As a Certified Public Accountant (CPA) specializing in construction company accounting, I often encounter questions from clients about the complex tax regulations they must adhere to. One of the critical areas that demand attention is choosing the right accounting method, as it directly impacts the company's financial statements and tax liabilities. In this blog, we will delve into the Internal Revenue Service (IRS) thresholds that construction companies need to consider when selecting between cash, accrual, percentage of completion (POC), and completed contract methods (CCM).
What are the basic accounting methods?
Accounting methods refer to the rules and principles used by businesses to record income and expenses for tax and financial reporting purposes. All businesses generally choose between two primary methods: the cash method and the accrual method.
1. Cash Method
The cash method recognizes income and expenses when cash is received or paid. It is relatively straightforward and often preferred by small businesses, as it is easier understand and maintain. Accounts receivables and payables are not generally part of cash basis financial statements. When work is completed and invoiced is not relevant to cash basis, only when the cash is received or paid.
2. Accrual Method
The accrual method records income and expenses when earned or incurred, regardless of when cash is received or paid. It is argued that this method provides a more accurate view of a company's financial performance. As soon as the work is complete and invoiced, generally the income is recorded. Similarly, when bills are received from vendors, the expense is recorded. When you receive payment on an invoice or when you pay your bill is not necessarily relevant to accrual basis.
What are the IRS requirements for construction company accounting methods?
The IRS establishes specific thresholds to determine which accounting methods any business (including construction) must use. These thresholds were adjusted as part of the TCJA in 2018 in order to provide relief to small businesses, including construction companies. Prior to TCJA, businesses with an average annual gross receipts of $5 million were considered "small business". TCJA is set to expire in 2025, so for 2023 the thresholds are still generous:
1. Gross Receipts Threshold
For 2023, businesses with average annual gross receipts of $29 million or less for the previous three tax years, they can freely choose between the cash and accrual methods. Falling under the $29 million threshold allows the business to be classified as a "small business" which comes with some advantages.
2. Long-Term Contracts
The IRS defines a "long-term" contract as any construction contract not finished before the end of the tax year. For example, if you are a calendar year taxpayer, and the contract begins on December 31 and is finish on January 1 the next year, the IRS considers it a "long-term contract". Long-term contracts must use the following accounting methods:
Percentage of completion (POC) - The IRS requires construction companies to use the POC method for long-term contracts unless the "small business" classification applies. There are other exceptions that apply to residential construction and manufacturing. In summary, the POC method uses an estimate to determine the progress on a contract which determines the amount of profit that can be recognized on that project.
Completed contract method (CCM) - Only "small business" entities meeting the qualifications noted above are able to use CCM. It is generally easier and simpler to manage than POC, which is why it is appealing to construction companies. All costs and income related to the project are postponed until the project is complete.
The following factors should also be considered when choosing the best method for your construction business:
1. Company Size and Growth: Smaller companies generally prefer to use cash method and CCM due to its simplicity. Larger companies tend to prefer POC and accrual because it can give you a better picture of profitability of a project as it progresses.
2. Project Duration: Construction companies often have a mixture of both short and long-term projects, so the balance between them needs to be considered. Primarily short-term projects would make the simpler accounting methods appealing, but a majority of long-term projects might make POC more beneficial.
3. Financial Reporting Needs: If your construction company seeks external funding or intends to attract investors, using POC and accrual methods are generally preferred.
Seeking guidance from a qualified CPA with expertise in construction company accounting is essential. A CPA can assess your company's unique circumstances, future projections, and goals to help you make informed decisions that align with IRS regulations and optimize your financial position.