What Accounting Method Should My Construction Company Use?

Ask a general accountant whether a construction company should be on cash or accrual and you will get a reasonable answer that is missing the part that matters most. Cash versus accrual is the overall method question, and every business in the country has to answer it. Contractors have a second question layered on top of it that most other businesses never encounter, which is how income from long-term contracts gets recognized, and that second question usually has more effect on a contractor's tax bill than the first one does.

Both questions have real answers with real consequences. They also interact with each other, with the size of the business, with how long the jobs run, and with what a surety or a lender expects to see when they ask for financial statements. Getting this wrong is not the kind of mistake that shows up immediately. It shows up two or three years later when a method change becomes necessary and the cumulative adjustment is larger than anyone planned for.

Cash and Accrual Describe When You Record Money, Nothing More

Under the cash method, income gets recorded when payment arrives and expenses get deducted when they are paid. Under an accrual method, income gets recorded when it is earned regardless of when the customer pays, and expenses get deducted when the liability is incurred regardless of when the check goes out. IRS Publication 538 lays out both methods along with the rules governing how consistently they have to be applied.

For a contractor, that difference is not academic. A company on the cash method that invoices $400,000 in December and gets paid in February has no December income to report, which is why cash-method contractors sometimes find themselves managing the calendar around collections in a way that accrual-method contractors do not. The same company on accrual reports the income when the work is earned and pays tax on money that has not arrived yet, which creates its own problem when the client is slow or the retainage sits for a year.

There is also a hybrid option, where a business uses cash for some items and accrual for others, provided the combination reflects income clearly and gets applied consistently. In practice most contractors are better served picking one and running it properly than trying to manage a hybrid, but the option exists and there are situations where it makes sense.

The Gross Receipts Test Decides Whether You Get to Choose

Not every contractor has a free choice here. Section 448 of the tax code prohibits certain taxpayers from using the cash method, specifically C corporations, partnerships with a C corporation partner, and tax shelters, unless they pass the Section 448(c) gross receipts test.

The test looks back three years and averages the gross receipts across that period. For tax years beginning in 2026, a business passes if that three-year average does not exceed $32 million, a threshold that started at $25 million under the 2017 tax law and gets adjusted upward for inflation each year. Sole proprietors and S corporations are not subject to the Section 448 accrual mandate in the first place, but the gross receipts test still matters enormously to them, because passing it unlocks a set of exemptions that have nothing to do with the cash method and everything to do with how construction contracts get taxed.

There is an aggregation rule worth knowing about. Businesses treated as a single employer under common control get combined for purposes of the test, so a contractor running three related entities cannot simply divide revenue across them to stay under the line.

Long-Term Contracts Are Governed by a Separate Set of Rules

Here is where construction stops resembling other industries. Section 460 of the tax code requires taxpayers to recognize income from long-term contracts using the percentage of completion method, which means reporting income as the work progresses based on the ratio of costs incurred to total estimated costs, rather than when the contract finishes or when payment arrives. The IRS covers the mechanics of this along with the look-back interest rules for long-term contracts that apply when a job closes out.

A long-term contract, for these purposes, is any contract for building, installation, construction, or manufacturing that is not completed within the same tax year it was entered into. That definition catches a very large share of commercial construction work and a meaningful share of residential work as well. If a job starts in October and finishes in March, it is a long-term contract under Section 460 even though it only ran five months.

The exemption is where contractors find relief. A taxpayer that passes the gross receipts test and is not a tax shelter is exempt from the percentage of completion requirement for construction contracts estimated to be completed within two years of the commencement date. A contractor who qualifies can use the completed contract method, the exempt-contract percentage of completion method, or another permissible method for those contracts. There is also a separate exemption for home construction contracts that operates on its own terms.

That exemption is the single most valuable thing in this entire discussion for a mid-sized contractor, and a surprising number of contractors either do not know it exists or have never been walked through whether they qualify for it.

Completed Contract Defers Income, Percentage of Completion Smooths It

For contractors who qualify for the exemption, the practical choice is usually between the completed contract method and percentage of completion, and the two produce very different timing.

Completed contract recognizes no income and deducts no contract costs until the job is finished and accepted. A contractor with a large job spanning two tax years reports nothing on it in year one and everything in year two. The deferral is real and it can be substantial. The tradeoff is volatility, because income lands in lumps determined by when jobs close rather than by how much work got performed. A year where three big jobs happen to finish produces a tax bill that has very little to do with how the business actually performed that year.

Percentage of completion spreads the income across the life of each contract, which produces steadier reporting and fewer surprises, but eliminates the deferral entirely. It also brings the look-back interest rules into play. When a contract that used percentage of completion closes out, the IRS requires a recalculation using actual costs rather than the estimates used along the way, and if the original estimates caused income to be reported too late, interest is owed on the difference. That calculation happens on Form 8697 and it catches contractors whose cost-to-complete estimates were consistently optimistic.

Neither method is better in the abstract. Completed contract favors contractors with lumpy job schedules who want deferral and can manage the volatility. Percentage of completion favors contractors who want predictable reporting and are already maintaining accurate cost-to-complete estimates for other reasons.

Your Tax Method and Your Financial Statements Do Not Have to Match

This is the part that resolves most of the confusion, and it is the piece general accountants often fail to explain.

The method a contractor uses to report taxable income to the IRS and the method used to prepare financial statements for a surety, a bank, or an owner are two separate decisions. A contractor can be on the completed contract method for tax purposes, capturing the deferral, while producing accrual-basis, percentage of completion financial statements with a full WIP schedule for the surety. That is not aggressive and it is not a loophole. Tax accounting and financial reporting answer different questions for different audiences, and construction is one of the clearest cases where the right answer differs depending on who is asking.

Sureties want percentage of completion financials with a proper WIP schedule because that is the only presentation that shows where every job actually stands. A cash-basis financial statement handed to a surety underwriter tells them almost nothing about the company's real position, and the capacity they extend will reflect that. Banks reviewing a construction company for a line of credit want the same thing for the same reason. Meanwhile, the tax return can pursue whatever legitimate deferral the contractor qualifies for without any of that affecting the statements the surety sees.

Contractors who understand this stop treating the accounting method question as a single choice with a single answer and start treating it as two parallel decisions, each optimized for its own purpose.

Changing Methods Requires IRS Permission and a Cumulative Adjustment

A contractor who concludes their current method is wrong cannot simply start using a different one. Section 446(e) requires IRS consent to change an accounting method, and the request goes on Form 3115.

Most common changes, including switching to the cash method under the small business exception, fall under the automatic consent procedures, meaning no user fee and no waiting for approval, though the form still has to be filed correctly and on time with the return. Non-automatic changes require a fee and advance approval, and those take considerably longer.

The part contractors underestimate is the Section 481(a) adjustment. Changing methods requires calculating the cumulative difference between the old method and the new one, so that income and expenses are neither duplicated nor omitted in the transition. For a contractor switching from cash to accrual with significant outstanding receivables and retainage, that adjustment can be a large number, and it does not disappear because the change was voluntary. Favorable adjustments generally get recognized in the year of change while unfavorable ones can often be spread over four years, which softens the impact but does not eliminate it.

The Bottom Line

The right accounting method for a construction company depends on the size of the business, the typical duration of its contracts, whether it passes the gross receipts test, and what its financial statements need to accomplish beyond satisfying the IRS. A contractor under the $32 million threshold running jobs that finish inside two years has the most flexibility and often the most to gain from using it deliberately. A larger contractor, or one running multi-year work, has fewer options and needs to focus on getting the percentage of completion mechanics right, including realistic cost-to-complete estimates that will not generate look-back interest at closeout.

What almost never works is inheriting whatever method got set up when the business was small and never revisiting it. Revenue grows, contract durations change, thresholds move with inflation, and a method that fit a two-truck operation frequently stops fitting a company doing eight-figure work. The review is not complicated and it does not need to happen often, but it needs to happen more than once.