Managing the finances and accounting for a construction or trade business can be challenging. The construction industry in particular can involve a large number of transactions, huge sums of money and complex financial structures that can be overwhelming for anyone.
One of the most critical decisions construction company owners must make is the type of accounting method to use. The accounting method you choose will determine how your business bookkeeping recognizes and reports business income and expenses which in turn affects your business taxes, financial statements, and overall financial health.
The two most common accounting methods used in the construction industry are Cash and Accrual.
Cash accounting recognizes income and expenses at the time that money is received or paid. In other words, you record revenue when the money hits your bank or wallet, and you record expenses when money leaves it.
This method of accounting is simpler and easy to manage, making it a popular choice for small businesses in Canada. It provides a real-time snapshot of your cash flow, helping you make informed financial decisions.
However, the cash method may not be suitable for larger construction companies or those with complex financial structures. This is because the cash method doesn't accurately reflect the overall financial performance of your business. It doesn't take into account outstanding invoices (money owed to you) or unpaid bills (money that you owe). Also, tracking long-term trends and financial projections can be more difficult with the cash method.
Accrual accounting recognizes revenue and expenses at the time they are earned or incurred, regardless of when cash is received or paid. This means that you record revenue when you complete a project, no matter if you received payment before starting or halfway through completion. You record expenses when you incur them, even if you don't pay the bill for 3 months afterwards.
The accrual method provides a more accurate representation of your construction company's overall financial performance and allows for better long-term planning and forecasting. It also helps make sure you comply with Generally Accepted Accounting Principles (GAAP), which help attract investors and secure loans.
However, the accrual method can be more complex and time-consuming than the cash method. It requires meticulous record-keeping and may make it harder to manage cash flow in the short term. So if you tend to treat your bookkeeping like a once-a-year event, this method is not a great fit for you.
Confused? Here's an example scenario:
You purchase all the lumber and supplies needed to complete a job at the local hardware store and put it on your account. You have 30 days to pay. As you are leaving the store, you realize you need a new hammer, run back in and pay cash for the tool. The job in question takes two months to complete. The client paid a 50% deposit at the start of the project, and the remaining 50% upon completion.
Money out: Account for the cost of the tool the day you bought it and the supplies when you pay the store's invoice two weeks later.
Money in: Account for the first 50% the day you get paid, and the remaining 50% two months later.
Money Out: Account for the cost of the tool and the supplies the day that you went to the store.
Money In: Account for the deposit and the balance the day the project is completed at the end of the two months.
The Completed Contract Accounting Method
There is one more method you can consider for your construction business. Completed contract accounting recognizes revenue and expenses only when a project is completed. This means that you don't record any revenue or expenses until the project is finished, even if you receive partial payments or incur expenses along the way.
The completed contract method is suitable for long-term construction projects that can take several months or years to complete. It helps to show each project's profitability and allows you to defer taxes until the project is finished.
However, the completed contract method can be risky and unreliable, especially for small businesses. It might make it harder to manage cash flow and may not accurately reflect your construction business's overall financial performance.
It's also worth pointing out that this is a one-time use method. This means that if you choose this method, and then decide it's not for you, the CRA will let you switch to either a cash or accrual accounting method, BUT you can not go back to the completed contract method if you decide it's the best method to use a few years later.
Like all other important business decisions, there is no absolute answer. Much like your accounting software, you need to choose the right accounting method that suits the needs of your construction company. This will depend on the size, structure, and financial goals of your business.
It's crucial to consult with a Canadian CPA or an accounting professional to determine which method is best for your business. If you're interested in finding out how we can help you navigate accounting for the construction industry, reach out!