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Boost Project Profitability: Switching Accounting Methods Might be the Answer

March 11, 2024

Timing counts when reporting revenue and expenses for tax purposes, particularly for contractors that work on long-term residential and commercial projects. Let’s explore.

Your accounting method determines when your company will recognize revenue and expenses from jobs. Under current tax law, certain construction companies may be eligible to use the cash accounting method or the completed contract method (CCM). While both methods are simpler than the percentage of completion method (PCM), ease of use isn’t the only factor to consider when choosing the optimal method of accounting for tax purposes.

Cash Method

Under the cash method, revenue is recognized when customers pay invoices and expenses are recorded when your company pays them. This method is simple, and it facilitates cash flow tracking. So, it’s often used by start-ups.

This method can also help reduce your tax bill for the year: Businesses that use the cash method can 1) defer income by delaying sending invoices to customers, and 2) accelerate expenses by pre-paying suppliers and vendors. That means you don’t have to pay taxes on income not yet received.

But IRS rules restrict the availability of the cash method to businesses with average annual gross receipts for the three prior tax years equal to or less than an inflation-adjusted threshold of $25 million. For 2024, the inflation-adjusted threshold is $30 million (up from $29 million for 2023).

Beware: The cash method can distort profits, which can limit your company’s access to capital. For example, if you receive a significant payment from a customer at year end, that year may look very profitable, while the next year shows a loss. Such fluctuations in profitability could alarm potential lenders and investors.

Completed Contract Method

As its name suggests, the CCM allows you to defer contract revenue and contract-related expenses until the year you complete the contract. As a result, you don’t need to regularly estimate percentages of project completion, as required for the PCM. You also won’t have to worry about making adjustments as circumstances or estimates change.

On the other hand, this method provides less tax planning flexibility than the cash method. With the CCM, you can’t defer income or accelerate expenses like under the cash method. In addition, the CCM could cause cash flow issues when you’re taxed on income before you’ve received payments from customers. Plus, companies that use the CCM may have difficulty securing bridge financing for projects from which they haven’t recognized any revenue.

Percentage of Completion Method

If your company uses the PCM, it recognizes revenue and expenses proportionately over the life of a contract. You’ll generally determine the degree of completion by comparing the total allocated contract costs incurred to date with the total estimated contract costs. This is known as the “cost-to-cost method.”

This method allows revenue to be better matched with their related expenses, producing a more accurate picture of your company’s profitability. For this reason, it’s often preferred by lenders and other stakeholders that prioritize financial stability. The PCM also complies with U.S. Generally Accepted Accounting Principles, so you have fewer discrepancies between your financial statements and tax returns.

However, the PCM can be time-consuming and complicated to execute. It requires construction companies to track each project closely and allocate revenue and job-related costs while the project is ongoing. Often contractors that use this method hire dedicated in-house accounting personnel — or they may turn to outside construction accounting specialists — to estimate project completion and allocate costs properly.

The IRS generally requires PCM for contractors with long-term contracts. However, it allows exceptions for 1) home builders, and 2) small construction contracts estimated to be completed within two years. For the small construction exception, you also must satisfy the annual gross receipts test that applies to the cash method.

When may it be beneficial to use two methods of accounting.

Many privately held businesses use their tax method of accounting to manage their books and records. However, as outlined above, some of these methods do not provide the business with an accurate accounting of the performance of the business. Waiting to the end of the project to measure its profitability doesn’t allow management to make the proper corrections to improve results, (ie manage change orders, adjust cost estimates, etc).

In many cases, the business may be required to provide financial information to third parties, raise capital or look for outside investors. In these instances using the GAAP method of accrual accounting will provide the most accurate picture of the Company’s performance. This would require using the PCM method of accounting for book purposes and potentially more favorable method for tax purposes. While this process can seem daunting, working with the right team can help the business set up the proper systems to manage the process.

Contact us to determine the optimal tax accounting method for your business. Our outsourcing specialists can also help handle the complexities of applying the PCM, if you’re not ready to hire a full-time controller or CFO.

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