Construction Contract Income: Accounting Insights for Business Success

By Denise M. Holmes, CPA, Partner

Construction Contract Income: Accounting Insights for Business Success

Optimize tax accounting and bookkeeping for your construction business

Accounting for income from construction contracts is not always easy or straightforward. Construction accounting is a highly specialized type of financial management due to the industry’s unique characteristics. Unlike many other types of businesses, construction companies need to track and account for multiple contracts, construction projects, and job costs. Some methods can accelerate income, while others allow for deferral of income.

The basic principles of construction accounting include tracking job costs and revenue recognition.

Job Costing involves accurately tracking and recording all costs associated with a particular project. This includes material costs, labor costs, subcontractor fees, equipment rental fees, and any other expenses incurred for the project.

Accurate Revenue Recognition is essential because construction contracts are often long-term and have agreed-upon payment schedules.

Contractors have a choice of contract revenue recognition methods, and many use one for internal bookkeeping purposes and another for tax reporting.

Income and expenses are reported on tax returns based on one of two accounting methods, which include either the cash method or the accrual method. Either method must clearly reflect a consistent treatment of income and expenses from year to year. Most construction businesses use two different tax accounting methods, one for long-term contracts and one overall method for everything else, which is often the accrual method.


Three overriding issues when choosing a method for tax reporting:

When choosing a method for construction contracts, consider three overriding issues when choosing a method for tax reporting:
1. Is the construction contractor considered “small” for tax purposes?
If a contractor’s 2024 annual gross receipts average less than $30 million (based on the prior three years of receipts) it may be considered a small contractor. (Rev Proc 2023-34) ($31 Million for 2025- Rev Proc 2024-40)
2. Is the contract short-term (i.e., started and completed during the tax year) or long-term?
At the time the contract was entered into is the estimated time frame for completion within a two-year period beginning on contract commencement date
3. Does the nature of the work performed fall within a specialized category (e.g., residential or home construction contracts (HCCs))?

Common construction tax methods

  • Cash method

Under the cash basis of revenue recognition, income is recognized when cash is received from a sale or contract. This method of revenue recognition is simple and straightforward, and it is often used by small businesses that do not have complex accounting processes in place.

  • Percentage of completion method

The percentage of completion method (PCM) of revenue recognition is a popular and commonly used accounting method for construction companies with long-term projects. Under this method, income from each project is recognized proportionally based on the amount of work that has been completed on that project. This allows the construction company to recognize revenue as the project progresses instead of waiting until the project’s end.

  • Completed contract method

The completed contract method (CCM) is a more conservative approach to revenue recognition than the percentage of completion method, as it does not recognize any income until the project has been completed and all performance obligations have been satisfied. This is beneficial because the company can delay paying taxes on revenue if it will not wrap up the construction project until the following year. The completed contract method can only be used for tax purposes by small contractors and on contracts with an estimated life of two years or less.

Cash method: Advantages and disadvantages

Advantages

  1. Provides a more accurate reflection on ongoing project status.
  2. Helps manage cash flow for long-term contracts.
  3. Simplicity and avoidance of potential cash flow timing issues.
  4. Useful for small companies that get paid in cash.
  5. This method calculates income based on the inflow and outflow of cash. Under this method, accounts receivable, retainage, work-in-progress (WIP), and prepaid assets are not considered to be a part of income for tax purposes until realized (collected or paid).

Disadvantages

  1. Cash basis accounting is limited to contractors whose revenue is under $30 million per year.
  2. The cash method may make it harder to secure financing or loans.
  3. It provides limited visibility into trends and accrued work.
  4. The cash method results in a delay between earning revenue from performance and billing, affecting the accuracy of financial statements.

Percentage of completion: Advantages and disadvantages

 Advantages

  1. From a financial reporting perspective, PCM allows a company to recognize income as work progresses on a long-term project. This offers a more accurate picture of profitability throughout the project rather than waiting until the project is fully completed to record income, which can lead to significant fluctuations in earnings.

Disadvantages

  1. This method relies on the use of estimates, and any inaccuracies in these estimates can lead to significant errors in reporting revenue and profits throughout the project. Similarly, these estimates are subjective.
  2. The use of estimates allows for the potential manipulation of the financial results.
  3. Cash flow management challenges may present themselves when the actual cash flow does not align with the revenue recognized through work progress.
  4. Revenue is recognized as costs are incurred and not when cash is collected, thus potentially causing cash flow issues from a tax perspective since contractors may not have the resources to pay the tax liability.

Completed contract method: Advantages and disadvantages

Advantages

  1. Since the income is deferred until the project is complete, this generally will result in the maximum deferral of income for tax purposes.
  2. Aggressive billing practices can enhance cash flow and not impact taxable income.

Disadvantages

  1. When completing several long-term contracts in a single period, the contractor may end up recognizing a substantial amount of income during that period.
  2. In addition, spending cash aggressively from early billings may cause cash flow issues when the tax liability becomes due. Losses on contacts are not deductible until the job is completed.
  3. The alternative minimum tax (AMT) still requires the use of PCM on all long-term contracts, so there will be an AMT adjustment required for contracts accounted for using the CCM, except for home construction contracts.

Staying on top of tax accounting and bookkeeping for a construction business is essential for success in this industry. Keeping accurate records and financial data helps ensure you make a profit, track expenses and costs, and adequately allocate overhead expenses.

If you need help making the right tax accounting method decisions, Keiter’s Construction Opportunity Advisors can consult with you on the best approach to managing your successful construction business.

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About the Author


Denise M. Holmes

Denise M. Holmes, CPA, Partner

Denise serves a wide variety of industries with a major concentration in healthcare and medical practices. She shares her industry knowledge and tax expertise with physicians to assist them in reaching their personal and business financial goals. Some of her specialty areas with Keiter include consulting, compliance and tax research for individuals, partnerships, and S Corporations. She is the leader of Keiter’s Construction niche team.

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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.

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