Don’t worry, this isn’t going to be an article on the history of Al Capone and how it was a simple accountant who ultimately took him down. Nor will this be an insider’s guide to how a construction company can detect—or, worse, get away with—fraud by setting up its accounting records in various ways.
Instead, this article will provide a high-level outline of the three types of books that contractors generally maintain and why.
But first, let’s think about what the books are there for. In the simplest terms, the books contribute to the success of the company by providing information that is timely, accurate and relevant, so better decisions may be made. This is a common thread for each type of book. The differences between the books have more to do with who uses them, their motivations and who has to make decisions based on them.
INTERNAL SET OF BOOKS
Contractors have to keep their books in a way that helps them run their business. There is a potentially unlimited number of ways to keep internal books. Each contractor will have certain key performance indicators that they’re focused on, are motivated by and view as crucial to the company’s success. Whether it’s labor hours, feet of wire, miles of paving or yards of asphalt, contractors look at jobs in ways that are distinct to their own experiences and their own history.
Jobs are generally run and success is measured using costs that directly relate to each project. It’s rare that overhead and administrative costs are incorporated in planning or executing work. In addition, key employees are typically incentivized based on how projects are recorded internally. It’s guaranteed that project managers will not be happy about overhead allocations being added to a project when it comes to their bonus.
A contractor’s internal books should track detailed information and be done in such a way that they serve multiple internal users. The CEO, the CFO, the COO, project managers, equipment and shop managers, inventory specialists, accountants and others all need financial information to effectively run the company and their individual departments. A good example of this is equipment costs, which are critical to track at a detailed level in order to help fuel (yes, pun intended) the success of a contractor. Understanding the cost of a piece of equipment, calculating its run cost, figuring out the cost of idle time versus the cost of availability, knowing when to trade in, when to sell, when to buy, when to lease—everything should be determined by information.
This is only one example of the level of detail with which internal books should be kept. In an age of artificial intelligence and unprecedented technological solutions, there are no excuses for not being able to drill down into the details, solve problems and reward good work. The detail just needs to be there to be drilled down into.
Internal vs. external books: In general, the typical contractor—not the big, established companies but rather the small ones that are just starting out—tend to run their business on a “checkbook” basis, without concern as to “timing” or “accrual” items. If it hasn’t been collected or paid, then it doesn’t count.
Many contractors don’t have monthly close processes that include updating over/under billings, posting depreciation or giving much concern as to what the Financial Accounting Standards Board has to say about how they should record leases. Those are typically done at year-end, and only when the auditor gives them the entry. Allocation of indirect costs and overhead is rarely done by small contractors, because project managers run jobs by the costs they can control.
The role of the accounting profession, in many ways, is to advise contractors on how posting monthly internal adjustments that align with the requirements of external reporting can provide better insight into how their business is operating.
Going in guns blazing, ready to tell a contractor how they’re doing things wrong when they’ve been making 20% margins for the past 40 years, is a sure way to lose a client. But there is value in understanding how others see the books, what motivates them and why they expect to see things a certain way.
EXTERNAL SET OF BOOKS
At some point in a contractor’s business cycle, there will be the need for financing, insurance, bonding or valuation by third parties. The external set of books are those that the company takes to the market, typically in the form of financial statements. Unlike the internal set of books, external books are required to be reported in accordance with FASB’s generally accepted accounting principles. Occasionally, third parties will “accept” tax-basis or cash-basis financial statements, but they’re generally not happy about it.
Motivation at the highest level for the external set of books is the facilitation of commerce, which is a crucial part of any healthy economy. People in charge of allocating resources need an effective and efficient way to make decisions on how they utilize and allocate those resources. Who they invest in, loan money to, give bonding or insure all will be based on the numbers in the financial statements.
One of the principal ways this is achieved is through the use of GAAP-compliant financial statements. GAAP is written in such a way that the proper accounting treatment for most situations is consistent across companies and industries, allowing for the comparability of financial information. After all, if one contractor defines and calculates revenue differently from another, then one could see the problems.
For the contractor, the external set of books is most often provided to their surety, bankers and, sometimes, for bidding. Bonding capacity and limits are set, covenants are made or broken, and bids are won or lost based on the financial strength of the company. As long as it’s within the confines of the GAAP framework, the stronger a company looks, the better it looks.
External vs. tax books: Before going into the motivation behind the set of tax books, let’s address some of the basic accounting differences between them and external books. Much to the chagrin of your tax professional, 90% of tax strategies don’t actually reduce taxes but rather delay them and thus provide time value of money savings. After all, a tax paid next year is better than a tax paid today.
As complicated as taxes can be, the differences are laid out annually on a contractor’s tax return using the little-known Schedule M-1, which shows the adjustments from the financial statements to the tax returns. The most common variance is accelerated depreciation. Tax books try and record depreciation expense immediately, while external books smooth out over time.
Other typical variances include adjustments to the contract schedule depending on tax recognition of revenue, any accrual to cash adjustment such as payroll that straddles two periods, meals and entertainment having limits for taxes, officer life insurance and, of course, backing out any “leases” adjustments under FASB’s Accounting Standards Codification 842. That is correct: Your CPA is adding these things in for the external books and then taking them back out for the tax books.
TAX SET OF BOOKS
To put it nicely, has there ever been a more bizarre system of moving variables circling around one central source since the formation of the universe than taxes? Even worse, taxes aren’t just numbers; they also can be considered a socioeconomic force to motivate behavior. If we want people to do something, they get a tax break. If we want them to stop, we tax the heck out of them—and, of course, the whole thing is subject to an alternative minimum tax.
In addition, when it comes to complexity, the construction industry takes it a step further. It’s recommended that small contractors have multiple methods of accounting for contract revenue and that tax methods are applied not only overall, to the contractor, but also individually, to the contracts. Contractors can use accrual, cash, completed contract, accrual adjusted for retainage, 70/30 or one of the many other methods of tax accounting.
While taxes themselves may be complex, the motivation behind having a tax set of books is simple—and generally the opposite of why a contractor maintains internal and external books. For owners, banks and for bonding purposes, a contractor wants to show strong asset balances, positive working capital, steady growth in the top and bottom lines and a healthy backlog. But for tax purposes, the contractor basically wants to show that the zombie apocalypse has descended on their company, everything is worthless and they’re not making any money.
As easy and simple a motivation as that may be, you must be careful and find a compromise between external reporting and minimizing taxes. It’s easy to decimate a balance sheet for external reporting with an overly aggressive tax strategy. On the flip side, auditors can blow up a tax strategy depending on how they report something in the financials.
BALANCING THE BOOKS
Finding a balance between reporting and taxes—and understanding the cost of taxes in whole—is crucial. What is the cost to a contractor of an IRS audit? What is the cost of complexity? What keeps a contractor up at night? All these questions can and should be factored into your accounting strategies.
Ironically, these decisions may not be the most complex or important tax ones to make. Setting up a corporate structure to help avoid suspended losses and aid in the transference of wealth to the next generation are infinitely more complex and well beyond the space limits of this article.
Understanding the motivation and methods of how a contractor tracks financial information and providing insight to them in optimizing their overall accounting strategy is a service everyone in the accounting industry must strive toward. This is the way the accounting profession can add value to your company and make a difference in how the industry moves forward. It boils down to the information being tracked—how you run your business as a contractor, and how you show your business to internal and external audiences.
