Accounting methods used in construction bookkeeping and accounting include cash basis, accrual basis, the completed contract method (CCM), and the percentage method (PCM). In this part, we’ll compare cash basic vs accrual accounting and how to choose the right accounting method for your construction business or for individual projects within a construction business.
Cash vs Accrual Accounting
Cash basis accounting is a method of accounting in which income and expenses are recognized when cash is receivable or expenses when they are paid. In short, Cash basis accounting only recognizes a transaction when you spend or receive money (when you cash a cheque). In cash accounting, everything’s based on its real-time impact on your cash.
For example, your construction company has just completed framing and you bill your customer $10,000 due 30 days from the invoice date. Meanwhile, you still have to pay for payroll costs. Under the cash method, you don’t have any income from the work you have done up to this point. Only after your customer sent payment the following month can you say you made money.
Accrual accounting is a method of accounting where revenues and expenses of an enterprise relating to assets, liabilities, equity, revenue, and expenses must be recorded at the time of occurrence, regardless of when the money is actually received or paid. In short, Accrual Accounting recognizes a transaction when money is earned, but not exchanged (when you send an invoice). Accrual accounting records revenue as it’s earned rather than when it’s received.
For example, let’s look again at the mentioned case. This time, when you finish framing and bill your customer, you will record $10,000 of accounts receivable even if you haven’t received this amount. It’s literally receivable under the accrual accounting method. When you receive payment next month, you’ll simply move the $10,000 from A/R to your cash account.
The difference between Cash Accounting and Accrual Accounting
Accrual accounting is superior to cash accounting because accrual accounting information fully reflects a manager's overall impact on future cash flows. As a result, accrual accounting is more effective for administrators than cash accounting.
In fact, small businesses use the method of cash accounting because it is often easy to understand and simple. This method does not require any special accounting training or skills, as long as the staff can organize numbers in a table and manage a simple spreadsheet.
However, some larger firms with more complex business operations must use a different approach. The vast majority of companies in the world choose accrual accounting because cash basis accounting cannot meet the needs of keeping records, especially in large companies, corporations with large and complex business operations.
Specifically, businesses with inventories must use accrual accounting methods, recording revenue, and expenses when selling without being dependent on revenue or expenditure. This helps the company understand the actual causes and results of the business activities, the revenue recognized during the business operation period, and the expenses recognized in the same period as the joint venture revenue.
| Cash Basic Method | Accrual Method |
How does it work? | This method recognizes revenue when cash is collected and expenses are spent. | The approach records revenue in the period earned, not when received, and expenses in the period incurred, not when paid. |
Limitations | Financial statements aren’t very useful in this method since they won’t reflect accurately any of the money a company expects for the work they have done. | A company owes taxes on revenue that was earned and accrued, but where the cash has not yet been collected. |
Limitations | Companies flexibly manage their income levels by timing disbursement around period deadlines. By delaying receipts, they can pay taxes in another period. | It provides a full, more accurate picture of financial results. It is the only method that complies with GAAP. |
How to Choose The Right Construction Accounting Method
Choosing between cash basis and accrual basis accounting should be a non-issue for your construction business given that your firm has to follow the standard accounting principles of GAAP and taxes. You must use actually to produce GAAP financial statements.
Issues to consider when choosing between cash versus accrual include:
Project terms
Short-term projects that are completed within a single fiscal year, might be appropriate for the basic. For long-term contracts, the accrual method will provide better financial data to analyze the health of the business.
Capital machinery
Construction companies can capitalize and depreciate the cost of machinery in the accrual method. This method allows you to spread equipment costs out over time, based on the life of the equipment. If using a cash basis, you would recognize the entire expense in the period the equipment was paid for.
Customer Payments
In construction, billing methods are more complicated and asynchronous, such as the American Institute of Architects (AIA) billing process that provides for retainage, scheduled payments, and stored materials concerns, then the accrual method is a better fit.
Conclusion
The cash method is best if you have a lot of transactions and deal directly with consumers. The accrual method is best if you deal with large businesses and don’t get paid quickly.
Are you ready to get help, or are you still not sure if you need help to run your construction business? Contact Construction Cost Accounting to have a free 15-minute consultation!
