Percent-Complete Accounting

In most industries, accounting is a straightforward matter of matching revenue from the sale of a product with all the costs of production and delivery within the same accounting period. This is also true of the remodeling business, with one big exception: The product sold does not exist at the time of sale, and the ultimate cost to produce it is not yet known.

Beyond cash and accrual

Of the four methods used to recognize income, costs, and profits on construction contracts, cash and accrual are most familiar. The cash method is simplest for filing tax returns because income is recognized when payment is received and expenses are recognized when bills are paid. However, it's easy to lose track of payables and receivables using the cash method.

The accrual method solves this problem because income is recognized when it is earned (typically when the invoice is prepared) and expenses are recorded when they are incurred (when invoices are received). While this works well for time and material or cost-plus contracts, when dealing with contracts in which expenses are "front-loaded" to maximize cash flow, accrual accounting may result in income amounts unrelated to actual costs incurred. The danger in using either of these accounting methods is that you may be led to believe that you have more money than you really do.

One alternative is the completed contract method, under which revenue and expenses are not recorded until the contract is complete. While this arrangement enables you to defer paying taxes on a project's profit until the job is completed, management-wise you don't have the tools you need to run your business.

Percentage of completion

The best accounting method for remodeling projects is percentage of completion because it recognizes revenue, cost, and gross profit throughout the life of each contract based on a periodic measurement of progress.

Imagine, for example, that ABC Remodelers has a $500,000 contract for a major addition for which the estimated cost is $400,000. During the first month of the job, ABC does the following:

1. Pays $10,000 for permits, fees, and other start-up costs.

2. Receives an invoice for $10,000 from a sub.

3. Prepares the first progress billing for $60,000.

The table below shows how each of the four accounting methods would treat these transactions in ABC's income statement. Only the percent-complete report gives a true picture of the company's profitability as of the end of the month. --Steve Maltzman, CPA, is president of Builder Accounting Services in Redlands, Calif.