Every contractor, regardless of their business structure (sole proprietor, partnership, corporation) has to choose an overall method of accounting; before the first federal tax return is filed. Accounting methods include:
the cash method- the accrual method
- the accrual method which excludes retentions, and (possibly)
- a hybrid method(s)
Depending on the type, size, and length of the construction contract, there are various methods of accounting for long-term construction projects that are allowed – each method has its own advantages and disadvantages.
A contractor will need to select a specific long-term contract accounting methods – possibly with different methods for it’s exempt and non-exempt contracts – and also selects sub-treatments for the classification of contracts and the allocation of indirect costs.
In a nutshell, accounting for long-term contracts relates to the treatment method that is chosen; or that is required by the rules and regulations of the tax code, in order to account for income and cost recognition for long-term contracts.
10+ Methods of Accounting for Construction Contracts
| Method | Revenue Recognition | Cost Recognition |
|---|---|---|
| Cash | As payment is received | As expenses are paid, except for depreciation and capitalization rules. |
| Hybrid – (Part Cash/Part Accrual | Cash or accrual – depending upon the method selected | Could be cash or accrual. For example, the contractor could use the cash method for receipts and disbursements AND accrual for inventory and payables related to inventory. |
| Accrual | As billing invoices are issued | Based on economic performance regulations of §461(h) |
| Accrual Excluding Retention | Based on when billing invoices are issued OR billings minus retainage deferred under the contract. Recognition of retainages, once entitled to receive | Based on economic performance regulations of §461(h) |
| Completed-Contract (CCM) | Billings or total contract price once contract is finished and accepted. See 1.460-4(d) for revenue recognition for disputed contracts | Costs are deferred as incurred. Specific costs are outlined in 1.460-5(d). Once completed, costs are closed out to expense.SG&A costs are expensed as incurred. See 1.460-4(d) for expense recognition for disputed contracts. |
| Exempt Percentage-of-Completion (EPCM) | Contract price (including change orders) multiplied by percent complete.Percent complete determined by various alternative methods, such as:
| Based on economic performance regulations of §461(h).Costs determined by 1.460-5(d). All costs are expensed as incurred. |
| IRC §460(b)Percentage-of-Completion Method (PCM) | Revenues determined by only the cost-to-cost formula | Based on economic performance regulations of §461(h).Costs determined by 1.460-5(b). All costs are expensed as incurred. |
| IRC §460(b)(3) Simplified Cost-to-Cost Method | Same formula as §460(b), except costs determined as outlined by §460(b)(4) or 1.460-5(c) | Based on economic performance regulations of §461(h).Job costs are direct material, direct labor and depreciation, amortization, and cost recovery on equipment directly used. All costs are expensed as incurred. |
| Reg. 1.460-4(e), §460(a) Percentage-of-Completion/Capitalized-Cost Method (PCCM) | Use PCM formula as §460(b) with same type of costs for 70%, and use exempt contract method for the remaining 30%. | For 70%, same as the §460 PCM method, the balance of the contract is accounted for by the exempt-contract method. |
| IRC §460 10% Deferral Method | Same as §460(b) above, except that revenues and billings on all contracts with less than 10% complete, determined by the cost-to-cost formula, are deferred until greater than 10% complete. | Based on economic performance regulations of §461(h).All costs are expensed as incurred. All costs on contracts less the 10% complete are not expensed as incurred, but rather are deferred in an account similar to an inventory account |