There are so many tasks on a building site that few people have time to take a special interest in construction accounting.
But taking control of construction business finances is vital not only for a healthy business today, but plays a part in empowering sustained growth in the long term.
Whether you’re looking to learn about architect accounting or accounting for builders, this blog serves as a construction company accounting guide.
It explains in simple terms how to do construction accounting in all its forms, and it answers the fundamental question: what is construction accounting?
Here’s what this article covers:
How is construction accounting different from accounting principles?
Basic business accounting is fundamentally about profit and loss, and ensuring a healthy cash flow.
Construction accounting adds in an additional element: project accounting. Not only that but projects can last a long time, leaving large gaps between cash coming into the business.
How construction accounting differs from normal business accounting is in the following, which could effectively form the chapters of an accounting manual for a construction company.
Most firms focus on the following areas when it comes to watching and presenting the numbers.
The first step towards taking control of your finances is to understand your project costing each and every time.
You need to be able to easily and effectively detail contract amounts, estimates, costs, subcontracts, purchase orders, quantity totals, production information, customer information, billings and other project information in as much detail as you need.
Because of the nature of construction and the fact timelines are often stretched, you’ll also need to be able to detail project totals by job, year, quarter, month or week, as well as period-to-date accumulators on a daily, weekly, two-weekly or a more irregular semi-monthly basis.
This kind of data is the bare minimum for any construction firm that wants to stay on top of it all rather than lurch from one financial challenge to the next.
The nature of construction work means even the best plans are regularly torn up or rejigged. That means being able to anticipate these changes and pivot to take control of variations or change orders is vital.
This includes changes to the design, materials, work patterns and more. An experienced construction manager knows to anticipate and then manage what’s required.
This starts before the first spade hits the ground.
Your contracts should include clauses to allow for variations, and these should state clearly what the anticipated costs might be with reference to the project and job costing.
Understanding your budget and why it’s changed is critical to pinpointing your true job costs.
Documenting and monitoring the status of change orders will give you that vantage point and make sure you get paid for all the work you do.
Firms are increasingly being hit by legislative accounting requirements, which not only impacts construction accounting but effectively defines how it’s done.
The UK government has introduced a raft of changes to construction accounting, including the VAT domestic reverse charge, and new processes for submitting tax returns via Making Tax Digital.
How to prepare a final account in construction
Well-prepared financial statements in the final accounts contain a goldmine of timely and revealing information about your company’s financial position.
What are its strengths?
What are its vulnerabilities and challenges?
Is the business making money?
Savvy construction executives use the information on these final accounts—most notably the balance sheet, income statement and statement of cash flows—to drive decisions and chart a course for the company’s future.
Measuring your true growth from year to year can help assess your policies and financial strategies.
Here are the four most useful indicators you’ll find in a final account in construction.
1. Debt-to-Equity Ratio for construction accounting
The debt-to-equity ratio is used as a standard for judging a company’s financial standing and its ability to repay its obligations.
Banks look at the ratio and use it to assess risk in providing a loan.
Lenders prefer low debt-to-equity ratios (less than 1.5-2:1) because their interests are better protected in the event of a business decline.
Higher ratios indicate the company is being financed by creditors rather than from its own financial sources, which could send up a few red flags.
2. Gross Profit Margin for construction accounting
Gross margins reveal how much a company earns on projects, taking into consideration the costs that it incurs for producing its products or services.
It’s one of the most commonly used measures in the construction industry because it provides a good indication of how profitable a company is at the most fundamental level—including how efficiently a company uses its resources, materials and labour.
As a construction executive, you should analyse gross profit on jobs frequently throughout their lifecycle.
By performing a fade analysis, comparing gross profit at the completion of a project to the estimated gross profit at inception, as well as at interim points along the way, you can detect and resolve problems on the job and determine strategies for better controlling costs.
3. Average Age of Accounts Receivable for construction accounting
The only thing worse than not having work is doing the work and not getting paid for it.
Cash is king. The age of your accounts receivable, therefore, has become an important measuring stick for executives and other reviewers of financial statements.
If your invoices are taking longer to collect, questions will arise regarding the status of your jobs and clients.
Review your Accounts Receivable Aging constantly and use it as a tool to detect collection problems and take action if your average age of receivables exceeds more than 10 to 15 days over terms of collection.
4. Working Capital Ratio for construction accounting
When third parties review finances, the main basis for their decision-making is typically a construction firm’s working capital ratio—the central indicator of the health of your business finances.
To calculate this fundamental figure, start with current assets and divide by the current liabilities on your balance sheet for a year-end or period financial statement.
For example, if at the end of the year your firm has £1m in current assets and £500,000 in current liabilities on your year-end balance sheet, you have working capital ratio of 2-to-1.
Frequently asked questions about construction accounting
Although the above explains the fundamentals of construction accounting for the likes of builders, accountants and others, let’s take a quick look at some of the basic questions that get asked.
What is construction accounting?
Construction accounting focuses on tracking materials and labour, and the scope of construction accounting is beyond just a fixed office or manufacturing environment.
The needs of construction work mean different kinds of accounting processes need to be used.
Some of this is the same kind of traditional number crunching, as seen in any business, but much of it relates to the project work undertaken by construction firms.
For most firms, there are two elements to construction accounting: project-level accounting and business level accounting.
At the project level, construction accounting aims to always have the financial details that provide answers to the following questions:
- Is the project on schedule?
- Is the project on budget?
- Is the work free from defects?
- Is the work getting done right the first time?
- Is the work being performed safely?
At the business level, construction accounting must provide the financial data to answer the following questions:
- Is enough cash coming in?
- Do we have enough work?
- Is our labour productive?
- How is our profit margin?
What is construction contract accounting?
This is a form of accounting that uses the construction contract as the basis of the accounting – which is to say, revenues are projected based on the likely costs.
This way profits can be assured because there’s a constant measurement of the actual on site costing compared to the contractual amounts.
As such the stage of completion is also used as a measure to measure the profitability of the project against the contract’s milestones.
What does a construction accountant do?
Specialist accountants or chief financial officers have a deep understanding of the nature of construction accounting.
They’re clear on the two strands of project and business accounting, and they’re used to working with an industry where the plans are altered on a daily basis.
They are able to anticipate these changes and pivot to take control of variations or change orders.
This includes changes to the design, materials, work patterns and more. An experienced construction accountant knows to anticipate and then manage what’s required.
How to do construction accounting
Construction accounting is best aided by accounting software that connects the office to the site.
Therefore, that means not only is it easy to make adjustments when events occur but it also means those who sit behind desks can see instantly when situations change.
In addition, if cloud accounting software is used, adjustments can easily be made on site using a mobile phone or tablet.
It’s not necessary for everybody to understand the deep fundamentals of construction accounting, but you do need to have access to accurate and up-to-date data.
What is the best accounting software for construction?
By having integrated software systems in place you get easy access to current, consistent data, allowing for timely measurement against key performance indicators (KPIs) and quicker, more accurate completion of key processes.
Data is centrally managed in a single database and structured consistently.
This kind of high-quality cloud-based software built for this industry transforms your accounting processes, and does the following:
- Supports and automates critical industry-specific functions (such as job costing, estimating, equipment, and project management).
- Provides information transparency and supports tracking of timely measurements against KPIs.
- Eliminates silos of information and reduces data re-entry that can result in errors.
Technology underpins nearly every business process today.
Used effectively, that technology can help you unlock your business potential, improving your use of critical data, tracking KPIs more effectively, and creating vital reports that can steer your company in the right direction.
A final word on construction accounting fundamentals
For those operating in the construction industry, whether just starting out or as an established small or medium-sized business, managing business accounts often takes a back seat.
And that’s completely understandable.
After all, construction is an industry where so much effort goes into securing work, building and maintaining professional contacts, and actually getting the job done to your client’s—and your own—satisfaction.
The impulse to handle your accounts on an ad-hoc basis might be a short-term time saver.
But in reality, it can limit your potential.
With a streamlined system of accounting in place, you may be able to capitalise on your experience and specialise to improve your operations.
You can make real-time decisions while projects are ongoing, and you can create long-term plans for growth—as well as mobilise your business to make that happen.
Tackling the Construction Industry Scheme with Sage Accounting
Learn about the Construction Industry Scheme and your legal responsibilities, and find out about the new VAT reverse charge for construction.
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