Building Design and Construction Handbook - Merritt - Ventech!

17.19 ACCOUNTING METHODS
CONSTRUCTION PROJECT MANAGEMENT 17.61
The contractor together with an accountant should select a method of accounting
best suited for the contractor’s operations. The method selected will determine, to
a great degree, the amount of taxes paid as well as the accuracy of the information
that the contractor will be able to furnish to his bonding company.
One of two bases is generally used: the cash basis or accrual basis. The accrual
basis is subdivided into (1) straight accrual basis; (2) completed-contract basis; (3)
percentage-of-completion basis.
The cash basis is used mainly by small contracting companies. The gross income
is reported on the basis of cash receipts. Contract costs are reported on the
basis of actual expenses paid. This method has the advantages of simplicity, control
of net income by the timing of requisitions and receipts, and payments of taxes
after profits have been earned and collected.
The disadvantages of the cash basis are as follows: It is not an accurate reflection
of the company’s financial condition. It does not show monies earned and not
collected, or debts incurred and not paid. It cannot be used for surety purposes.
The straight-accrual method can be used for both short-term and long-term
contracts. In this method, the gross income is recorded when earned and expenses
are recorded when incurred, regardless of when the cash is received or disbursed.
It has the advantages that statements of income reflect actual operations during the
period, all receivables and payables are recorded as incurred so that the balance
sheet is more useful, and if there are more payables than receivables, less tax has
to be paid.
The disadvantages are as follows: The gross income may not be accurate. It
may not be the same as the gross profit because of advance billings (caused by
unbalanced requisitioning, or front-loading) or job-site inventories. There is less
flexibility in tax planning than in other methods. If there are more receivables than
payables, the accrual method will result in a higher tax.
The completed-contract basis is used for long-term contracts. It is also very
good for joint ventures. The income of each long-term contract is recognized only
when that contract has been completed or substantially completed.
The advantages are as follows: Taxes are effectively deferred until completion
of the project, thus augmenting the contractor’s working capital. Contract profits
are figured on the basis of actual results, rather than on estimates that could overlook
unforeseen future costs or delays. All receivables and payables are recorded
as they occur, making a more accurate balance sheet. Taxable income can be regulated
between years by deliberately hastening or deferring contract completion.
Profits as accrued can be invested and used to earn interest before taxes are paid.
And payment of taxes has a better relationship to cash flow from accounts receivable
and retained percentages.
The disadvantages of the completed-contract basis are that it does not reflect
current performance when a contract spans more than one fiscal year and unincorporated
contractors may be penalized, since net income may be irregular and taxed
at higher rates one year and at lower rates in another year.
The percentage-of-completion method recognizes the gross income on each
contract as work progresses. Annual income for each contract should be the same
percentage of total income as contract costs to date are of the estimated total contract
costs. In computation of contract costs, all or portions of costs may be temporarily
excluded during the early stages—for example, start-up costs—if the exclusion
would result in a more accurate allocation of income. The advantages of