The ultimate guide to construction accounting for small businesses and contractors

The construction industry is constantly changing. It is influenced by global economic events, trends in property investment and new government initiatives like a drive to build more affordable housing. As an industry in constant flux, construction accounting can be complicated.

Accounting takes on new meaning for construction firms and contractors due to the nature of the work, per-project pricing, fluctuating operating costs, and much more. Construction companies need to keep a close eye on their income and outgoing, deduct the right amount of tax, navigate government legislation like IR35, Construction Industry Scheme (CIS), and process VAT domestic reverse charges. 

Keep reading to learn more about construction accounting, including:

• How construction accounting differs from other industries
• Construction Industry Scheme (CIS)
• VAT domestic reverse charge
• Basic construction accounting practices
• Project-based accounting
• Tracking expenses
• Reconciling payments
• Cash flow management
• Construction accounting software

As an evolving industry, construction accounting can be a sweeping task – covering everything from routine repairs, single-house renovations to new and large developments. 

When managing your finances, you often need to use specific accounting practices to comply with government regulations and process your annual tax return correctly. While some construction accounting can be rather specialist, we will illuminate some of the main aspects you’ll encounter to help you become more confident with your business’ finances.

Here are some of the main ways that construction accounting differs from other industries:

Most people within the construction industry work as contractors. Contractors typically handle multiple projects at once and often employ subcontractors to help manage any overspill. Projects aren’t always paid as soon as they are completed, so contractors usually charge an upfront deposit for part or all of the work, as otherwise, it can take months till the invoice is cleared.

As a result, construction companies often need to create separate profit and loss (P&L) statements for each project.

Construction companies often offer far more services than other industries. While most businesses offer one to five different products or services, construction companies offer a greater range covering consulting, engineering, labour, design, physical products, sourcing materials, etc. 

As a result, we recommend you set up a process or use an app to help you accurately track your expenses and business operations so you can allocate your accounting records correctly.

Typically businesses track the overall cost of each product or item sold. However, construction companies have to handle both direct and indirect costs, which fall into various categories. As a result, accounting systems for construction companies need to be robust to track income, record expenses and reconcile transactions accurately. 

Only through accurate reporting can construction companies understand their financial performance and profitability.

Most companies can quickly identify the difference between the cost of goods sold and overheads. However, this becomes more complicated in the construction industry. Most items a regular business would consider ‘overheads’ are actually classed as ‘cost of goods sold’ in the construction industry as they directly connect to the clients’ project.

As you’re managing your accounts, you may wish to define and separate costs that are overheads to your business versus the cost of clients’ projects. This can help you make sure you have a proper distinction when calculating your gross and net profits for your business, even if you use the term ‘overheads’ more loosely when talking to clients.

Most industries can calculate their break-even point easily, and once you’re more familiar with construction accounting by the end of this guide, so will you for your construction business.

Because many of your projects are often custom jobs or subject to delays, it may make it trickier to provide quotes upfront. However, as your trading becomes more established, you can begin to get a feel for the major elements that will determine a project’s profitability and its impact on your cash flow overall.

In the meantime, you can hedge your bets by making conservative estimates that take account for project length, payment dates, payment sums, and regular expenses during these same periods.

The construction industry also has to handle a range of UK government guidelines and legislation unique to the sector.

The Construction Industry Scheme (CIS) essentially requires contractors to deduct taxes from subcontractors and then pass this money onto HMRC. These deductions are then counted as advanced payment towards the subcontractor’s overall tax and National Insurance.

If you employ subcontractors, you need to register for the scheme. While it’s not mandatory to register if you work as a subcontractor, it may be a good idea as you are charged at a higher rate if you’re not registered.

From the 1st of March 2021, the UK government has implemented a domestic VAT reverse charge for supplies of building and construction services. This regulation is essentially an extension of the Construction Industry Scheme (CIS) and changes how construction companies must charge and process VAT.

Under the new regulations, companies that supply construction services to VAT-registered customers don’t need to account for VAT. Instead, the customer is responsible for processing and paying VAT to HMRC.

Given the complexities of the industry, construction firms must adapt different techniques for accounting. 

Construction accounting is a type of project accounting, which allows firms to track costs to specific contracts. Every project is set up separately in the construction accounting system. Direct costs, such as materials, consulting and architectural fees, and indirect costs, like equipment rentals and insurance, are allocated to the project.

When setting up your construction accounting system, you’ll first need to decide which type of accounting you’ll use. 

Cash accounting is ideal for smaller construction projects as income and expenses are accounted for when transactions occur, and money changes hands. Income is taxed after costs are deducted from the total revenue.

Most construction companies use accrual accounting for larger projects as income and expenses are accounted for when they’re incurred rather than paid. With accrual accounting, accounts may be based on the part of the contract that’s been completed, especially if the project takes more than one tax year.

Once you’ve determined how you’ll track and account for expenses and income, you’ll then need to calculate job costing. Job costing allows you to monitor the profitability of each contract by giving you an overview of the overall expenses and revenue for each project. 

You can calculate job costing using the below formula:

Total job cost = direct materials + direct labour + applied overheads

Once you know how much a job will cost you, you can work out how much profit you’ve made on the project. The construction industry is notorious for low-profit margins, with a survey from Building magazine reporting two-thirds of respondents saying that profit margins were unlikely to reach 5% anytime soon.

You’ll want to keep a record of all day-to-day transactions, including any expenses you incur as well as any income.

While it may be tempting to only hold onto your receipts, it’s much better to keep a digital record of each transaction with an app like Countingup, which will automatically include the date it occurred and any revenue received. You can then add this fee into your job costs formula. It’s also important to categorise your expenses by service and individual job to accurately track project profitability. Using a simple app like Countingup will do this for you.

Keeping up-to-date records of all your daily transactions will make your job much easier when tax season rolls around and provide better visibility during the project’s lifecycle.

As someone working within the construction industry, you’re likely to incur expenses such as:

• Insurance
• Business registration and licensing
• Tools and equipment
• Travel expenses (for getting to the job)
• Trade school fees (for upskilling)
• Vehicle maintenance
• Materials 
• Safety equipment & uniforms
• Subcontractors
• Bookkeeping and accounting

Some of these costs will be tax-deductible and can help maximise your profits. This is why we highly recommend that you keep digital records of each of your business expenses to save time and money when it comes to completing your tax return. 

Find out the expenses you can claim on in this downloadable guide.

Almost all construction companies use invoices as a way to request payment from clients. As a contractor or subcontractor, it’s essential to keep detailed records of all the work performed and then invoice accordingly.

Creating and your invoices via an accounting app like Countingup is an excellent way to keep digital records and avoid having to manually input information into a spreadsheet.

At the end of every month, you want to reconcile your transactions and make sure they match the details in your accounting system. This means making sure entries in your bank account match the ones in your financial records. You can use the below steps to reconcile payments and make sure your accounts stay up to date:

1. Compare your bank records to your expense record
2. Try to identify any differences between your accounting system and bank account
3. Compare transactions to the expenses in your revenue sheet
4. Flag any discrepancies with your bank

Alternatively, you can use a two-in-one business current account and accounting app, which will do it automatically for you.

As part of reconciling your accounts, you may also want to review whether you’ve had any unexpected expenses. Unexpected expenses will impact the profit forecast for a project by raising the predicted job costing. You’ll want to make sure this is accounted for, and you have a plan in place to make sure you don’t lose profitability and compromise your profit margin.

Industry and economic changes have a significant impact on construction projects. It’s essential to safeguard against any changes by planning ahead and making sure you have cash flow forecasting in place.

Most construction companies and contractors take a deposit for projects before starting work. This is because you need to cover material costs upfront and may not receive final payment till months after the job has been completed (if at all). A client may go bankrupt halfway through the project, meaning they’re unable to pay, and the substantial costs you’ve had to invest in the project could also cause you to go bankrupt too. 

Poor cash flow is one of the biggest causes of insolvency in the construction industry. You can avoid poor cash flow by keeping accurate records and preparing cash flow forecasts. 

Construction professionals should invoice upfront for any major material or labour expenses and agree on payment stages throughout the project, so you don’t need to wait for the work to be completed to receive payment. If a client doesn’t pay their invoice, pause work till the payment is received.

Managing your cash flow carefully is one of the best ways to ensure the success of your small business.

Before you get started, you may want to consider buying construction insurance. Running a company in the construction industry comes with a degree of physical and legal risk, which is why many insurance providers offer specialist insurance for small construction firms, contractors and subcontractors.

You might want to consider the following types of insurance:

Anyone working near other people and/or their property should have this type of insurance.

While you may not have employees in the traditional sense, if you enlist the help of subcontractors, you may want to get employers liability insurance.

Anyone working on a construction project should have Contractors All Risk insurance (CAR) to protect against physical damage to works and site materials. Say you accidentally damage part of a property you’re contracted to work on. CAR insurance would cover you.

Plant and equipment insurance will cover equipment that you’ve hired or own and can also protect temporary site buildings and security devices.

Anyone building a new building should have a structural warranty to protect against ‘latent defects’ to the structure of the building. To bring five-star Trustpilot-rated cover to growing businesses like yours, we’ve partnered with insurance provider, Superscript. 

Click here to get a quote for key coverage for your business in minutes.

Countingup is the business current account with free, built-in accounting software.

With all your financial information in one place, you can automate the time-consuming aspects of accounting admin. The Countingup app comes with automated invoicing features, expense reminders and a receipt capture tool so you can add expenses and schedule client payments on the go and with ease. Countingup also provides real-time insights into your trading performance so you can keep on top of your business finances everyday.

Find out more here and sign up for free today.