Often clients ask me, “How can I move income into next year?” I tell them that if they correctly calculate their work in process, it will reduce the amount of income recognized for the year. This strategy can be used only when the percentage of completion method is utilized. The completed contract method is not eligible for this strategy because it only recognizes income upon the entire completion of a job.
When materials are purchased for jobs, construction companies often include all the inventory purchased in the percentage completed immediately, rather than when it is installed on the job. Ultimately this increases the amount of income recognized on these jobs at the end of the first year and decreases income when the job is completed. Start by asking yourself, are the materials located at a job site contributing toward the completion of a specific job? Or, are the materials purchased simply general materials and supplies that are usable for any number of jobs?
If the materials have not been installed and are not unique to a specific job, then they should be classified as inventory. Why inventory? If you have a spool of uninstalled wiring located at a job site that you could take and use on another job, it is not contributing to the completion of that job even though it is located at the job site. Construction companies can, and often do, have inventory located at multiple job sites that is not specific to any one job, which should not be assigned to a job until it is installed.
A simple indicator of projects that may be in need of an adjustment are jobs with a high material to labor ratio. If a company has a job with high material costs and low labor costs, material costs could be contributing a higher percentage completed than is actually completed. Of course, there are always exceptions such as custom-built items for a specific project that cannot be used at another job site.
By properly tracking which materials should be inventory and which materials have been used on the job, you can accurately recognize the profit and pay taxes on the work that is completed instead of work that has not been performed. After all, most of us would rather pay taxes later rather than today.