The contractor together with an accountant should select a method of accounting best suited for the contractors 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 companys 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 contractors 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 this method are: It is the most realistic annual determination of income. Receivables and payables are recorded when earned or incurred. Liability for taxes arises in the fiscal year when it is actually incurred. And it provides consistent data with very little distortion.
The disadvantages are: It is dependent on estimates from management of percentage of completion and cost to complete. Retained percentages and accounts receivable not yet billed are taken as income although they may not be collected until a much later date. It does not permit the deferral of income taxes, a procedure that may be available with the cash or completed-contract method.