Construction Accounting Methods for Financial Reporting and Income Tax Reporting

Topic 606, Revenue from Contracts with Customers

Contractors are required to adopt Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers (Topic 606). ASC 606 did not eliminate cost-to-cost recognition for many contractors, but it changed the framework and documentation requirements. Management should evaluate contract existence, performance obligations, transaction price, variable consideration, contract modifications, measure of progress, contract assets/liabilities, and required disclosures. Topic 606 requires the recognition of revenue to coincide with the transfer of goods and services to customers, which for construction contractors will continue to follow the recognition of revenue over time, consistent with cost-to-cost percentage of completion.

While it is true that the adjustment to the financial statements of a construction company is not always material, there must be an analysis performed by the management of said construction company to support this conclusion.

Topic 842, New Lease Standard

The new accounting standard on accounting for leases, Accounting Standards Update 2016-02 (Topic 842) changes the way operating leases are recorded. In the past, operating leases only appeared as an expense in the financial statements, with future obligations for operating leases not appearing on the company’s balance sheet. Topic 842 requires that these off-balance liabilities be recorded, presenting an asset related to the right-to-use each leased item, and a liability for the value and obligations created by the full terms of every lease. The related asset is presented as a long-term asset while the corresponding liability is presented as both current and long-term, depending on when the liability is due.

While the impact of Topic 842 will result in a net zero change to the reported gross profit and net income of the contractor, recording right-to-use assets and liabilities on leases will have an impact on the contractor’s debt covenants and overall working capital. Additionally, contractors will be managing the effects of Topic 842 by potentially restructuring the leasing of equipment for projects.

Cost to Complete

Contractor financial statements rely heavily on estimates. One thing that is critical to the contractor is the Estimated Cost to Complete on Contracts in Progress (ECCCP). Without accurately determining the ECCCP, a contractor’s financials can fluctuate wildly from one month to the next. Changing these estimates can have a significant impact on financial statements, so contractors should take this task very seriously.

Depreciation

Another estimate that is important for contractors that have equipment-intensive businesses, such as heavy highway contractors, is depreciation. If the equipment’s useful life is not correct, the contractor could be charging an excessive amount of expense to a project, which would have a negative impact on profitability. More often than not, contractors are incorrectly using the same depreciable lives and methods for financial statements and income tax reporting. Contractors should not default to tax depreciation methods for GAAP reporting unless those methods reasonably approximate the assets’ useful lives and pattern of economic benefit. Doing so  may significantly understate equity by using an accelerated tax method for financial statement reporting. This can have a significant impact on bonding and banking programs.

Understanding IRC 460

Enacted by the Tax Reform Act of 1986, Internal Revenue Code section 460 (IRC 460), Special Rules for Long-Term Contracts, exists as one of the only code sections that is aimed almost exclusively at a specific industry – construction.

There are many income tax methods of accounting available to contractors. The first overall concept to understand is that if a construction contract is long term, contractors are required to use the percentage-of-completion method (PCM) for income tax reporting tax purposes. While this is a requirement, exemptions do exist for a home construction contract or if the taxpayer meets the small contractor exception.

A home construction contract is any contract where 80 percent or more of the estimated total contract costs are reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of dwelling units in buildings containing four or fewer dwelling units. In this case, that contract is not required to use PCM and another method may be used. The subcontractor may look through the contract to see the work required by the general contractor and thus may have a home construction contract.

The One Big Beautiful Bill Act (OBBBA) expands the home construction exception to residential construction contracts, which includes apartment buildings, condominium complexes, student housing, long-term care facilities, and other properties with multiple residential units. See the details of the exception below.

The following two requirements need be met in order for the small contractor exception to apply:

• At the time the contract was entered in to, it was estimated that the contract would be completed within a two-year period beginning on the commencement date of the contract;
• The contractor’s average annual gross receipts for the three taxable years preceding the year in which the contract was entered does not exceed $25 million. For the tax year 2026, the inflation adjusted average annual gross receipts threshold for the IRC Section 460 small contractor exception is $32 million.

Average annual gross receipts are measured on the revenue reported for income tax purposes. Therefore, it is necessary to apply proper tax reporting to exempt and non-exempt IRC 460 contracts so as not to inadvertently overstate gross receipts. The three years is looked at on a current and going forward basis. In a year that the small contract exemption is not met, only contracts that start in subsequent years are required to be reported on PCM. Existing contracts will remain exempt from IRC 460 and the contactor continues to use the elected method of accounting for income tax purposes until the job is complete. Conversely, a large contractor who eventually meets the small contractor exemption may begin using whatever exempt methods they have previously elected on their new exempt contracts.

There are yet other income tax reporting opportunities for large contractors and, probably for that reason, CPAs who work with construction clients often spend a lot of time trying to maintain small contractor status in order to avoid reporting under PCM. There are a variety of deferral options available to the large contractor under IRC 460 including:

• 10 percent elective deferral;
• Residential contracts;
• Retainage receivable and payable;
• Methodologies to allocate G&A in accordance with IRC 460.

Another major concept often overlooked is that applicable methods of tax accounting are determined on a contract-by-contract basis. Therefore a contractor could be reporting revenue from construction contracts under several methods of accounting, each of which can produce different results. Discussed below are some income tax methods available to contractors.

Cash Basis

The cash basis method is very enticing for contractors (if they qualify). This method calculates income based on the inflow and outflow of cash. Under this method, accounts receivable, retainage, work in progress, and prepaid assets are not considered to be a part of income for tax purposes until realized (collected or paid). Since this method results in deferrals it is not uncommon for a contractor to show a significant income for financial statement purposes while possibly showing a loss for income tax reporting purposes.

To qualify for the cash basis method, contractors cannot have significant inventories or be required to maintain inventory, cannot average more than $25 million (Note: the $5 million for C-Corporations requirement has been eliminated by The Tax Cut and Jobs Act) in gross receipts for the prior three years (as measured on the income tax return(for the tax year 2026, the inflation adjusted average annual gross receipts threshold is $32 million)), and the use of the cash method cannot significantly distort income. In almost all situations, electing for the cash method will result in lower taxes than any other income tax method.

It is important to know the type of work the contractor is performing as we sometimes see contractors reporting using the PCM for income tax purposes when IRC 460 is not applicable (construction managers not at risk) and the cash or other methods of accounting for income tax purposes may yield a better result.

Accrual Method

This income tax method of accounting reports income from construction contracts as progress billings are made and deducts expenses as job costs are incurred. Utilization of the accrual method of accounting may result in a situation where the contractor is able to show significant income for financial statement purposes while minimizing taxable income. Taxable income will increase when a contractor is overbilled on a job, and taxable income will decrease when a contractor is under-billed on a job.

Accrual Less Retainage

Retainage is defined as when a percentage of billings for services performed are withheld by the customer until completion. A contractor can establish a method of accounting to defer retainage receivables from accrual basis income until the contractor receives a green light on completion and acceptance from the customer. This method could create a significant income deferral for small contractors exempt from IRC 460 when selected as an income tax method of accounting. Large contractors who elect this method may benefit on their short-term contracts if retainage receivables and/or retainage payables are outstanding at year-end. If a contractor is not currently deferring retainage and wants to elect this provision, look to the provisions under Revenue Ruling 69-314 (a change in method of accounting requires a Form 3115 filing). The requested change is now an automatic change.

Completed Contract Method (CCM)

CCM is one of the most commonly used methods for exempt contracts because all contract revenue and related contract costs are deferred until the job is finished. A contract is considered complete when at least 95 percent of contract costs have been incurred and the customer has use of the property. The contractor then must report the remaining total contract revenue in the year the contract is deemed (for IRS purposes) to be complete and account for all remaining costs in subsequent years under its overall method of accounting. Additionally, CCM is not a permissible method for alternative minimum tax (AMT) and is thus a tax preference item. Take note of how this AMT preference under CCM will impact the contractor’s tax liability.

Cost Allocation

As required under IRC 460, a contractor needs to allocate additional costs (general, administrative and overhead (G&A)) to contracts when costs are already allocated for financial statement purposes. In general all costs that directly benefit or are incurred by reason of the performance of the long-term contract must be allocated to each long-term contract. One might think that allocating additional G&A costs to a contract in progress will accelerate the percent complete and therefore cause additional revenue to be recognized and thus increase taxable income (at least this is what the IRS believes). However, the formula for the calculation of PCM for income tax purposes dictates that when you allocate current G&A cost incurred to date you also have to estimate the future G&A costs to be incurred on that contract job in progress. In all likelihood your percentage complete will be different as will the revenue recognized to date. Establishing a methodology to estimate the future G&A costs to be incurred, thus complying with the requirements of IRC 460, will result in a different gross profit on contracts for income tax purposes.

10 Percent Elective Deferral

Under IRC 460, a contractor may defer recognition of gross profit until the job is at least 10% complete. This is a one-time election and applies to all long-term contracts entered into during and after the electing year. In addition, this income tax deferral is not an AMT preference item.

Expansion for the Exception from Using Percentage of Completion Method (POCM) for Residential Construction

The One Big Beautiful Bill Act (OBBBA) increases the types of construction projections excluded from the requirement to use the POCM. Under prior law, contractors were required to use the POCM for long-term contracts, except for home construction contracts and certain small contractors. The home construction exception applied to a building with four or fewer dwelling units. Where an exception applies, the contractor is able to use the completed contract method, which can defer profit recognition until the construction is substantially complete, or any other acceptable accounting method. The new law expands the home construction exception to residential construction contracts, which includes apartment buildings, condominium complexes, student housing, long-term care facilities, and other properties with multiple residential units. This law change is effective for contracts entered into in tax years beginning on or after the date of enactment of the OBBBA (i.e., for contracts entered into in 2026 for calendar year taxpayers). This law can apply to heavy highway and sub-contractors working for home builders, developers, or contractors building anything that people are going to live in.

Residential Construction Contracts

A contract that qualifies as a residential contract allows a taxpayer to report 70% of the contract on PCM and 30% of the contract utilizing the large contractors’ exempt method of accounting for income tax purposes. If the contractors’ exempt method is CCM, then 30% of the job profit is deferred for income tax reporting purposes until that job is complete. Also take note of how this deferral is an AMT preference and will impact the contractor’s tax liability. The definition of a residential construction contract is similar in definition to a home construction contract, except that “dwelling unit” is more broadly defined as a house or apartment used to provide living accommodations in a building or structure. Examples of residential contracts include apartment buildings, nursing homes, assisted living facilities, prisons, dormitories, barracks and mixed-use developments.

The One Big Beautiful Bill Act (OBBBA)

OBBBA was signed into law on July 4, 2025. Since the bill was introduced, it has served as a vehicle for extending tax provisions introduced by the 2017 Tax Cuts and Jobs Act (TCJA), several of which were set to expire after 2025. In addition to making several provisions permanent, OBBBA provides new advantageous provisions that encourage business leaders across many industries to take a fresh look at their tax strategies.

Here are the aspects of the OBBBA expected to have a significant impact on the construction sector.

IRC Section 199A/Qualified Business Income (QBI) Deduction

Many firms in the construction industry are structured as pass-through businesses, which would have been particularly vulnerable to the expiration of the TCJA’s Section199A/QBI deduction, scheduled to sunset after Dec. 31, 2025. The expiration would have amounted to a federal income tax increase of 7.4% in 2026 for those in the maximum tax bracket. Instead, the Section199A/QBI deduction is now made permanent at 20% under the OBBBA.

Bonus Depreciation and Section 179 Expensing

The OBBBA restores the 100% depreciation bonus introduced by the TCJA and makes it permanent. Construction firms will certainly benefit from this change as it incentivizes investment in machinery, vehicles, and other assets, improves cash flow, and may accelerate equipment upgrades that have been on hold. This provision applies to property that is both acquired and placed in service after Jan. 19, 2025.

Additionally, the maximum amount a taxpayer may expense under IRC Section 179 has been increased to $2.5 million, with the phase-out threshold beginning at $4 million. This becomes increasingly important for companies paying taxes in states that do not conform to the OBBBA’s 100% bonus depreciation.

100% deduction for “qualified production property” costs

This provision allows full and immediate deductions for certain nonresidential real property used in manufacturing or production. Qualified costs include expenses relating to building or acquiring property used for manufacturing, production, or refining with construction that begins after Jan. 19, 2025, and before Jan. 1, 2029, and which is placed in service before Jan. 1, 2031. Contractors may see a significant increase in new bid opportunities. Additionally, contractors who fabricate materials used on construction projects (e.g., sheet metal or steel) may be able to take advantage of this accelerated write-off directly.