Construction Accounting and Tax Services
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Types of construction contracts
There are different types of contracts that a supplier can enter into with a customer. Each type has specific characteristics that tend to favor one party or the other, depending on the circumstances. We will explain each of them below.
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Fixed fee contract
A flat rate contract is used when a contractor agrees to pay the customer a fixed amount. In this situation, the costs incurred by the contractor do not affect the price paid. This provision appears to greatly favor the customer as there is no risk of paying more than the contract price. Indeed, this arrangement is most common in a multi-party bidding scenario where a number of potential suppliers are forced to bid against each other. From the perspective of both the client and the contractor, it is best to create fairly detailed specifications for a flat-rate contract so that there is no doubt about what is expected of the contractor and what constitutes an acceptable end result.
Cost-plus contract
Contract cost plus is a cost method of pricing a construction project based on a contractual agreement. The contractor adds the direct material costs, direct labor costs, and overhead costs of the project and adds a markup percentage to these to derive the price of two invoice. From the customer’s perspective, this can be an expensive pricing system, as costs can significantly exceed initial expectations. However, it is an ideal system when there is a high degree of uncertainty about the design specifications of the final product.
Time and material contract
A time and material contract is a variation of the previous cost-plus contract. Customers are charged a standard hourly rate per hour worked plus the actual cost of materials used. The standard hourly labor rate charged is not necessarily related to the base labor price; instead, it may be based on the market rate for the services of someone with a certain skill set, or on the cost of labor plus a specified percentage of profit.
Unit price agreement
A unit price contract is an agreement in which the customer pays a specific price for each unit of performance. This arrangement is rarely used in large and complex construction projects where there are multiple output units that can be easily replicated. For example, a customer is unlikely to require a unit price contract for each group of condominiums. However, the general contractor can use this type of contract with his subcontractors for selected labor arrangements. For example, a road construction general contractor might have a unit price contract that pays a certain amount per square foot of installed pavement.
Revenue recognition
Revenue recognized under a contract may be based on the completed contract method if the percentage of completion of the project cannot be determined. As the name suggests, this means that the contractor will only account for all project revenue and profit after the project is completed. The percentage-of-completion method is more commonly used, whereby the contractor reports revenue by applying an estimated percentage of completion to the total expected profit. This approach allows the contractor to report revenues and profits at regular intervals over the life of the project. Another option is the cash method, where revenue is recognized only when cash is received; this approach works best for smaller projects with a short duration.
Percentage of completion method
The percentage-of-completion method involves the ongoing recognition of revenue and revenue related to longer-term projects. Thus, the company may record some profit or loss related to the project in each accounting period in which the project remains active. For example, if a project is 20% complete, the company may recognize 20% of expected revenues, costs, and profit. The method works best when it is reasonably possible to estimate the stages of project completion on an ongoing basis, or at least to estimate the remaining costs to complete the project.
Conversely, this method should not be used if there are significant uncertainties about the percentage of completion or remaining costs to be incurred. A business’s estimating capabilities should be considered sufficient to use the percentage-of-completion method if it can estimate the minimum total revenue and maximum total cost with sufficient confidence to justify bidding for the contract.
Essentially, the percentage-of-completion method allows you to recognize as revenue the percentage of total revenue that corresponds to the project’s percentage of completion. Percentage completion can be measured using any of the methods listed below.
Cost-to-Cost method
The cost-of-cost method is a comparison of contract costs incurred to date with total expected contract costs. The cost of items already purchased for the job but not yet installed should not be included in determining the project’s percentage of completion unless they were specifically manufactured for the job. Also, allocate equipment costs over the life of the contract, rather than upfront, unless ownership of the equipment is transferred to the customer.
The effort method
The effort method is the ratio of effort expended to date compared to the total effort expected to be expended on the job. For example, the percent complete can be based on work hours spent to date.
Unit of work method
The units of work done method are the proportion of physical units of production that have been completed to date. For example, the percent complete could be based on the amount of material installed, such as square yards of concrete placed or cubic yards of material excavated so far. This approach does not work well if significant costs are incurred before or after the physical units are produced. For example, laying pipelines involves building an access road to the pipeline site; the cost of building a road would result in no earnings if the percentage of completion was based on the number of feet of pipe laid.
Completed contract method
Under the completed contract method, the business recognizes all revenue and profit related to the project only after the project is completed. This method is used when there is uncertainty regarding the collection of funds due from the client under the terms of the contract. For example, it would be used for a speculative project where there is no buyer of the property.
This method provides the same results as the percentage-of-completion method, but only after the project is complete. Since revenue and expense recognition occurs only at the end of the project, the timing of revenue recognition can be delayed and very irregular. Due to these issues, the method should only be used under the following circumstances:
1. When it is not possible to derive reliable estimates of the percentage of project completion; or
2. If there are inherent hazards that may interfere with the completion of the project; or
3. If the contracts are of such a short-term nature that the results reported under the completed contract method and the percentage-of-completion method would not be materially different.
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T5018 Statement of contractual payments
If the subjects providing the workforce are self-employed workers or subcontractors and are not employees to whom T4 certificates have been issued, the provider is required to declare the payments envisaged by the contract. The requirement is relatively new and was introduced in an attempt to achieve the “shadow economy”, a system of undocumented clandestine payments not uncommon in the construction sector, which has led many traders to avoid paying taxes by undermining their income.Looking to get tax preparation and tax accounting services in Canada? Webtax Online can help.
The amounts paid for construction services must be disclosed by completing the form T5018 “Declaration of contractual payments”. It consists of a T5018 summary and related bulletins of all payments made to subcontractors and documentation including all required information on the T5018 bulletins and summary.
T5018 is a fact sheet that identifies total contract payments, including GST/HST, made by a supplier to a recipient during a calendar year or fiscal period. The issuer is not required to provide a copy of Supplement T5018 to the payee, but it generally does.
A copy is required for the Canadian IRS and effectively serves to create an audit trail that allows the credit rating agency to ensure that the payee is reporting income correctly.
The construction subcontractor who will be the recipient of the T5018 must provide the issuing contractor with a Social Security Number or Business Number (BN) if they are a sole proprietor or partnership. All registered entities must declare their BN.
A business can have a range of BN for income tax, GST, and payroll reporting. To report contractual payments, the recipient must provide the exhibitor with a company number that will be used for filing the tax return.
Account settings
Most builders use project or labor accounting, which requires revenue and expense to be accrued for each job accepted by the business.
If the contract awarded was valued on a cost-plus basis (as defined below), it is essential that the contractor keeps track of the specific costs of the project, as the amount to be invoiced will be based on these costs.
However, regardless of how the contract is priced, it is almost always necessary for revenues and costs to be separated by the project in accounting. Allocating income and expenses in this way is often called “project accounting” or “labor cost accounting”. The number of accounts will depend on the level of detail that provides useful information for management.
For example, a plumbing contractor who supplies only labor and materials might set up labor accounts (these accounts are for supply vendors) that have only two child accounts: labor and materials.
A general contractor, on the other hand, would likely want to create a large number of subaccounts to have useful cost information available: direct material, direct labor, engineering, permits, and subaccounts for each of the main subaccounts. The use of detailed cost accounts is demonstrated in the trial balance statement of a contractor who established separate cost subaccounts to better manage costs on a recreation room project.Looking to get tax preparation and tax accounting services in Canada? Webtax Online can help.
Tax declaration
No one wants to recognize income and pay income tax ahead of time. Therefore, it would be desirable that each contract could be accounted for in calculating taxable income using the completed contract method, as it postpones the recognition of income for as long as possible.
However, a credit rating agency usually permits the use of the completed contract method only if the contract is expected to be completed within two years of the inception date. If the taxpayer chooses to use this “performance method”, it must be used for all contracts of that duration and must be applied consistently from year to year.
For income tax purposes, the supplier who does not use the method of completion has the right to modify it at any time without prior consent, provided that he has never used this method before. A contractor using the completion method may switch to a more accurate percent complete method at any time without prior approval, but doing so is barred from using the completion method again.
Treatment of withholding tax
The credit rating agency agrees that a statutory or contractual hold that has been invoiced by a supplier is not actually payable until the terms of the hold are released.
Therefore, it is acceptable for income tax purposes to reduce income for accounted withholdings that have been included in sales proceeds but for which the withholding period has not expired and the conditions for withholding have not yet been met. This provision is then charged to the income statement in the year in which the related equity investments become receivables.
Retail Sales Tax
How provincial retail sales taxes apply to suppliers can be confusing. As a general rule, retail sales taxes do not apply to the supply of immovable property, which includes anything permanently attached to the land. Consequently, if a contractor has a contract for the construction of a building or for the supply of goods and services which become a permanent item of the property, the contractor does not charge retail sales tax on his contract invoices but pay retail sales tax on all taxable items like goods or services obtained in this process.
Alternatively, the contractor may have a ‘supply and install’ or ‘supply only’ contract that does not involve real estate, such as machine repairs. This is a contract in which a supplier is hired to acquire the goods and install them on the customer’s device or simply deliver the goods to the customer. The supplier then supplies taxable goods or services,
which means that the supplier buys its inputs without paying retail sales tax, but charges retail sales tax on the contract price. Each province has slightly different ways of describing how these rules apply. It is good practice to always check the published information available for that province and if in doubt, confirm your understanding with the retail sales tax authorities.
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