Choosing an Accounting Method

RESIDENTIAL OPENERBy Jennifer French, CPA

When it comes to accounting, many contractors have two burning questions: which accounting method is best for my company, and which will give me the best tax advantage?

For regular taxpayers, their only concern is whether their overall accounting method should report income on the cash basis or the accrual basis of accounting. However, contractors have other factors that need to be considered. Contractors have the opportunity to use multiple methods of accounting for their long-term contracts. These methods will depend on whether the company is a small or large contractor and whether their contracts are short-term or long-term.

Cash vs. Accrual

Under the cash method of accounting, taxable income is comprised of cash receipts net of expenses and constructive receipts paid during the year. A constructive receipt occurs when money or property is available to the taxpayer without any restrictions.

If the taxpayer receives a check in the mail on December 30, 2017, but does not deposit the check until January 2018, it is still considered income in 2017 since the funds were available to the taxpayer in 2017. Typically under the cash method, expenses are deducted in the period paid with the exception of some prepaid expenses. For example, prepaid insurance of $1,000 paid in July 2017 that covers the period July 2017 to June 2018 would be deducted half in each year since the payment benefits both years.

The small business exception expands the use of the cash method of accounting to individuals, S corporations and partnerships without a C corporation as a partner with average annual gross receipts of $10 million or less. The cash method of accounting does not apply if your business is a corporation or a partnership with a C corporation as a partner, when average annual gross receipts exceed $5 million.

If a contractor is unable to use the cash method of accounting, they must use the accrual method. This method attempts to match expenses incurred during the year with the related income. Income is reported when income is earned and the amount can be determined. Expenses are deductible when the contractor becomes liable for the expense, the amount can be determined and economic performance has occurred.

Long-Term Contracts

There are several methods of accounting for long-term contracts. Contractors should base their selection on three criteria.

First, do you have contracts that are short-term or long-term? The IRS considers any contract spanning more than one tax year to be long-term. For example, a contract started on December 1, 2017 and not completed until January 25, 2018 is considered a long-term contract.

Second, are you a homebuilder or a general construction contractor? Home construction contracts are ones where 80 percent or more of the total contract costs are on buildings that have four or fewer units. All other long-term contracts are considered general construction contracts.

Third, are you a small or large contractor? Your company is considered a small contractor if the annual average gross receipts for the last three tax years is $10 million or less. Large contractors are required to use percentage-of-completion for their general construction contracts. Small contractors have more flexibility.

Small contractors must look at their contracts and divide them into two categories: contracts that will likely be completed within two years and ones that are estimated to take two years or longer to complete. For the longer contracts, small contractors are required to use the large contractor method, percentage-of-completion, even though they are a small contractor.

Small contractors with contracts not exceeding two years must either use the cash, accrual, completed contract or percentage-of-completion method for all general construction contracts.

Completed contract method reports all income and job costs when the project is considered complete. General and administrative costs are deducted under the accrual method. Since income is deferred under this method until the contract is complete, the contractor has some control over contract completion. The IRS deems a contract complete when the earlier of at least 95 percent of total allocable contract costs have been incurred or upon final completion and acceptance of the job.

Percentage-of-completion method reports income as the job progresses. Income is calculated by comparing allocable contract costs incurred to total estimated allocable contract costs. Allocable contract costs include direct and indirect costs along with retainage. Change orders are also included in the percentage-of-completion method.

Wouldn't it be nice to exclude retention payments from costs incurred to date when calculating percent complete on a contract? Large contractors who are required to use the percentage-of-completion method of accounting may want to consider changing their accrual method to include deferral of retentions. This method excludes retention amounts until the retention is payable to the subcontractor.

Another option available to those contractors using percentage-of-completion method of accounting is the ability to defer recognition of gross profit under a long-term contract if less than 10 percent of the total estimated contract costs have been incurred. This threshold is usually exceeded in the subsequent year.

Many accounting methods require a change in accounting method file with the Internal Revenue Service. Consult your tax advisor for the most advantageous method for your company.

Jennifer French is a partner in PBMares, a Williamsburg, Va.-based accounting and business consulting firm. She can be reached at jfrench@pbmares.com.

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