Accounting methods available to construction contractors can be a very complex and confusing issue to both construction executives and accountants alike. One area that becomes particularly confusing is that a contractor actually has two methods of accounting:
1) An overall method of accounting which is elected when the company files their first income tax return.
2) A method of accounting for long-term contracts.

Many people I've spoken with believe that they don't enter into any "long-term" contracts. However, a contract does not have to extend twelve months from inception to be classified as long-term. The Internal Revenue Code (IRC) §460(f) defines a "long-term contract" as any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into. For example, if a December 31st year end tax payer starts a contract on December 28th and completes it on January 3rd, that contract would be classified as a long-term contract for income tax purposes.

There are four basic methods of accounting available for an overall method of accounting. They are:
1) The cash method - Under the cash method, income is recognized when actual cash is received by the taxpayer and expense is recognized when paid.
2) The accrual method - The accrual method recognizes income when billed and expenses upon economic performance.
3) The accrual less retainage method - This method is similar to the above method, except that retention withheld under contract provisions is not reported as income until the right to receive the income is fixed under the contract terms.
4) Hybrid methods - Could be utilized for a variety of circumstances, such as part cash and part accrual where a specific component (such as inventory) is accounted for using the accrual method and the remaining accounts are maintained with the cash method. If the company has long-term contracts as defined above, then they are subject to IRC §460, which is the primary guidance for accounting for long-term contracts and imposes many more restrictions than other methods.

The IRS does provide some relief via the Small Contractor Exemption under IRC §460(e). A contractor with long-term contracts may be considered to have exempt contracts if the two following conditions are met:
1) At the time the contract is entered into, the taxpayer estimates that such contract will be completed within the two-year period beginning on the contract commencement date of such contract, and whose 2) Average annual gross receipts for the three taxable years preceding the taxable year in which the contract is entered into do not exceed $10,000,000.
 
Contractors qualifying under the Small Contractor Exemption are allowed more options to choose a method of accounting for long-term contracts than those not meeting the exemption requirements. Possible choices include:
1) The cash method
2) The accrual method
3) The accrual less retainage method
4) Hybrid methods
5) The completed contract method (CCM)
6) The percentage-of-completion (PCM)
7) The exempt percentage-of-completion method (EPCM)
8) The percentage-of-completion capitalized cost method (PCCM)

Once a contractor has exceeded either of the two Small Contractor Exemption requirements, then they become what is commonly called a Large Contractor for long-term contract reporting. Choices are then limited to the following:
1) The percentage-of-completion method (PCM)
2) The percentage-of-completion capitalized cost method (PCCM)
3) The simplified cost-to-cost method
4) The 10% deferral, PCM, under §460(b)(5)

When selecting overall accounting methods and long-term contract accounting methods, the process should not be taken lightly as the choices and implications will linger for some time. The staff of SS&C Business & Tax Services, Inc. has extensive experience working with construction contractors and will be able to assist you in determining the most advantageous method for your situation.