Does your accountant have special expertise in the construction industry? Construction-specific accounting methods aren’t taught in school. This week, Wade is walking us through those methods and how accounting looks different for construction companies.
Topics we cover in this episode include:
- The individual quirks with construction accounting that aren’t taught in school
- How the percentage of completion method gives a truer picture of where your company is
- The importance of job costing
- How so many people treat retainage receivable incorrectly on their books
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[00:00:00] Rob Williams: Welcome to the Contractor Success Forum. Today, we are discussing the differences in accounting for construction. And we at the Contractor Success Forum discuss financial strategies for running a more profitable, successful construction business.
And in one corner we have Wade Carpenter, Carpenter, and Company, CPAs. Helping contractors nationwide to become permanently profitable for over 30 years. Wade provides accounting, auditing, bookkeeping, and consulting with tax matters in construction.
And in the other corner, we have Stephen Brown. He’s providing construction risk control through bonding and insurance. Stephen stays relevant through a career dedicated to solving the needs of his clients and offering solutions that work for his customers with over $500 million of bonds approved in just the last five years. Stephen is poised to help take you to the next level. Stephen is with McDaniel-Whitley bonding and insurance agency.
And I am Rob Williams, your profit strategist with IronGate Entrepreneurial Support Systems. I’m helping drive profits in your business with decades of experience as a contractor myself. So today guys, Wade, are there any differences between accounting for construction versus other businesses, how could they be different?
[00:01:29] Wade Carpenter: Well, absolutely they are. And I’m here to tell you that construction accounting is not taught in school. Basic accounting is taught in school. There’s a lot of different methods and there’s a lot of different individual quirks from construction that are just not taught in school. So, the question came up like, why do you need a construction CPA? A lot of CPAs don’t know the rules, quite frankly, from the GAAP standpoint that’s, you know, accounting principles, as well as the tax principles, they are different.
[00:02:02] Rob Williams: Oh, yeah. Stephen, in, in your bonding experience?
[00:02:06] Stephen Brown: Generally Accepted Accounting Principles for Contractors. There’s a whole book on it that just about every underwriter, underwriter trainee, and agent has read about contracting. And then from the bonding standpoint, there’s a percentage of completion accounting methods that are everything.
It’s the engine that drives our ability to keep your bonds going throughout the year. Not just based on what your fiscal year end says, but it’s what drives your bond program.
[00:02:36] Rob Williams: Yeah. For so long, I guess, I guess I’m old. So I was around this a long time, I guess I didn’t understand what GAAP meant because we did our taxes– excuse me, our, well, that’s what we do. Our accounting, we did it for tax purposes. And we did it the way we wanted to report it. And then the accountants or, or the guys that would do the stuff to give to Stephen, to give to the bonding agency, they would take our books and then do whatever they had to make it GAAP. Where it’s supposed to be the other way around. So I just didn’t really understand what GAAP was for construction.
I thought we were all just deciding what the best method that would make the most sense to us. I didn’t realize for decades that they, they had a book that told them how, that there was a standard way that everybody needs to be doing this.
[00:03:27] Stephen Brown: And did we make clear GAAP stands for Generally Accepted Accounting Practices? Is that right?
[00:03:32] Wade Carpenter: No principals. Yeah.
[00:03:34] Stephen Brown: Principles. Okay.
[00:03:36] Rob Williams: Which are–
[00:03:37] Stephen Brown: Generally accepted.
[00:03:38] Rob Williams: It’s not the IRS. I didn’t realize that. It’s different.
[00:03:42] Wade Carpenter: it is different and believe it or not, there are different hybrid methods for the IRS that are acceptable, that are not acceptable for GAAP. And there are some rules for, the accounting methods for, for tax purposes that, don’t follow a GAAP either. So, I don’t know if we’re going to talk about accounting methods.
You have accrual method taught in school. To an extent you have a cash method taught in school. That is it. But what what Stephen’s looking at is percentage of completion. And there may be some other methods like completed contract we can talk about in a minute, but with cash or accrual, it’s very easy to say, you could be way far billed in advance on your jobs and look really good on a cash basis. But, you could be so far underwater on that job that you could be next to being out of business because you’re out of work. And the percentage of completion is the reason why the bonding companies want it because that’s a truer picture of where they are.
[00:04:44] Rob Williams: Before we get too deep in it, let our listeners know, okay, why do we do GAAP? What you were just saying. It’s a standardization. Is that right? So people like the banks and Stephen and them can know what they’re looking at to compare them to?
[00:04:57] Wade Carpenter: It is the standardization for accounting, this is what we’re supposed to be following. And I guess I could also say that, there are different types of construction that percentage of completion is also not necessarily the accepted method for that. If you’ve got a construction management job, that would be accounted differently from something like this typical construction contract where you would do percentage of completion.
Something like a developer, or, just, we don’t talk about on the residential side as much, but a home builder that’s doing spec homes. They’re essentially doing accounting, or they should be doing accounting, based on completed contract method. It’s essentially inventory for your costs. And it’s a liability for your billings until you complete that job or you sell that house.
[00:05:49] Rob Williams: Does everybody need to do GAAP? That was my one thing, cause I’ve run into some guys that say, I don’t want to go into the commercial. I’m not going to do a bonding job. I got to do all that different accounting stuff that I don’t understand. So, so you can run a business without GAAP if you don’t need financing and if you don’t need– well, you might, there’s another way to get financing.
But if you don’t need a big bond and if you don’t need regular, I’m calling it regular financing, that’s compared to that, then you don’t need to do GAAP. I guess you could put up collateral or something for that. I, I don’t know if the bonding, if you can get bonded without doing GAAP accounting. Yeah. Okay. I was wondering about that.
[00:06:32] Wade Carpenter: Yeah. You can get by with a banker. And not to knock a banker, but most of the bankers don’t know the difference. You could have reported on accrual basis. Or, cash basis or your tax method. Typically a lot of bankers will look at your tax return and that’s the only way to do it. And we may have a very different method of accounting for your tax purposes. And it’s unfortunate because we’re trying to minimize your taxes, but to maximize your financial statement or maximize bonding, we follow GAAP and we do different things to get there.
[00:07:06] Rob Williams: Yeah, I think this is one of the big hurdles that people have that take the road that I did that went from residential to the commercial side. And this was one of the intimidating factors of having to go through GAAP and having to make these changes that we didn’t even know what the heck we were looking at doing.
So it’s, it’s kind of a big deal, but it’s not a big deal. And I don’t know how much it changes the business. As long as they’ve got somebody to report it. Now they can’t have their regular bookkeeper probably do GAAP accounting because most of the people they’re just doing the cash basis set of books that I see, the small guys. And to convert to this, it’s probably gonna take more than the bookkeeper, it’s your cousin in the back that needed some work or something that’s doing that. So. Your cousin may be smart, but, but you need somebody with experience with GAAP to do that. Anyway. I hope, I hope I’m not getting off of the topic, but on the differences of that, some of the differences to me are the intimidation factors of switching this.
And why do you even need it?
[00:08:10] Wade Carpenter: Well, number one, the distortion factor. If you are on accrual basis, you could bill a whole bunch up front, but you may not be able to collect that. You may have a bunch of retainage or whatever, but you know, the reason percentage of completion kind of gets that out, if you’re way far overbilled, build ahead, that’s what we want to do, you may not have earned that much yet. So you actually could be having a liability. And it brings that revenue back to a point of what have you actually earned based on the percentage that you’ve gotten done?
Conversely, you could be so far underbilled, and Stephen and his underwriters are probably looking at, how much are you overbilled or underbilled as a percentage of different things on your balance sheet or your revenue. But a lot of the things that we’re doing on a percentage of completion basis are not intuitive. If I had a accrual basis or a cash basis contractor and I increased my cost, what does that do to my profit? It brings our profit down.
Now on percentage of completion, if we increase– this, doesn’t make sense to people unless they really think about it. If you increase costs on jobs that you are making profit on, you’re increasing your percentage of completion. You’re also going to be bumping up your profit.
So a lot of people try to avoid getting their bills in or whatever. Well, number one, it’s distorting the picture, but number two, you’re shooting yourself in the foot with percentage of completion account. Does that make sense? Because we’re going to make an adjustment for whether you’re over or under billed based on whatever percentage– and your revenue, based on whatever that percentage of completion you actually are.
[00:10:01] Rob Williams: Want to define the over, under billing in there? Maybe it gets difficult. I know on some of these tests that Stephen and I were in some classes, just the concept of over and under billing, I got it until they started asking me these really detailed questions on these tests and, and how it affected things.
[00:10:18] Wade Carpenter: Let’s just take some easy example. Let’s say we had a hundred thousand dollar costs. We’re expecting a $200,000 revenue. The whole contract’s going to be $200,000. We got $50,000 of costs in on that job. So 50,000 of the a hundred thousand we’re expecting in costs, that’s going to be 50% of revenue.
Well, number one, going back to what I said before, if we actually had some costs like $10,000 more of costs, that would be $60,000 worth of revenue or 60%. And 60% of 200,000 would be $120,000 of revenue earned. We may have billed $140,000. So in that case, we would be overbilled by $20,000. We’ve earned revenue up to 120,000.
I’m not trying to get too deep in the woods, but does that kind of make sense to you?
[00:11:12] Rob Williams: Yeah, it does, but it definitely gets your head spinning sometimes because you’ve got the cost. And when you’re in the residential world, you just have a cost. When the cost goes up, your billing in your contract was the same. Where the cost and the billing, the revenue is tied to your costs and you get these percents. That’s the thing that is not intuitive for the guys coming from the residential.
Because if you got a a hundred thousand dollar addition you’re doing, and you spend $60,000 this month instead of 50, well, you’re just $10,000 over budget. It didn’t change your billing. It didn’t change anything like that. And in the commercial, you’ve got to realize with that when that cost is going up. And what do you do with that extra 10 that you’re over budget? Going ahead and reporting that now as over budget, under budget, under billing over-billing. And then, then I guess you’re trying to line that up with, with what your contract is.
[00:12:14] Stephen Brown: We had a whole podcast on over and under billings, I remember. Under billing show up as a asset because you haven’t built out, but you’ve incurred costs. So that’s an asset. But over billings is the work that you haven’t performed, the costs haven’t been accounted for yet.
[00:12:31] Wade Carpenter: And then that’s one of the things, I know we could talk about cash flow all day long, too. Encouraging your subs or your material suppliers to get their bills in before you do your billing. A lot of people say, I don’t want to pay that yet. Well, but if you get that bill in, whether you paid it or not, a lot of people don’t realize how much costs they’ve actually got in that job.
And then they’re sitting on, expenses they’ve already incurred and work there they’ve already done. So it’s counterintuitive, but it definitely helps bump up the profit, as long as you’ve got a profitable job. If you got a negative job, well, you may want to take a, you know, a lost job, you been want to take a little different approach to it, but.
[00:13:10] Rob Williams: Right. Yeah. That’s that was my example a minute ago. Yeah. And then that gets a little difficult, so.
[00:13:16] Wade Carpenter: But you know, one of the things that I know, we, we also wanted to talk about this time is, we can’t really do percentage of completion or completed contract if we don’t have job costing.
[00:13:32] Rob Williams: Great point.
[00:13:32] Wade Carpenter: I know that’s one of our hot topics we talk about. But number one, job costing is not taught in schools. Maybe more advanced manufacturing type things where we’re costing out. But I, just had this conversation with a multi-family general contractor last week that basically has exploded in growth, but they have no job costing and they can’t get it in their heads that they got to do this.
Number one in school, they teach you well, okay. So you got an expense, that goes to materials. But not, well, it goes to materials and we’re going to cost this to this job. And usually when I price out, like doing bookkeeping services for construction contractors, we kind of put it in two different buckets. Do we want to do like basic job costing, or detailed job costing?
Basic job costing would say, I want to put this cost for materials into just that chart of accounts. Detailed job costing is going to say like this, say it was subcontractor. Well, basic would say, we’re going to put it to subcontract, track expanse, but detailed would say, well, we had a, electrical, subcontractor, HVAC subcontractor. The phases and cost codes is what I refer to it as.
Getting down to a little more, we don’t have to get too deep in the details, but you know, if you’ve got a contractor and you’ve never done this, maybe you need to start with the five categories: materials, labor, subs, equipment, and other. If you can do that, that’s a great start.
And you know, if you make it too complicated from the start, sometimes it’s just tough to do, but you know, I’ve, I have that multi-family, never been bonded and now they’re being approached by a bonding company. They got a job, they’ve got to bond and they want us to create a WIP report with nothing. So with no job costing. And it’s tough.
[00:15:25] Rob Williams: You don’t know where you are in the middle of the job without the job costing and stuff. Especially the longer the jobs go. When you’re, if you’re building a one month project, you probably don’t need that stuff. Cause you start it and then you finish. But when you’re in the middle of that, how do you know where you are at for these monthly quarterly reports?
Financials and get some reasonably accurate picture. And I guess the only way to do that is with job costing. That’s how I know how to do it.
[00:15:52] Stephen Brown: From a bonding standpoint, you get these credit score bonds, usually up to about a half a million dollars. Over that, you’ve got to produce some reports, accounting reports. That’s, that’s just the way it is. You have to be able to show what you’re billing, your receivables, what your costs are. And these companies that want to transition from credit scoring bond programs to regular programs, they don’t get how huge that gap is.
[00:16:21] Wade Carpenter: Yep.
[00:16:22] Stephen Brown: I’m not talking about GAAP, G-A-A-P.
[00:16:24] Wade Carpenter: yeah, We’re just talking about that, but yeah, I mean, one of the things I hear from contractors all the time, it’s like, I run it by what’s in my bank account. And I, in my gut, I know how I’m doing on this job. Well, your gut can be wrong. And a lot of times in your gut, your overhead factor may be something that has absolutely nothing to do with what’s actually your overhead factor should be.
But from a Profit First standpoint, if we’re going to do that, well, number one, you can get so far with putting things in the Op ex bucket. And that’s when, we need to start breaking it down more into materials and subs, things like that. You know, You don’t really know about what’s in your bank account, because it can fool you.
[00:17:06] Stephen Brown: Also, you’re not getting bids. You’re just right in the middle or you’re high and you don’t understand, how can so-and-so be doing this job for that amount? That’s my cost. Is it really? Be for sure. They may be bidding at below cost, but do you really know?
[00:17:24] Wade Carpenter: I know this whole podcast is about differences in construction accounting. I don’t think we’re going to hit all of them today, but one of the other ones I wanted to talk about was retainage receivable. Because so many people treat that incorrectly on their books. And number one, when you bill on an AIA billing, and they, say, take out 10% for retainage, and you have say a billing of a hundred thousand dollars and they took out 10,000 retainage. Your revenue should reflect a hundred thousand dollars and you should have $90,000 sitting in your accounts receivable. And you should have a separate tracking of your retainage receivable for the remaining 10.
I see people in their books, they’ll show $90,000. And this particular contractor that I was talking about with the multi-family stuff, they always backed that out and they wanted a WIP report. And their billing needs to reflect the entire billing that they’ve earned, including that retainage. Does that make sense?
[00:18:25] Stephen Brown: I’ll see a retainage column on an ACE receivable list. It makes a lot of sense.
[00:18:31] Wade Carpenter: And again, going back to the fact that you need to have that in a separate account. Because number one, if you’d put it all in your accounts receivable column, you’re going to look like you’re taking 120 days or more, depending on how long your contracts go before you collect that retainage. You’re going to look out of whack to your bonding companies. They’re going to say, why are your receivable so high? You’re not collecting any money. If they understand that, that retainage, if it’s in a separate bucket, they understand that. If you’re seeing your regular accounts receivable is over 90 days, they’re going to throw it out the window because they know you’re probably not going to collect the regular accounts receivable once it gets over a certain period of time.
[00:19:10] Rob Williams: When you see that retainage in there and you said you’ve, you’ve already realized the revenue? You’ve already put that there? Have you realized that for tax purposes, or are you waiting till you receive it to do it on tax purposes?
[00:19:24] Wade Carpenter: Well for tax purposes, that’s they’re–
[00:19:26] Rob Williams: Oh, this is GAAP, right? This is not–
[00:19:27] Wade Carpenter: This is, this is GAAP.
[00:19:29] Rob Williams: This is GAAP. And that’s the things that we got to get straight in our head, cause this is when we got to remember.
[00:19:33] Wade Carpenter: That’s a great example. Because retainage receivable, there are hybrid methods in accounting. If you know how to apply it, you can do an accrual basis, less retainage receivable. That’s an accepted accounting method and it’s not a GAAP method, it’s not anything– and unless you know construction accounting, you would never know that you could do that.
[00:19:55] Rob Williams: So what you’re saying is if we’re, I guess typically they’re billing that they’ve got the whole billing thing it’s down there. It’s the revenue, but then they’ve got this, I guess it’s an asset leftover. Is it, would it be an asset?
[00:20:08] Wade Carpenter: It is an asset.
[00:20:09] Rob Williams: it would be an asset. But you’ve already got that revenue, but you make an adjustment for your taxes.
[00:20:16] Wade Carpenter: If you’re on a accrual less- which is a hybrid method.
[00:20:20] Rob Williams: Yeah.
[00:20:20] Wade Carpenter: If you’re on accrual less retainage.
[00:20:24] Rob Williams: Yeah. So, so those are a lot of basic questions that I’ll get and think about when we’re talking about that. It’s well, I don’t, I don’t want to pay taxes on, I may never receive that and I haven’t received it yet.
[00:20:37] Wade Carpenter: Yeah, exactly. And I know we were probably running out of time here, there’s other things like retainage payable, that kind of goes the other way. And you really got to think about those kind of things. You know, construction four walls and, we could talk about it depending on if you’re getting bank. Mine are typically commercial guys, but if you’re like a home builder and you’re getting construction draws or something like that, they’re going to have a phase code cost code kind of thing that the bank is going to require.
So there’s a lot of different things that we haven’t even really touched on with the construction accounting, but just know that they do not teach a lot of these concepts in school, even to CPAs, you know, even the advanced stuff. They don’t teach this because it’s not something that people do every day. And unfortunately, when a bookkeeper or whatever, a lot of them never learn that if they, they try to go to the local college and take a course. It’s not out there because they don’t teach it. And you got to learn it on the job or from somebody that knows these laws and, from the tax side or whatever. That’s why you can’t just jump out of school and throw it in your QuickBooks and expect it to be right.
[00:21:46] Rob Williams: Those are some great points, really good points. And the fact that, you know, after all these years, I still get it in my mind that there’s sort of two sets of books. There’s a set of books that you pay taxes. They’re not two sets of books, but I guess it’d be better to say they’re adjustments for taxes.
[00:22:02] Stephen Brown: Yeah,
[00:22:03] Rob Williams: you’re doing something–
[00:22:04] Stephen Brown: I threw that out once on one of our podcasts and I was wrong and I was corrected on it. There are not two sets of books. That’s just it.
[00:22:14] Wade Carpenter: I know it sounds bad. And if you actually do have two sets of books, well, that’s the one you’re trying to hide from IRS. Well, those are the ones you’re going to jail for. So I guess on that note..
[00:22:25] Stephen Brown: Okay, good point. So, one way you learn about accounting for contractors is through the Contractor Success Forum. And you also we’ve been preaching all along, you need a construction oriented accountant who does this all the time. There’s a lot of tweaking that can be done that can really benefit you by the right accountant. Any other ways, Wade?
[00:22:50] Wade Carpenter: Well, again, believe it or not, I would say 90% of the CPA’s out there, probably more than 90%, don’t know these rules unless they specialize.
[00:22:57] Stephen Brown: It’s certainly frustrating for me to try to get bonds for commercial contractors that don’t get that.
[00:23:05] Wade Carpenter: Yeah.
[00:23:07] Rob Williams: All right. Well, that’s great. Well, this has been very, very insightful and thought provoking. So that’s, that’s a big thing is you’re definitely not going to get all this in one little podcast, but it starts your brain flowing. So hopefully there’s one or two points that we pick up. That’ll just register.
It’s one of these things that you have to hear over and over and over again to sink in your head, especially if you’ve been around for awhile, if you didn’t begin with GAAP principles that we were just talking about.
So, this has been a great show, guys. I appreciate you coming out early this morning to get on the Contractor Success Forum.
Thank you. Wade Carpenter, Carpenter and Company, CPAs and Stephen Brown with McDaniel-Whitley bonding and insurance agency. And I’m Rob Williams with IronGate Entrepreneurial Support Systems. Thanks for being here today. If you need our information, if you need to get in touch with Wade, check out our show notes or our web page Contractor Success Forum dot com. And you can ask him some of these GAAP questions and see if he can help you. Thanks a lot. Have a great day.