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The Top 3 accounting methods and the lies they tell to contractors

Should you run your contracting firm on the Cash Method, the Billings Accrual Method or the Completed Jobs Accrual Method? Take 4 minutes to read this, and you will probably know.


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April 14, 2015 by Victoria Downing

By Victoria Downing

Keeping track of your revenue and expenses as a contractor can be very time-consuming and even confusing. How can you accurately determine what your budget is, how much your expenses are eating into your profit and how to budget for a future project?

At its core, the biggest problem contractors face when it comes to understanding how to best manage their money is the answer to one simple question:

When is a sale a sale?

Following are the three most common accounting methods we see contractors using when they first come to us at Remodelers Advantage. They all answer this fundamental question in entirely different ways.

1. THE CASH METHOD

Question: “When is a sale a sale?”

Answer: “When we actually get the money!”

In the Cash Method, income includes all revenues received, and expense includes all bills paid. So we must have actually collected the money for it to be income, and we must have actually paid the bill for it to be an expense.

This method gives you a good idea of cash flow for the time period. However, this report potentially can be very misleading. Collect a first draw, and it goes to income. But you haven’t earned that money. You haven’t done the work it pays for. You’ve just gotten an advance.

Most entrepreneurs (not just contractors) use the cash method when they first go into business.  It’s common but it does not give the most accurate picture of the company’s health. If you really want to manage your business effectively, stop using the cash method as fast as you can!

2. THE BILLINGS ACCRUAL METHOD

Question: “When is a sale a sale?”

Answer: “As soon as we send an invoice!”

In the Billings Method, income includes all billed receivables (money people owe you) and cost of goods includes all expenses for which you have been billed (money you owe someone else).

This method, too, can be a very misleading way to present company operations. One of our business management rules for contractors is to stay ahead of your client in your billings and collections. This means that you are not acting as the bank for project expenses… that you have collected money from your client in advance of purchasing for the project.  However, this “staying ahead” means many of your reports would look too rosy while others might look too dire.

For instance, you may have actually completed 30% of a job, yet billed the owner 45%. Because this method recognizes all billed amounts as income, your P & L report will show that 45% as income against only 30% of the job costs. Your next reports, however, will show 55% of the billings against 70% of the job costs. In this circumstance, your P & L’s would at first show your financial position as much rosier than reality. Then later P & L’s would show a poor picture as though your job costs were running very high in comparison to your income. This wild swing in your financial reports makes it difficult to use them as management tools.  You want to manage with realistic figures.

3. THE COMPLETED JOBS ACCRUAL METHOD

Question: “When is a sale a sale?”

Answer “Why, it’s not a sale until the job is finished (or substantially finished).”

This method tallies all money coming in for a job and all money paid and billed for the costs on the job but does not show these as income and expense on the P & L until the job is completed. Meanwhile overhead expenses are usually shown as they are expended each month. This is commonly used by new home builders.

Because this method is the slowest to show new dollars in income, it may well be chosen by your accountant to present information for tax purposes since it may defer your income to the next year for tax purposes. Of course, ultimately that income catches up with you in the next year.

If you use this method for your management reports, your profit and loss statement may look too negative. If you are a specialty contractor and your jobs are very short in duration (under a week), you can use this method effectively.

However for full line renovation contractors, this method is the most misleading.

Do not use the completed jobs method of accounting for your management reports if your jobs are under construction for more than a week or two.

Which method is best for you?

As you can see, these three “common” methods all have very misleading characteristics. Because of this, we at Remodelers Advantage requires our Roundtables members to run their day-to-day financials with the Percentage of Completion Method.  This method will give you the most honest and clear picture of where your company stands financially at any point in time.

 


Victoria Downing

Victoria Downing

Victoria Downing, President of Remodelers Advantage Inc., is a leading authority in the remodeling industry. Remodelers Advantage is based in Laurel, Maryland.
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