Different Accounting Methods: Cash Accounting, Accrual Accounting, and Percentage of Completion
Cash accounting, accrual accounting, and percentage of completion accounting are all methods of accounting used by businesses to track their financial transactions and report their financial results.
Cash accounting is the simplest form of accounting, where revenue and expenses are recorded when cash is received or paid. This means that revenue is recognized only when cash is received, and expenses are recognized only when cash is paid out. For example, if a business sells a product on credit, under cash accounting, the revenue is not recognized until the customer pays the bill. This is a no-go for contractors trying to obtain more surety capacity for their bid bonds, performance, and payment bond needs!
Accrual accounting is a more sophisticated accounting method where revenue and expenses are recorded when they are earned or incurred, regardless of when cash is received or paid out. This means that revenue is recognized when the sale is made, and expenses are recognized when the goods or services are received, regardless of when cash is exchanged. For example, if a business sells a product on credit, under accrual accounting, the revenue is recognized at the time of sale, even though the customer has not paid yet. Similarly, if a business receives an invoice for a service under accrual accounting, the expense is recognized at the time of service, even though the payment has not been made yet.
Percentage of Completion Accounting:
Percentage of completion accounting is a method of accounting is the preferred method for surety and used in construction or other long-term projects. Under this method, revenue and expenses are recognized based on the percentage of the project that is completed. This method is used to spread the revenue and expenses of a long-term project over the life of the project. For example, if a construction company is building a bridge that is expected to take two years to complete, under the percentage of completion accounting, revenue and expenses are recognized proportionally over the two years, based on the percentage of the project that is completed each month.
In summary, while cash accounting is the simplest and accrual accounting is the most commonly used method of accounting, percentage of completion accounting is specific to long-term projects and is used to spread the revenue and expenses of a project over its life. Why cash accounting is not good for construction companies Cash accounting is not a suitable method of accounting for construction companies because it does not accurately reflect the financial position of the company. This is because construction projects are typically long-term and involve multiple phases that can span over several accounting periods.
Under cash accounting, revenue and expenses are recognized only when cash is received or paid out, which can lead to misleading financial statements for construction companies. This is because construction companies typically receive payments in installments over the duration of the project, which can span over several accounting periods. Therefore, the cash accounting method may not capture the total revenue earned or expenses incurred for the project.
Moreover, construction projects often involve large upfront costs, such as material and labor expenses, which are paid at the beginning of the project but are not recognized as expenses until cash is paid out. This can result in distorted financial statements as the expenses incurred are not matched with the revenue earned over the project's duration.
For example, suppose a construction company receives an advance payment for a project in the current accounting period but does not complete the project until the next accounting period. Under cash accounting, the company would recognize the revenue in the current period, even though the project is not complete, and the expenses incurred are not matched with the revenue earned. This can lead to an overstatement of revenue and profits in the current period and an understatement of revenue and profits in the next period. Therefore, construction companies typically use the percentage of completion accounting method, which recognizes revenue and expenses based on the percentage of the project that is complete. This method provides a more accurate representation of the financial position of the company, especially for long-term construction projects.