Construction Methods of Accounting: Cash Basis vs. Accrual Accounting

Construction is already a tough industry. Add accounting into the mix, and it’s easy to become completely lost. Thankfully though, you don’t have to become a CPA to make sure your accounting system follows the book.

While construction accounting is a highly specialized practice with multiple unique rules, there are just two main methods of accounting contractors use for bookkeeping and recognizing revenue: cash basis and accrual basis.   

Key Takeaways

• Small business owners bringing in less than $30 million in annual revenue can use cash basis accounting, while larger businesses will have to make the switch to the accrual method.
• While there are advantages and disadvantages to both types of accounting methods, we recommend contractors use the cash method as long as they can, because it is easier to understand.
• When it comes to taxes, partnering with a construction tax specialist can help you not only make the switch from cash basis to accrual, but make sure you owe as little as possible. Find someone you trust who can be a long-term partner to your company.

What is Cash Basis Accounting? 

In cash basis accounting, a construction company recognizes revenue when cash is received and expenses when they are paid - no matter when the services are actually performed or incurred. So, if you send out a billing under cash basis, you don't earn the money till the customer pays you.

For example: Let’s say you get a deposit to construct a new building. With the cash method, you’d recognize that deposit as revenue as soon as it’s paid to you, even if the project hasn’t started yet.

One of the nice things about the cash method is that it’s pretty straightforward. At the same time though, it doesn’t give the most accurate picture of your financial health if there’s a significant time gap between billing the customer and receiving the cash. Still, we highly recommend construction businesses stick with this method as long as possible because of its ease of use, along with some other important benefits we’ll get to later. 

Most small-to-medium business owners will use this method for revenue and expense recognition until they’re forced to move to accrual accounting.

Something to think about: As of 2024, the cash basis method of accounting is reserved for small businesses (corporations and partnerships) operating under $30 million in annual revenue under IRS publication 538.

Pros of Cash Basis Accounting

• The cash method of accounting is all about simplicity. Since you’re only accounting for cash received or paid, tracking your company’s cash flow and income statement is easier.
• With this method, you know what you’ve earned and will have a good idea of what your tax liability will look like in general.
• To get an even better idea of what your tax year will look like, you can calculate your estimated taxes in your books as you collect. 

Cons of Cash Basis Accounting

• Because the timing of receipts and payments can vary, the cash method can actually overstate your financial position.
• The cash method makes projecting future revenue difficult.
• Cash basis accounting isn’t recognized under Generally Accepted Accounting Principles (GAAP).

What is Accrual Basis Accounting?

Unlike cash basis, the accrual method of accounting is a bit more complicated. This method of accounting uses the matching principle, where revenue and expenses are recorded in the accounting period earned/incurred, regardless of when you actually received or paid money. Because it reflects a job’s financial progress (even if cash hasn’t exchanged hands yet), accrual accounting paints a much more accurate picture of the economic reality of construction. Because of this, the banks and bonding agencies you work with will most likely prefer you use this method.

For example: You bill a customer for a job completed on April 10th. Under the accrual method, you’ll create a receivable account and recognize that revenue when you send the invoice over, even though the owner has 30 days to pay the invoice. Because you’re creating an accounts receivable and revenue at the exact same moment, but not being paid for the accounts receivable until later, you need to make sure you’re carefully tracking your business’s cash to avoid a cash crunch.

Before ASC 606 was passed, there were two processes contractors on the accrual method would use to recognize revenue — percentage of completion and completed contract.

Percentage of Completion Method – With this method, revenue is recognized based on an estimate of how far along a job is, the costs incurred, and expected profit. This was the main method used by most construction contractors until ASC 606 was passed as the standard. It’s important to know that ‘percentage of completion’, or ‘percent complete’ as it is called, is favored for its ability to match revenue recognition with the costs incurred to earn that revenue as a project progresses. This allows for revenue to be reported more evenly throughout the life of the project.

Completed Contract Method – This method defers recognizing all revenue and expenses until a contract is completed. It’s used when the total contract value or date of completion is unknown. Completed contract accounting offers a clear picture of a project’s success after its completion, though it can lead to significant fluctuations in your income statement and balance sheet as you move from one reporting period to another.

How GAAP Comes Into Play

The accrual, percent of completion, and contract completed methods all come from Generally Accepted Accounting Principles (GAAP), which are set by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board. All publicly traded companies (and many private companies) follow GAAP rules because they help company leadership better understand their accounting records and financial statements. 

Pros of Accrual Accounting

• The accrual method aligns with banks' and bonding companies' views of how business financials should be handled.
• After you become familiar with accrual accounting, you’ll have a better understanding of what larger construction companies are doing - and how to follow their lead.
• You can defer the tax liability of the retainage of your revenue (when done properly under tax laws). To do this right, make sure you consult with a tax professional.
• Because it’s the only construction accounting method compliant with GAAP, many investors and lenders require it.  

Cons of Accrual Accounting

• Unfortunately, you may owe taxes on revenue that’s been earned, even if you haven’t received the cash payments yet.
• Accrual accounting is much harder to understand than cash basis. And now, ASC 606 has made it much more difficult to understand, especially if you don’t deal with it on a daily basis.

When to Switch From The Cash Basis to the Accrual Method

Unlike deciding which project delivery methods you want to bid on, there’s not a lot of choice when it comes to the method of accounting you use. If you’re operating under $30 million, you can (and should) use the cash basis method. In our experience though, most construction companies opt to make the switch around the $10 million mark.

You may also be pushed to change your accounting method by the banks, bonding companies, and state licensing agencies you work with. For example, if you need to create GAAP-compliant financial statements, you’ll have to use the accrual accounting method.  

Either way, you’ll want a construction accounting expert in your network who you can count on to guide you through the process. Making the switch isn’t easy, especially when you factor in changes in how taxes are handled. Partnering with an expert early on will make sure nothing falls through the cracks. As you grow your business over the years, these are the kind of long-term partners who will help you be successful for years down the line.    

How Each Method of Accounting Handles Taxes

As we mentioned above, the method of accounting you use will have tax implications. All construction companies have to fulfill specific tax reporting regulations set by the Internal Revenue Service. While financial reporting has placed requirements on which method you can use, the IRS allows you to use different accounting methods.

Cash Method: Cash basis accounting allows your income to be reported when received, and expenses when they are paid. Not surprisingly, this is the easiest method to understand from a tax point of view because it will line up very closely (around 95%) with the cash method. 

Accrual Method: On the other hand, the accrual method of accounting may not coincide with your actual cash flow, so you may experience a tax lag. Plus, retainage can be an issue if it’s not handled correctly. There’s also the matter of how depreciation is handled, which we’ll explain more in a bit. 

🔎 Dive Deeper: Essentials of Construction Accounting

An Example of How Cash Basis vs. Accrual Taxes Play Out

For this example, let’s assume you’re an SMB contractor with a bookkeeper who can proactively manage the business’s monthly financial transaction flow. In your business, the following transactions happen, and you end up with this Income Statement (These will not affect cash basis):

Current Income Statement - Cash Basis 

For the period 1/1/24 - 12/31/24

• Revenue - $900,000
• Direct Costs - $650,000
• Gross Margin - $250,000
• Overhead Expenses - $150,000
• Net Income - $100,000

Most transactions until October will be processed in the same way for a cash basis and accrual, with standard pay terms for tax purposes. Once you get to the last few months of the year though, you’ll see a big difference depending on which method of accounting is used. 

Let’s assume transactions from October to December 31st look something like this: 

If you’re using the accrual method, your income statement for the year will look like this instead:

Current Income Statement- Accrual Basis 

• For the period 1/1/24 - 12/31/24
• Revenue - $945,000
• Direct Costs - $676,500
• Gross Margin - $268,500
• Overhead Expenses - $151,000
• Net Income - $117,500

This extra $17,500 may not seem like a huge difference, but at a 25% tax rate, this is an additional $4375 that will have to come out of your pocket if you don’t time your tax situation well. Always remember that in construction, cash is king. As your revenue grows, this potential tax burden can become much larger.

Here are a few more tax tips to keep in mind: 

• Especially if you’re using the accrual method of accounting, make sure you have a cash cushion.
• Make sure to follow the IRS’s rules to accurately calculate what portion of your revenue is recognized as “taxable revenue” during a given tax period. If revenue is recognized too early or too late, it can misrepresent your tax liability.
• There’s really no reason to file your taxes early, so hang onto your cash as long as you can.
• We can’t repeat this enough: Use a tax specialist. They’ll know all the tips and tricks on how to reduce your taxable income. For example, there are ways to make retainage not show up on your taxes, which will save you a chunk of change.

Asset Depreciation 

If you have items classified as assets, like trucks, buildings, or construction equipment, their value reduces over time. This depreciation could cause you to have a different tax amount than what’s on your books. 

What you need to know for tax purposes is that assets that are depreciated have set periods during which you will be able to depreciate them. For example, if you buy a truck, you would depreciate it over 60 months, or five years. Your company could own the truck for over five years and have the value of the truck on your books still, but at the depreciated value. The truck would still likely have some value which is referred to as salvage value. If you over or underestimate this salvage value, you’ll eventually see a tax difference between your books and the taxes you file. 

Wrapping Up

At the end of the day, good construction accounting is about staying proactive, not reactive. No matter what method of accounting you use, staying on top of your cash inflows and outflows will help you build a solid financial foundation that can grow with your business. And as always, a good construction accounting software won’t hurt, either. Check out our list of the top 5 construction accounting softwares out there.