Your Accounting Method Isn’t Set in Stone
Originally published on October 16, 2023
Updated on October 19th, 2023
Your daily accounting functions are the financial backbone of your construction business. So you might think that changing your accounting method would be disruptive and detrimental.
The truth? Quite the contrary. Switching to a different method can have significant positive effects on your taxes, cash flow and overall financial situation. While you don’t want to flip-flop often on this choice, it pays to at least know your options.
Your accounting method is the set of rules your company follows when recognizing income and expenses for federal income tax purposes. These rules dictate the timing of when this recognition happens, which in turn impacts your tax obligation. When your company was established, you selected an accounting method (even if you didn’t realize it at the time).
But like many aspects of running a business, the same method won’t always serve you well as your organization grows. And there are plenty to choose from — as many as 10 according to some guides!
So how do you choose? We’ve detailed the four accounting methods most commonly used by construction companies.
If you started your company from the ground up, chances are this is the first accounting method you used. In cash accounting, revenue is recognized when it is received and expenses are deducted when they’re paid. If you don’t have the cash or haven’t spent it, the transaction isn’t recognized. Because it’s more straightforward, this method makes it easier to track your cash flow.
Sole proprietors and small businesses most often use cash accounting due to its simplicity, as additional staff generally isn’t needed. It also lets you defer income to the next tax year by delaying invoicing (and in turn deferring tax liability) and speeding up expenses by paying invoices earlier.
If yours is a smaller company, you can use the cash accounting method for contracts that are expected to finish within two years of the start date. The IRS defines a smaller company as one with average annual taxable gross receipts under $29 million for the three preceding years . Companies not under this threshold, however, cannot use this method for tax filing.
The accrual accounting method bases recognition on action instead of when money changes hands. For example, your revenue is recorded when work is completed instead of when your company actually receives payment. Likewise, your expenditures are recognized when they’re incurred instead of when you pay for them.
Mid-sized construction firms generally choose one of these two accrual accounting methods:
Percentage of Completion Method (PCM) is a form of accrual accounting for long-term contracts. It recognizes revenue and costs proportionally as a contract progresses, better aligning revenues with costs incurred and providing a more accurate representation of profitability over time. This is favorable when dealing with lenders, bonding companies and investors because it shows consistent revenue generation and stability. This method also allows you to smooth out the swings in income created by another accounting method.
PCM is required by the IRS for contractors with average annual gross receipts for the previous three tax years over $29 million. It’s also compliant with the Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB). So by choosing this method, you’re financial statements and tax return align better
Completed Contract Method (CCM) – Under this accounting method, revenue and profit are recognized only when a contract is fully (or substantially) completed. It’s simpler than PCM as no complex periodic estimates of costs to complete or calculations of percentage completed are needed. (This in turn reduces administrative overhead.) Unless your jobs are incurring losses, it’s also a safer method if you face significant uncertainties in your projects. By deferring revenue and profit recognition, you can avoid excessive adjustments due to changing circumstances or estimates.
Should my construction firm switch accounting methods?
Many companies are often unaware they can change their accounting method or know about the benefits such a change can provide. It’s one of the many reasons why a construction CPA is your best bet to guide you in these matters.
Companies change methods for a variety of reasons, both operational and strategic. Here are some of the primary reasons to consider this decision.
Tax Considerations: Different accounting methods can result in different taxable incomes. So you might switch to one that reduces your tax liability.
Better Reflect Economic Reality: Some methods provide a better representation of your company’s actual economic position and operations than others. This is particularly important if you’re trying to secure financing/bonding or having trouble with gross profit fading on jobs.
Lender or Investor Requirements: Some investors and lenders require use of a specific accounting method as a condition of their investment or loan.
Operational Simplification: The complexities involved in maintaining some accounting methods might outweigh the benefits. This could lead a company to switch to a simpler method that requires less administrative effort.
Comparability: If your competitors or peers use a particular method, you might switch to make your financial statements more comparable to theirs.
Improve Perception: Different accounting methods can paint a more favorable picture of your company’s financial health. For example, changing depreciation methods can influence reported profits.
Mergers and Acquisitions: If your company acquires another or merges with another entity, you might adopt a unified accounting method different from what either entity used before.
Adapting to Business Changes: If the nature of your company’s business changes, you might adopt a new method that better suits current operations.
Technological Changes: As technology evolves, some older methods may become outdated. This sometimes prompts companies to adopt more modern approaches.
The Alternative Minimum Tax (AMT) calculation is another complexity in the construction industry. If your company chooses a method other than PCM and has nonresidential contracts, you are subject to AMT. This requires companies to recalculate their income on a percentage of completion method. If the difference from your tax method to percentage of completion is large enough, you could owe additional AMT. If your company uses the percentage of completion method for tax purposes, this calculation is not required.
How do I make this change?
As you can imagine, you can’t switch accounting methods on a whim. You’re required to complete Form 3115 and file it with the IRS. You often need to explain the reasons for the change to regulators and stakeholders and in your published financial statements.
Also keep in mind that some of the above-mentioned accounting methods are applied to individual projects. So projects started before that change stay on your old method, while those started after it are on your new method. This can get confusing. For this and other reasons, get help from a CPA well versed in construction financial operations.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
Other Posts You Might Like