Construction Company Accounting Procedures – What You Need to Know

Construction Company Accounting Procedures – What You Need to Know

Good accounting systems and practices are important tools for managing any construction business. Given the uncertainty in the construction industry, it is particularly important to monitor job performance, control costs, improve profitability and manage cash flow. To help our construction clients, prospects and others better understand the basic accounting procedures, we have provided the guide below:

REVENUE RECOGNITION

Construction accounting is different from other types of accounting because of the long-term nature of many contracts. In a typical business, revenues are recorded when they are earned and expenses are recorded when they are incurred. This generally happens at the time an exchange occurs. However, with a long-term construction contract, this may last for several months or even years, waiting until an exchange occurs. This may result in misleading financial information. In order to present an accurate reflection of the company’s finances, there are two options to recognize construction revenue and costs.

  1. Completed Contract. As the name suggests, the completed contract method does not recognize revenues or expense until a project is substantially complete.  In a simple example, a construction company enters into a $100,000 contract in June 2017. The job is expected to be completed in May 2018 at a cost of $80,000.  Using the completed contract method, the company would recognize all revenue and expense in 2018, regardless of actual costs incurred during 2017. The completed contract method is typically only used for short-term contracts or when contract costs are difficult to estimate.
  1. Percentage of Completion. Under the percentage of completion method, revenue and costs are recognized as a contract progresses toward completion.  Most construction companies, with long-term contracts, should use this method.  Using the contract example from above, assume the company has incurred and recognized $32,000 of costs as of the end of 2017, the project is considered to be 40 percent complete. Thus, the company would also recognize 40 percent of the total expected revenue, or $40,000.

These two methods are not interchangeable. Once an accounting method has been chosen, it must be applied consistently to all similar contracts.

<< To learn more, read Revenue Recognition – 5 Items Affecting the Construction Industry. >>

JOB COSTS

All construction jobs have direct and indirect costs associated with them. Direct costs include labor, subcontract expense, materials, equipment, and tools. Since these costs are directly related to a project, it is easy to allocate them. Indirect costs are those benefiting more than one job, such as insurance, supervisor wages, rent and utilities. A construction company needs a reliable method for allocating these indirect costs to the various jobs that they benefit. An accurate allocation method will lead to a more realistic representation of job costs and profitability. 

CASH FLOW MANAGEMENT

A construction company owner should always consider ways to improve cash flow when negotiating contracts, specifically retainages, payment terms and penalties for late payments. Ensure invoices and change orders are processed and sent quickly. Consider shortening payment terms with customers or offering a discount for prompt or accelerated payment. Effective cash management is essential to maintaining a construction company’s overall financial health and plays a vital role in the success of the business.

Questions?

Industry knowledge and close collaboration are instrumental in providing our construction clients with the insight and awareness to make the best business decisions and seize growth opportunities. Smith Schafer is a recognized leader in providing accounting and consulting services to the construction industry since 1971. We have a team of experts, focused on working with the construction industry, and committed to helping our clients succeed. If you have questions about improving your business model, implementing an accounting practice or tax planning strategies to improve operations, Smith Schafer can help. For additional information, click here to contact us. We look forward to speaking with you soon.

Construction Industry: Tax Reform Impact

Construction Industry: Tax Reform Impact

The new tax reform law is the most significant tax legislation in decades. Now construction companies are trying to digest the details and evaluate how the changes will impact their tax situation. One key objective was to reduce taxes on companies doing business in the U.S. to make them more competitive. Prior to the change, the U.S. had one of the highest corporate tax rates globally.

While tax reform has been acknowledged as a good thing for businesses, many construction companies are still unsure how they will benefit from it. The good news is there are tax saving opportunities for industry companies, both large and small, that will result in immediate savings. Some of the changes include; new depreciation rules, expanded Section 179d limits, accounting method changes, percentage of completion requirement changes as well as a new deduction for certain business owners. To help clients, prospects and others understand the changes, Smith Schafer has provided a summary of key details below.

KEY TAX REFORM CHANGES FOR CONSTRUCTION INDUSTRY

  • Cash Accounting Method. Under the new tax laws, most construction companies will be permitted to use the cash method of accounting which includes not keeping inventory. This change applies to companies that did not exceed $25M in gross receipts for the prior year.
  • Percentage of Completion Method. Small construction contracts completed within the next year are exempt from using the percentage of completion method. It is important to note that the taxpayer must be able to pass the $25M gross receipts test.
  • Bonus Depreciation. This allows a company to immediately deduct a percentage of the cost of the property when it is acquired rather than doing so over a period of years. Under the new law, construction companies can take advantage of 100% bonus depreciation. The bonus depreciation level is available for property acquired and placed into service between September 28, 2017 and December 31, 2022. After that time-frame, the bonus amounts are scheduled to decrease by 20% annually.
  • Expanded Section 179d Limits. The new law increased the maximum amount a taxpayer can immediately deduct up to $1M in the year it was acquired. Beyond this, construction companies can now include roofs, HVAC, security, fire protection and alarm systems if they were installed after a building was constructed. This change creates additional tax saving opportunities for industry companies.
  • Qualified Business Income Deduction. There is a new 20% qualified business income deduction for owners of flow through entities through 2025. Examples of flow through entities include partnerships, limited liability companies, and S corporations. The 20% deduction is limited to the greater of two thresholds including 50% of the W-2 wages paid by the business or 25% of the W-2 ranges paid by the business plus 2.5% of the unadjusted basis of the qualified tangible property. Be aware, these limits do not apply to taxpayers with income less than $157,500 or married couples with income less than $315,000.
  • Entertainment Expenses. Under prior regulations a company could deduct 50% of the cost of business meals and entertainment and 100% of meals offered to employees as a convenience to the employer. The new law has eliminated the deduction for entertainment expenses and reduced the deduction for meals offered to employees as a convenience to the employer to 50%.

Questions?

Under the new laws there is an abundance of tax saving opportunities available that extend beyond what is listed above. It is important to review your tax planning strategies to ensure you are in the best position possible. If you have questions about how tax reform will impact your situation or would like assistance with tax planning for 2019, Smith Schafer can help.

Smith Schafer is a recognized leader in providing accounting, auditing and consulting services to the construction and real estate industry. Our Construction Group, comprised of numerous professionals, is committed to serving over 500 Minnesota construction and real estate entities.  For additional information, click here to contact us. We look forward to speaking with you soon.
 

Commonly Missed Tax Deductions in the Construction Industry

Commonly Missed Tax Deductions in the Construction Industry

For many construction industry business owners, they are concerned with the day-to-day activities that keep their business running. For example, hiring help for a new project or purchasing a new piece of equipment to replace an outdated one. Many owners tend to focus on the daily grind and put off thinking about the taxes until January or February, but doing so, may come at a cost. Success in the construction industry requires the ability to understand and prioritize accounting and tax planning.

Below are commonly missed tax deductions and credits construction industry business owners should take advantage of:

1. RESEARCH & DEVELOPMENT (R&D) TAX CREDIT

  • This tax credit was originally enacted in 1981 to incentivize companies to increase their investment in developing new or improved products or processes.
  • For a construction business to be eligible for this tax credit, they must meet a four-part test set forth by the IRS:

1. Qualified purpose – to develop new or improved products or processes resulting in increased performance, function, reliability, or quality.

2. Technological in nature – relies on the principles of hard science, such as engineering.

3. Development of a new or improved component – may include processes, software, techniques, formulas, or inventions.

4. Substantially all constitute experimentation – testing and evaluation

  • What are qualified research expenses?
    • Wages paid to employees for qualified services.
    • Supplies used and consumed during the R&D process.
    • Research expenses paid to a third party.
    • Research payments to qualified education institutions and various scientific research organizations.
  • Research and experimentation can occur anywhere, not just in laboratories. Whether on a job site, or in the office, the R&D credit is available to those researching new ideas or improving existing ones to make a job more efficient. The federal credit may be carried forward for 20 years or have the potential to offset payroll tax.

2. WORK OPPORTUNITY TAX CREDIT (WOTC)

  • Hiring people from targeted categories and employing them for at least 120 hours may qualify your construction company for the WOTC. This program is designed to increase employment opportunities for individuals who typically experience certain barriers to employment.
  • The WOTC provides employers a nonrefundable tax credit for a portion of wages paid before January 1, 2020, to certain new employees who qualify as members of disadvantaged groups.
  • Disadvantaged groups include:
    • Qualified IV-A Recipient
    • Qualified Veteran
    • Ex-Felon
    • Designated Community Resident
    • Vocational Rehabilitation Referral
    • Summer Youth Employee
    • Supplemental Nutrition Assistance Program Recipient
    • Supplemental Security Income Recipient
    • Long-Term Family Assistance Recipient
    • Qualified Long-Term Unemployment Recipient
  • If it is determined they qualify for the WOTC, the employee must complete IRS Form 8850 (Pre-Screening Notice and Certification Request for the Work Opportunity Credit) on or before their start date. This form MUST be postmarked within 28 days of the start date and sent to the state Department of Labor for Certification. This form is used to make a written request to the state workforce agency to certify an individual as a member of a targeted group.
  • Depending on which target group the individual belongs to, the maximum credit per new hire may range from $1,200 to $9,600.

3. 199A TAX DEDUCTION

  • The Tax Cuts and Jobs Act (TCJA) created a new deduction for pass-through business owners. This deduction, in certain situations, may provide up to a 20 percent tax deduction on qualified business income.
  • For taxpayers with taxable income exceeding $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers, the deduction is subject to limitations.
    • Limitations:
      • Whether a specified service trade or business
      • Taxpayer’s taxable income
      • The amount of W-2 wages
      • Unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business.

<< Click to read Construction Industry: Tax Reform Impact >>

Questions?

There are an abundance of tax saving opportunities available to construction industry business owners that extend beyond what is listed above. It is important to review your tax planning strategies to ensure you are in the best position possible.

Smith Schafer is a recognized leader in providing accounting, auditing and consulting services to the construction and real estate industry. Our Construction Group, comprised of numerous professionals, is committed to serving over 500 Minnesota construction and real estate entities.  For additional information, click here to contact us. We look forward to speaking with you soon.

Revenue Recognition: 5 Items Affecting the Construction Industry

Revenue Recognition: 5 Items Affecting the Construction Industry

The threat of revenue recognition has been around since 2010, when the first draft of the new standard was released. Three exposure drafts and numerous accounting standards later, we are finally on the doorstep of being required to recognize income under the five step approach found in Accounting Standard Codification (ASC) 606. Although public companies have been reporting under ASC 606 for all of 2018, non-public companies are not required to adopt until years beginning after December 15, 2018. 
 
The main goal of ASC 606 was to create a similar revenue recognition policy and calculation across all industries. The construction industry, which has historically had its own guidance and industry practices, is no exception. After completing the first four steps as required by ASC 606 – identifying the contracts, identifying the performance obligations, determining the transaction price, and allocating the transaction price to the performance obligations – here are five items that may affect the construction industry when finally recognizing revenue in step five:
 

  1. Timing of recognition

ASC 606 has two basic options for recognizing revenue once control has been transferred:

  • over time or
  • at a point in time. 

In order to recognize revenue over time, one of the following criteria needs to be met:

  • The customer receives and consumes the benefits provided by the seller’s performance as they perform.
  • The seller’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. For example, you are constructing a building on the customer’s land, even if construction is stopped half way through the project, the customer’s asset (land) has received value.
  • The seller’s performance does not create an asset with an alternative use to the seller, and the seller has an enforceable right to payment for performance completed to date.  For example, pre-fabricated wall panels are customized for a specific project and the contract stipulates once production starts costs are the customer responsibilities.

Before determining if a contract meets one of the above requirements, construction companies will need to understand when transferring control of the asset, as defined within ASC 606, occurs. It is not until control is transferred that revenue can be recognized. ASC 606 defines “control of an asset” as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from an asset.
 
Examples of indicators that transfer of control has occurred include:

  • An entity has a present right to payment for an asset.
  • Customer has legal title to the asset.
  • Physical possession of the asset has transferred.
  • Customer has accepted the asset.

These concepts are easier to conceptualize when the end product is a tangible item, but when considered in relation to the construction of a building, parking lot, house or any component within a larger construction project it becomes more difficult. Often in these projects, the customer will not accept the asset until all punch list items have been completed.
 

  1. Terminology

Percentage of completion and completed contract methods, in name, no longer exists. In essence, “billings in excess of costs” and “costs in excess of billings” will shift to the concepts of “contract liability” and “contract asset.” Additionally, instead of percentage of completion, contractors will use a cost “input method” as described in ASC 606 when calculating the contract liability/asset. Although the actual math using the new input method will be nearly identical to the calculation used for over and under billings, the path to that point will be different.
 

  1. Change orders

Under ASC 606, the scope of a change order determines if it should be considered a separate contract or should be combined with the original contract. The determining factors in that decision is based on if the change order results in an addition of a distinct good or service and if that good or service reflects the standalone selling price.
 

  1. Wasted materials

The accounting for wasted material was emphasized within ASC 606.  If a company has wasted costs (purchased the wrong materials, had re-work due to error, poor job management, etc.) those costs are recognized immediately and not taken into account as a job cost. Therefore, this is not part of the cost input calculation when recognizing revenue over time.

  1. High material costs

Based on the type of construction project, material costs can be the majority of the total job costs. ASC 606 requires construction companies to consider the realistic progress made on a job when determining if the material costs can be included in the cost input method calculation.
 
Example – If a $500,000 job includes a $300,000 generator and on day one of the job the generator is purchased, the calculation would exclude the $300,000 in costs and in contract value when completing the cost input calculation. 

Even with nearly a decade of warnings, revenue recognition has arrived quickly, and is now requiring the attention of construction companies. Without careful planning and reviewing of contracts, revenue streams could unintentionally change.

To learn more about the revenue recognition standard and how it may affect your construction business, contact a member of the Smith Schafer Construction & Real Estate niche. Smith Schafer has been a recognized leader in providing accounting, auditing and consulting services to the construction and real estate industry since 1971. We look forward to speaking with you!

Wayfair: How It Affects Minnesota Construction Companies

Wayfair: How It Affects Minnesota Construction Companies

In the landmark South Dakota v. Wayfair, Inc. case, the U.S. Supreme Court struck down the physical presence nexus standard established in the 1992 decision Quill Corp. v. North Dakota. This means states can require certain retailers, with no physical presence, to collect and remit the applicable sales or use tax on sales delivered in locations within their state. Due to this decision:

HOW DOES THE WAYFAIR DECISION AFFECT THE CONSTRUCTION INDUSTRY?

  • Remote sellers in the construction industry, who sell goods or services into Minnesota from other states, must register and begin collecting sales tax in Minnesota no later than October 1, 2018.
  • Minnesota construction businesses, who remotely sell into other states, may also need to start collecting sales tax in those states.
  • Minnesota law provides a Small Seller Exception, which does not require remote sellers to collect sales tax until their sales during a period of 12 consecutive months total either:
    • 100 or more retail sales shipped to Minnesota
    • 10 or more retail sales shipped to Minnesota that total more than $100,000

Note: When calculating this exception, do not include any sales where the purchaser is buying for resale. Purchaser should give you a completed Form ST3, Certificate of Exemption claiming an exemption for resale. August 2017 is the earliest month to include to calculate if the business qualifies for the Small Seller Exception.

WHAT DOES THIS MEAN FOR YOUR CONSTRUCTION COMPANY?

The biggest impact of the Wayfair case on the construction industry is the requirement of all Minnesota sellers, regardless of their location, to collect state and local sales taxes based on where your customer receives the taxable product or service. Construction businesses tend to operate in multiple locations and construction sites and it will be important to determine if/when local sales taxes are payable. See examples below detailing how to source the sale and determine which taxes are applicable.

  • Example 1: A construction business is physically located in St. Paul. A customer from Rochester visits the store in St. Paul and purchases materials. In this example, the customer takes the materials with them when they leave, so the possession of the items were transferred at the physical location of the store. The tax assessed on the materials is the Minnesota general rate sales tax plus any applicable local taxes for St. Paul.
     
  • Example 2: A construction business is physically located in St. Paul. A customer from Rochester purchases materials online and has them shipped to their home in Rochester. The tax assessed on this sale would be Minnesota General Rate sales tax and any applicable local taxes for Rochester, since possession of the items were transferred when the items were received by the customer at their home. Sourcing would also be Rochester, if the customer went to the physical location and asked for the materials to be shipped to their home. Keep in mind, the cost to ship the materials should be included in the sales price and the entire amount taxed.

Note: Contractors or subcontractors must pay sales tax on the cost of all materials, supplies, and equipment to complete a construction contract.

Tax Tip: You may pass this tax on to your customers as part of the materials cost. Do not itemize it separately on customer invoices. Do not charge sales tax on construction contracts.

Credit for local tax paid

If you pay local sales tax in Minnesota to one locality, but use the items in another area that imposes local sales and use tax, you are allowed a credit for the local sales tax already paid.

When do you need to start collecting?

You must begin collecting no later than the beginning of your next filing cycle:

  • Monthly and Quarterly filers: October 1, 2018
  • Annual filers: January 1, 2019

Resources are available on the Minnesota Department of Revenue website, including a sales tax rate calculator and sales tax rate spreadsheet, among others, to help calculate local sales taxes.

CONTRACTS OUTSIDE MINNESOTA

Materials delivered to contractors in Minnesota for use in an out-of-state contract are subject to Minnesota tax, unless the materials are not subject to tax in the state or country where the contract work is done. You must give your vendor a completed Form ST3, Certificate of Exemption. For more information, see Fact Sheet 110, Items for Use Outside of Minnesota.

Materials delivered by a vendor directly to a construction site outside Minnesota are not subject to Minnesota tax. Those materials may be subject to sales tax in the state where the construction site is located.

What about the other states?

You are responsible for researching or contacting each state to determine your sales tax registration and reporting requirements. If you are not up to speed on all the changing and new state tax laws, it can put your company at risk for penalties and interest charges on unpaid tax liabilities – potentially in multiple states.

Smith Schafer works with construction industry businesses to identify where such tax liabilities exist. Our Construction & Real Estate Group, comprised of numerous professionals, is committed to serving over 500 Minnesota construction and real estate entities. Contact us today to learn tax saving strategies that best fit your situation.

Top 3 Accounting Mistakes We See in the Construction Industry

Top 3 Accounting Mistakes We See in the Construction Industry

Success in the construction industry requires the ability to understand accounting and financial statements. It is critical for construction company owners and accounting departments to understand what mistakes may be lurking behind the numbers. The summary outlined below covers the three most common accounting mistakes we see in the construction industry.

  1. Misstatements on percentage-of-completion calculation.
    For many construction companies, the percentage-of-completion calculation, or over and under billing calculations, drive the financial statements and thus, the accuracy of a company’s financial statements. Job costs are the most important part of this calculation. Tracking remaining job costs is often difficult because the engineer, on-site job manager and company management may all have different opinions on the progress of a job. Management needs to verify the job costs being shown in the accounting records represent an accurate portrayal of the progress on the job. Keeping accurate and up to date estimates requires communication between all parties involved. Management also needs to verify items such as change orders, open purchase orders, invoices and the estimated length of time needed to complete the job have been accurately reflected in the calculation.
  2. Incorrect allocation of overhead to jobs.
    Every construction company needs a reliable method for allocating overhead among jobs.Overhead refers to costs that benefit all jobs, such as: rent; insurance; salaries; office supplies; marketing; and professional fees. An accurate allocation method will lead to a more realistic representation of job costs and profitability. Many construction companies allocate overhead based on labor costs or hours, but in some cases this may not be the most accurate method.

    • Some projects may rely more heavily on equipment or materials. In these specific cases, it makes sense to allocate overhead based on one of those costs.
  3. Inaccurate reporting on loss.
    As noted above, misstatements on percentage-of-completion calculations are important for management to minimize, however additional considerations are needed if a job is likely to generate a loss. If so, the method requires recognition of loss fully at the time it is determined. Project management should regularly review each project’s costs and should accrue a loss if estimated costs exceed the contract amount.

Questions?

Smith Schafer is a recognized leader in providing accounting, auditing and consulting services to the construction industry. Our Construction Group, comprised of numerous professionals, is committed to serving over 500 Minnesota construction and real estate entities. Click here to schedule a 30 minute free consultation. We look forward to speaking with you!