What Is Construction Accounting? A Guide for Australian Businesses

Construction projects can span months or even years, so managing finances can be a daunting task. Construction accounting is the backbone that supports the financial health of construction projects. On top of standard accounting practices, a nuanced approach is required to handle the complexities of long-term contracts, fluctuating costs, and intricate regulatory requirements. 

This guide will walk you through the best practices in construction accounting, including various accounting methods and pro tips on ensuring financial health.

What is construction accounting?

Construction accounting is a specialised branch of accounting tailored to the construction industry. It focuses on tracking, analysing, and reporting financial transactions related to construction projects. 

As a construction business, you have many additional financial considerations when it comes to daily and long-term finances. Construction accounting deals with these various details, helping effectively manage project costs, revenues, and profitability.

Key components of construction accounting

Construction accounting considers several key components, so you can properly manage various types of construction projects. 

Job Costing

Job costing is a fundamental aspect of construction accounting, where costs are tracked by individual job or project rather than by department or line item. This approach allows you to monitor the profitability of each project and make necessary adjustments to stay within budget.

Revenue Recognition

Revenue recognition on a milestone basis lets you evaluate the profitability of a project before it’s completed. This means that you can account for revenue as the project progresses, providing you with a more accurate financial picture.

Work in Progress (WIP)

WIP accounting involves tracking incomplete work on ongoing projects. This way, you can assess the value of work done but not yet billed, ensuring that financial statements accurately reflect your company’s financial position.

Retention

Retentionrefers to a portion of payment withheld until a project is completed satisfactorily. This practice protects clients by ensuring that contractors fulfil their obligations but can impact your cash flow. 

Change Orders

Change orders represent modifications to the original project scope, often leading to adjustments in project costs and timelines. Proper accounting for change orders is crucial to maintaining accurate financial records and project profitability.

What makes construction accounting different?

Construction projects can take years to complete. They also often change in scope, delivery dates, and costs related to materials and labour. Unexpected or unpredictable events occur often as well, such as weather impact and additional work that arises due to structural issues or client demands. 

As such, there are many different things construction accountants must keep in mind. 

Managing cash flow in long-term projects

Challenge: Construction projects often span months or years, creating a mismatch between upfront expenses and delayed payments. This can lead to cash flow shortages during critical project phases.

Solution: Implement milestone-based billing and negotiate favourable payment terms with clients. Use building loans or construction-specific financing to bridge cash flow gaps.

Example: A builder working on a 12-month residential project could negotiate a payment schedule with 20% upfront, 30% at foundation completion, 30% at the lock-up stage, and 20% upon final inspection. This ensures a steady cash inflow throughout the duration of the project.

Dealing with fluctuating material costs

Challenge: Material prices can change significantly over the course of a project, potentially eroding profit margins if not accounted for properly.

Solution: Use cost-plus contracts or include price escalation clauses in fixed-price contracts. Maintain strong relationships with suppliers to secure better pricing and terms.

Example: A contractor could include a clause in their contract stating that if the cost of steel increases by more than 5% during the project, the additional cost will be passed on to the client.

Accurate tracking of labour costs

Challenge: Labour costs can be difficult to allocate accurately, especially when workers move between multiple projects or perform various tasks.

Solution: Implement a robust time-tracking system that allows workers to log hours by project and task. Use job costing software to allocate labour costs accurately.

Example: A construction company could use a mobile app that allows workers to clock in and out of specific projects and tasks, automatically feeding this data into their accounting system for precise job costing.

Handling multiple projects simultaneously

Challenge: Managing the finances of multiple projects concurrently can be complex, making it difficult to assess the profitability of individual projects.

Solution: Use project-specific accounting and implement a WIP schedule to track the financial status of each project separately.

Example: A builder managing three projects could create a WIP schedule showing the contract value, costs to date, billings to date, and estimated completion percentage for each project, allowing for a clear overview of each project’s financial status.

Navigating complex tax regulations

Challenge: The construction industry faces unique ATO tax regulations, including specific deductions and GST considerations, which can be challenging to navigate.

Solution: Stay informed about industry-specific tax laws and consider engaging a tax professional specialising in construction accounting.

Example: A construction company could claim depreciation on assets like scaffolding or heavy machinery, potentially reducing their taxable income. They might also need to use the cash or accrual accounting method for GST, depending on their turnover. The “margin scheme” for GST on property development projects can improve cashflow over a project’s life.

Managing retention

Challenge: Retention, where a percentage of payment is withheld until project completion, can significantly impact cash flow.

Solution: Factor retentioninto cash flow projections and consider negotiating for reduced retentionpercentages or earlier release of retained funds.

Example: If a $1 million project has a 10% retentionclause, the contractor should plan for $100,000 being withheld until project completion, potentially months after the majority of work is done.

What are the different construction accounting methods?

In Australia, construction companies can choose from several accounting methods to best suit their business needs and project types. 

Cash basis accounting

Cash basis accounting is the simplest construction accounting method. You record income when cash is received and expenses when they are paid. It’s suitable for small contractors working on short-term projects. However, keep in mind that it can distort financial performance for long-term projects.

Example: A small renovation company receives $50,000 for a kitchen remodel. They record this income when the payment hits their bank account, not when they invoice the client. Similarly, they record the $30,000 spent on materials and labour when they pay their suppliers and workers, not when they receive the bills.

Accrual basis accounting

Using the accrual basis accounting method, you record income when it’s earned and expenses when they’re incurred, regardless of when cash changes hands. It provides a more accurate picture of a company’s financial position but also requires more complex accounting practices. 

Example: A medium-sized construction firm signs a $500,000 contract to build a house. They record this income when they invoice the client for completed stages, even if payment hasn’t been received yet. They also record expenses for materials ordered, even if they haven’t paid the supplier yet.

Percentage of completion method

When you use the percentage of completion method, you recognise revenues and expenses based on the percentage of work completed. Typically, you’d use this for long-term projects. 

Example: A large construction company has a $10 million contract to build an office building over two years. At the end of the first year, they estimate they’ve completed 40% of the work. They would recognize $4 million in revenue and the corresponding percentage of total estimated costs for that year.

Completed contract method

Under this method, you defer all revenue and expenses until the project is completed. The completed contract method is useful for short-term projects or if you can’t reliably estimate the percentage of completion. It can also help defer tax liability, although it may not reflect your company’s financial situation accurately at a given point in time. 

Example: A contractor takes on a $200,000 project to build a small commercial space. They don’t recognise any revenue or expenses until the project is fully completed and handed over to the client, even if it spans multiple accounting periods.

Progress payment method

This method is similar to the percentage of completion method but ties revenue recognition more closely to actual billings and collections.

Example: A construction company working on a $5 million project bills the client monthly based on work completed. If they bill $500,000 in a month, they would recognise this amount as revenue, along with the corresponding costs incurred for that work.

The choice of accounting method can significantly impact your company’s financial statements and tax liabilities. Larger companies (with annual revenue over $10 million) will typically need to use the accrual method for tax purposes, while smaller companies have more flexibility.

Unsure which method to use? Consult with construction accounting professionals in Australia to determine the most appropriate method to manage finances for your company while staying tax-compliant. 

Best practices for effective construction accounting

In addition to choosing the right accounting method for your circumstances, here are some best practices you may wish to follow. 

Use specialised construction accounting software

Implement construction-specific accounting software that can handle job costing, progress billing, retainage, and other industry-specific needs. Popular options in Australia include MYOB, Xero Construction, and Buildertrend. This software can streamline processes and improve accuracy.

Regularly review financial statements and keep detailed records 

Frequently review financial statements, including profit and loss statements, balance sheets, and cash flow statements. This helps identify potential issues early and allows for timely corrective actions.

Keep comprehensive records of all financial transactions, including change orders, invoices, receipts, and contracts. This supports accurate reporting and decision-making. In Australia, businesses must retain financial records for at least 5 years.

Train staff in construction accounting or engage a specialist

Ensure that your accounting staff are well-versed in the unique aspects of construction accounting, including job costing, progress billing, and industry-specific tax regulations. 

Alternatively, consult with accounting professionals who specialise in the construction industry to ensure compliance with Australian regulations and optimise financial performance. This is especially important for navigating complex tax laws and claiming industry-specific deductions.

Implement effective job costing and accounting methods

Use accurate job costing to track costs and revenue for each project, breaking down labour costs, materials, and overhead in detail. This is crucial for monitoring profitability and controlling costs.

Select the accounting method that best suits your business size and project types. Options include cash-basis, accrual-basis, percentage of completion, and completed contract methods.

Manage change orders and cash flow

Implement a robust system for documenting, approving, and tracking change orders. This helps maintain project profitability and avoid disputes.

Regularly forecast and monitor cash flow, considering the timing of project expenses and payments. This is crucial in the construction industry, where large sums are often tied up in ongoing projects.

You can also implement progress billing to improve cash flow by billing clients at various stages of project completion rather than waiting until the end.

Stay informed about tax regulations

Last but not least, keep up-to-date with Australian tax laws affecting the construction industry, including GST requirements and potential R&D tax credits.

What can and cannot be claimed under construction accounting?

In addition to the complex accounting requirements, construction companies have access to various tax deductions. Claiming these properly can significantly reduce your company’s taxable income. However, be careful to not overclaim or miss eligible deductions. 

What can be claimed:

• Vehicle and travel expenses related to work, including fuel, maintenance, insurance, and travel between job sites.
• Tools and equipment under a certain value. More expensive items can be depreciated over their useful life.
• Employee wages and payments to subcontractors for work related to construction projects.
• Construction materials used in projects.
• Insurance premiums that are relevant to the construction business, such as public liability and workers’ compensation.
• A portion of home office expenses if you work from home, including rent, utilities, and internet.
• Professional and legal fees directly related to the operation of your construction business.
• Safety equipment and protective clothing required for construction work.
• Education and training expenses that directly improve skills required for your construction business.
• Marketing and advertising expenses for your construction business.
• Self-education expenses if they directly relate to your current employment and maintain or improve your skills.
• Costs of seminars, conferences, and training courses related to your work in construction.
• Stationery items like logbooks, diaries, pens, and notepads used for work-related purposes.

What cannot be claimed:

• Personal expenses which are not directly related to business operations.
• Expenses without proper documentation or receipts (except in some circumstances where receipts are not required).
• Repayments on study or training support loans, including HECS-HELP, FEE-HELP, VET Student Loans, etc.
• Expenses related to obtaining new employment or changing employment.
• Education expenses that only relate in a general way to your current employment.

What you can and can’t claim will depend on many factors, such as the size of your business, your accounting method, and the specific nature of the expenses. When in doubt, ensure tax compliance by consulting with a qualified tax professional or referring to the latest ATO guidelines for the most accurate and up-to-date information.

FAQ

What are the most important aspects of construction accounting?

The most important aspects of construction accounting include job costing, revenue recognition, and cash flow management, as they directly impact project profitability and financial stability.

What is the formula for construction accounting?

Construction accounting does not rely on a single formula but rather a combination of methods and practices to track costs, recognise revenue, and manage cash flow effectively.

What happens if I make a mistake in my construction accounting records?

Mistakes in construction accounting can lead to financial discrepancies and compliance issues. It’s crucial to regularly review records and consult with professionals to rectify errors promptly.

Final thoughts

Construction accounting is a complex yet essential aspect of managing construction projects. By understanding its components, methods, and best practices, construction firms can enhance their financial management and project profitability. 

Lawpath can help your business ensure tax compliance while maximising eligible tax deductions. Get in touch with us today to learn more.