Cash in = income. Cash out = expense. That’s pretty much it.
Easy peasy. It doesn’t take a five-year accounting degree needed to figure that out (yes, most CPA’s have a five year accounting degree!).
Cash basis shows income and expenses only when cash is received or paid out. Except for the very smallest of contractors (contractors with projects measured in weeks not months), this method makes no sense because most of the cash coming in to your business isn’t yours and most of it never will be. Also, good builders bill clients in advance (overbilling) as much as possible, so the cash-in happens before the cash-out…not a great recipe if you pay taxes based on cash.
Yet ~60% of construction accounting we see is set up on cash basis. Why is that happening when it’s clearly not in the best interest of the builder? Here is my theory…
Theory 1: Your tax preparer put you on cash basis because it’s easier: The easy-thing-to-do and the right-thing-to-do are rarely the same thing in construction. If building a home is easy, you’re probably cutting corners. That is certainly the case with your accounting as well. Easy is the enemy of good.
Theory 2: Your tax preparer put you on cash basis because they think it will lower your tax bill: If you’re good at what you do as a builder, then you’re collecting cash on your jobs faster than you are paying cash out on your jobs. If that’s the case, then you’re actually paying more taxes on cash basis. The worst part is, you’re paying taxes on money that you haven’t earned!
Theory 3: Your tax preparer put you on cash basis because they haven’t taken the time to understand construction: The IRS has special rules for contractors that allow builders (or require builders) to show profits in different ways than a typical business. In most cases, applying these special rules will significantly lower your tax bill. Bonus: applying the special IRS accounting rules for builders will actually result in reports that actually make sense! You see, as bad as the IRS stinks, some of the rules they have for contractors make a ton of sense if you use them to your advantage.
Measuring your building business using cash basis is like measuring the highway speed of your F150 using RPM’s. Sure, RPM’s tell you something, but not how fast you’re going. To know how fast you’re going, you need to measure something else.
To translate that analogy to accounting: cash in the bank tells you something, but it doesn’t tell you how much money you’ve earned…only how much you’ve collected. The IRS doesn’t care how much cash you have in the bank. What you’re ultimately after in your tax and other reports is understanding what you’ve actually earned. That’s what you really care about, and that’s what the IRS really cares about.
In a lot of other industries, cash balance and earnings are approximately the same thing. But construction is unique because, unlike a lot of other industries, rarely does cash ever approximate earnings.
Consider this scenario: You showed a client a proposal for a $750,000 remodel last December. The client loved the proposal made their first $100,000 payment to you just before New Years. You closed the deal and got some upfront money out of your client. Great job! You just made $100,000 in profit! Let’s put a downpayment on a Cybertruck! Not so fast….
You haven’t earned a dime yet. You still have to build the house, pay your subs and vendors, and collect payment from your client.
So how much of the $750,000 contract – or the $100,000 payment – was actually profit last year? Zero. None. Nada. Zilch. $0.00.
The client gave you $100,000, and in exchange you gave them an IOU – as in, IOweU a house, or IOweU your money back. Until you do some work on the house, you haven’t earned any of that money you’ve collected. And if you haven’t earned it, you shouldn’t have to pay taxes on it, right? Right!
Check this out….
If your margin on the job is say 10% (a skinny job for sure, but stick with me), that means you expect to have $675,000 in costs on the job. That will leave you with a $75,000 profit. Once the job is 100% done, you will have earned $75,000. Not a great outcome, but hey, $75,000 is nothing to shake a calculator at.
Remember when you collected $100,000 last December? Well, if you’re cash basis and don’t adjust for deposits (an accrual adjustment), then the IRS thinks you made $100,000 there. If you’re in a high tax bracket, you’ll pay the IRS $30,000+, and maybe pay your State another $10,000 in taxes.
Do you see the problem? You will have paid your subs $675,000, the IRS+State $40,000, and taken your profit of $75,000. All of that adds up to $790,000!!!! That’s $40,000 more than you have. You’re bankrupt!!!
Question: How did this happen?!?!?!
Answer: you paid income tax you didn’t owe with cash that wasn’t yours because your accountant set you up on cash basis and didn’t make any adjustements.
Brutal.
Construction and cash basis accounting are like oil and water. They don’t mix.
In the construction industry, choosing the right accounting method can make a big difference in how well you understand your company’s financial health and how correct your taxes are. The cash basis method has its advantages in other industries, but rarely are construction firms better off under cash basis.
Want to dive deeper? Check out Part 2 soon, where we’ll explore how your accounting should be done instead, and guide you through the process of transitioning from Cash to Accrual Accounting. This approach offers a more comprehensive view of your finances, setting you up for even stronger financial management in the long term.
Oh…and you’ll pay a lot less in taxes.
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