a change order.
2. Change orders
It’s impossible to anticipate every variable that may come up in a project. An overly broad direction in the original plan, a change in desired aesthetic or a need to control costs can stall a job. A change order can help you manage these changes quickly and keep the project moving.
A change order is an amendment added to a contract when a change is agreed upon. Most adjust deadlines or the work required by the contractor. For example, a client may decide they want to remove a wall or change the finish of a surface. Or they may decide to scrap that extra bathroom they’d planned to put on the first floor.
Whatever the nature of the change, it’s crucial to capture as many details as possible in writing. Either party can request the amendment, but both parties must agree on the changes and associated costs.
What you should know about compliance
The government mandates specific requirements on how to handle some finances in the construction industry. If you want to thrive, you need to know what these are and make sure your accounting practices comply. Consider the following.
1. The Construction Industry Scheme (CIS) for processing payments
This scheme requires contractors to deduct taxes from subcontractor pay and pass it on to HMRC. It doesn’t apply to direct employee payroll, which is covered by the pay as you earn system (PAYE). But if you hire subcontractors or operate as one, you’ll likely need to register for the Construction Industry Scheme (CIS).
Depending on the work you do and how you’re employed, you’ll register as a contractor, a subcontractor or both. The tax deductions taken under CIS count as advanced payments towards the subcontractor’s taxes and National Insurance. If you’re registered as a contractor, you’ll need to track your deductions carefully and file monthly returns. As a subcontractor, you’ll face lower tax rates if you’re registered.
Understanding the ins and outs of CIS will ensure your taxes are accurate and keep your payments as low as possible. Learn more about who needs to register and how to manage payments under CIS on GOV.UK.
2. Submitting taxes via Making Tax Digital
Making Tax Digital (MTD) is an initiative first introduced in 2019 to make taxes and manage finances easier and more efficient. It means you’ll need to use MTD-compatible accounting software to handle your taxes with HMRC.
HMRC has provided a list of software that can record and submit tax information. Several top choices, including Xero, Sage, FreeAgent, KashFlow and Crunch also integrate with Tide business bank accounts.
Going digital will save you time and money as you automate more of the processes. Failure to comply with MTD may result in penalties in the future, so you want to be aware of your responsibility as well as the opportunities this initiative offers.
You can learn more about this program and the changes happening at GOV.UK.
Top Tip: To learn more about how Making Tax Digital affects your small business, as well as how to sign up and stay compliant, read our guide to Making Tax Digital 🚀
3. VAT domestic reverse charge
Almost every business that sells goods or services is subject to VAT (the value-added tax charged at every point of sale for eligible goods and services). But CIS-registered contractors are also responsible for what’s known as the VAT domestic reverse charge.
It places the responsibility of paying the VAT to HMRC on the consumer instead of the supplier. This helps reduce fraud perpetrated by subcontractors who charge VAT but then stop trading before their return is due. They effectively disappear and pocket the money they charged.
With the reverse charge, a subcontractor doesn’t charge VAT. Instead, the hiring contractor pays the transaction VAT directly to HMRC in their own return. The subcontractor simply notes on their invoice to the hiring contractor that the reverse charge applies.
You need to be aware of correct procedures, whether you’re a contractor or subcontractor. Compliance will keep your taxes accurate and prevent any penalties that could affect cash flow.
Top tip: Make sure your returns are accurate by understanding how reverse VAT charges work. Get details about which projects are subject to the reverse charge and learn how to apply it in our guide to domestic VAT reverse charge procedure ✅
Simplifying your job with accounting software
Good accounting software is incredibly helpful in making your financial record-keeping more efficient. It automates finance tracking and runs complex reports, so you make the best use of your data and comply with MTD.
You may want to invest in construction accounting software made specifically to support managing construction finances. Whatever software you choose, there are some key features you should look for.
It’s helpful to have a cloud-based system. When your information is hosted on the cloud, it’s accessible from anywhere. That means you can update information or scope changes in real time, whether in the office and on the job site. In contrast, when you operate from a traditional locally installed software system, you’re limited as to when and where you can make changes.
You also want your software to have the functionality to manage construction-specific needs, including:
- Project management
- Job quoting
Top Tip: We’ve compiled a list of accounting software options to help you choose. Learn about tools that can help you with everything from accounting to marketing with our guide to the 26 best software and tools for small businesses 🔍
With an understanding of how construction accounting works, you’ll be able to stay on top of your finances and uncover opportunities to grow. It’s easier to make decisions and create long-term goals for your business when you have a clear picture of cash flow and profitability.
You can build in even more efficiency with a bank account that syncs with your accounting software. Open a free business bank account and start tracking expenses, scheduling payments and sending invoices straight from the app, so you can streamline your construction accounting.
Photo by Anamul Rezwan, published on Pexels