Accounting for Construction Processes Explained in Depth- Including Tax Treatement
How to Organize Bookkeeping & Accounting for Canadian Construction Businesses
In the last few years, there have been significant changes to the level of construction activity in Canada and the way in which it is regulated, particularly with respect to income tax filings. Often individuals provide contract services on a part-time or occasional basis particularly in markets that have significant levels of activity. Consequently, a number of contractors need help with their bookkeeping and the preparation of income tax returns.
When dealing with individuals engaged in building activities a commonly encountered issue is the determination of whether they are employed or self- employed. If a business exists (rather than an employment relationship) the broader bookkeeping issues must be addressed – the various ways in which contracts are entered into and their implications in keeping the accounts, sales tax accounting and statutory filing requirements.
Employed or Self-Employed?
Construction contractors are often confused when it comes to dealing with people who provide labour and sub-contract work. Because of the nature of the business, the confusion lies in whether the service provider is employed or self-employed
A contractor may have individuals providing services that consider themselves to be self-employed or who don’t want to be treated as employees, even if they are! Alternatively, a contractor may consider those providing labour as sub-contractors (or self-employed) when they are and should be treated as employees.
Over the years, the courts have developed criteria to be used in evaluating whether an individual is an employee or is self-employed. The following questions are a starting point to determine this status:
Has the individual entered into a contract of service (an employee) or contract for service (self-employed)?
What level of control does the payer have over the worker?
Does the worker provide his or her own tools and equipment?
Can the worker subcontract the work or hire assistants?
Is there a degree of financial risk taken by the worker? Does the worker have the potential for profit or loss?
What is the degree of the worker’s responsibility for investment and management?
What does the written contract state?
If an individual can establish that he or she is an independent contractor and not an employee he or she accounts for contracting income as business income, meaning:
Business-related deductions such as home-office expenses, promotion and entertainment expenses, capital cost allowance on equipment and other such expenses can be claimed.
Reasonable salaries paid to family members for services rendered are deductible in determining business profits and can be used to split income.
The owner may incorporate the business and claim the low tax rate applicable to active business income.
There is no requirement to contribute to Employment Insurance, and there is no ability to draw Employment Insurance during periods of inactivity. FYI https://www.canada.ca/en/services/benefits/ei/ei-self-employed-workers.html. There is however some new special benefits available to tradespersons. Canada Pension Plan contributions are still required.
Depending on the level of revenue, the business may need to register and collect GST on revenues.
It is not unusual that a contractor wishes his or her labour providers to be sub-contractors rather than as employees, as the contractor does not then have to contribute to payroll related statutory deductions, such as CPP, EI and WCB.
Depending on their commercial arrangement, a contractor and its sub-trades may have the ability to manage their relationship so as to create either an employment or self-employment relationship.
T5018 Statement of Contract Payments
If the individuals providing labour are self-employed contractors or sub-contractors and are not employees who are issued T4’s, there is a contract payment reporting requirement imposed on the person making payments to them.
This requirement is relatively new and was introduced in an attempt to get at the ‘underground economy’ – the system of undocumented below-the-table payments not uncommon in the construction industry, which led to many self-employed trades avoiding tax by failing to report their income.
Amounts paid for construction services must be reported by filing a T5018 ‘Statement of Contract Payments’ form. This consists of the T5018 summary and related slips of all payments made to sub-contractors and documentation which includes all the information required on the T5018 slips and summary.
The T5018 is an information slip that identifies the total contract payments including GST/HST made by the contractor to a recipient during a calendar year or a fiscal period. The issuer is not required to provide a copy of the T5018 Supplement slip to the recipient but generally will.
A copy to Canada Revenue Agency is mandatory and effectively serves to create the audit trail which allows the CRA to ensure that the recipient is properly reporting income.
A construction subcontractor who will be the recipient of a T5018 must provide the issuing contractor with a social insurance number or a Business Number (BN) if they are a sole proprietorship or a partnership. All incorporated entities must provide their BN.
A business can have a number of BNs for reporting income tax, GST and payroll. For contract payment reporting, the recipient is to provide the issuer with the business number that would be used when filing a tax return.
Setting Up the Accounts
Most builders use project or job accounting, which requires that revenue and costs be accumulated for each engagement the business takes on.
Where a contract entered into has been priced on a cost-plus basis (as defined below) it is essential that the contractor keep track of the costs particular to that project as the amount to be billed will be based on those costs.
However, no matter how the contract price is set, it is almost always necessary that revenues and costs be segregated in the accounts by project. The allocation of revenues and expenses in this way is often referred to as ‘project accounting’ or ‘job cost accounting’. The number of accounts will depend on the level of detail that provides useful management information.
For example, a plumbing contractor who provides only labour and materials may set up job accounts (such accounts are inventory for the contractor) that have only two sub-accounts: labour and materials.
A general contractor, on the other hand, would likely want to establish a large number of sub-accounts in order to have useful cost information available: direct materials, direct labour, engineering, permits and sub-accounts for each of the major sub-trades.
The use of detailed cost accounts is demonstrated in the extract taken from the trial balance of a contractor, who has set up separate cost sub-accounts to better manage the costs in a recreation room project.
As is always the case, the bookkeeper needs to use some discretion in establishing accounts. The more detailed the accounts are the more difficult it is to accumulate reliable information. The level of detail presented should be sufficient to meet management’s information needs but not significantly more.
Timing and Recognition of Income and Expenses
The way in which a contractor recognizes revenue and expense depends in large part on the type of contract that has been entered into. Two typical pricing models are the cost-plus or fixed-fee contract and the fixed-price or unit-price contract.
Cost-plus or Fixed-fee
Cost-plus or fixed-fee contracts are those where the contractor is reimbursed for allowable costs and is also allowed a profit margin calculated as either percentage of these costs or a fixed amount. Revenues, expenses and profit, which accrue throughout the period of the contract, are easily determined and no particularly complex issue arise with respect to the timing and recognition of the income.
EXAMPLE – COST-PLUS CONTRACT
A contractor agrees to renovate space in an office building that a landlord is fixing for a new tenant. The landlord uses a designer and provides the contractor with detailed specifications.
The contractor agrees to do the work for cost plus 15%. It is agreed that contract labour will be priced at $35 an hour, which will represent its cost.
Periodically, the contractor will provide the landlord with an invoice, detailing the costs that have been incurred, and adding 15% as the contractor’s profit margin.
Fixed-price or Unit-price
Fixed-price or unit-price contracts are those where the contractor agrees to a fixed contract price or at a unit rate. Any work the contractor provides beyond the originally defined scope is generally performed for additional fees using change orders or additional work orders.
Where the contract calls for a specified deliverable (such as constructing a building to a set of pre-determined specifications) for a fixed amount, it is referred to as a fixed-price contract. Where the contract calls for the delivery or production of a quantity of units beyond a pre-set number (such a laying a specified number of meters of pipe for a fixed amount per meter), it is a unit-price contract.
With either of these types there may be choices as to when the revenues and expenses are recognized for both accounting purposes and income tax purposes.
If the contract is started, fully completed and paid for within the fiscal period, there aren’t any issues regarding when revenue, expense and income are recognized.
On the other hand, the issue of income recognition can be problematic when the contract extends beyond the current fiscal period, and commonly over several fiscal periods. Where this is this case, it may be quite difficult in interim reporting periods to estimate what the overall profit will be and how much of it has been earned to date because total project costs may be difficult to predict. Generally the longer the contract period, the more the costs are likely to vary.
Virtually all long-term contracts and many short-term contracts provide for contractors to issue periodic progress billings. Typically the degree of progress in the project must be certified by a consultant, such as an architect or engineer, who will certify each periodic progress billing as each phase of the project is completed in accordance with the terms of the contract.
Methods of Accounting for Fixed Price Contracts Requires Updating to IAS 11 and 18
There are two accounting methods that are employed in accounting for revenue, expense and profit in long-term fixed- or unit-price construction projects: the percentage of completion method and the completed contract method. As noted below, the Canada Revenue Agency generally refers to the completed contract method as the ‘completion method’.
The Percentage of Completion Method
The percentage of completion method recognizes revenue as the contract progresses based on the degree of completion. The costs that are incurred during each phase or stage of completion are matched with the revenue. The result is to recognize in income the percentage of the anticipated profit on the project that is complete during that particular year.
This method should be used when reliable estimates of the degree of completion are possible and costs can be estimated with some accuracy. The percentage of completion method is the preferred method as it does a better job of matching the revenue and expenses in the period of benefit and therefore better allocates income to the periods in which it is earned.
The following summarizes how the percentage of completion method is applied:
The contractor estimates the proportion of the work that has been completed to date. This estimate is typically based on a comparison of total costs incurred to date to total budgeted costs but it can also be based on an estimate of the degree of physical completion of the project, which might be evidenced by an architect’s or engineer’s certificate. To be as accurate as possible, the calculation of the percentage should be taken to two decimal places.
Based on the degree of completion an entry is booked to record the cumulative revenue that should be recognized to date, less revenue that has already been recorded.
Where revenue to be recognized exceeds what has been billed, the excess is debited to a balance sheet account, typically referred to as ‘Costs in Excess of Billings’. If billings to date exceed the revenue to be recognized, a debit is posted to sales revenue and a credit to a balance sheet account, typically referred to as ‘Billings in Excess of Costs’.
EXAMPLE – PERCENTAGE COMPLETION METHOD
At the end of its fiscal year, Big Construction Company has one job in process. It is a fixed-price contract.
The total contract price is $50,000,000 and Big estimates that its total costs will be $42,000,000. At year end, total costs incurred to date are $27,000,000. Big has issued progress billings to its customer of $31,500,000.
Step 1 – Based on costs, Big estimates the project to be 64.29% complete ($27 million/$42 million).
Step 2 – Revenue that should therefore be recognized to date is 64.29% of $50,000,000 = $32,145,000.
Step 3 – As Big has already recognized $31,500,000 as revenue through the billing process, the following adjustment is recorded (sales taxes are ignored):
The Completed Contract Method (Completion Method)
The completed contract method recognizes revenue, cost and profit only when the contract has been completed. Progress billings made and costs are all accumulated throughout the course of the contract on the balance sheet and are closed out to the income statement once the project has been completed.
EXAMPLE – COMPLETED CONTRACT METHOD
At the end of its fiscal year, Small Contractor Company has one job in process. It is a fixed-price contract.
The total contract price is $35,000. At year end, total costs incurred to date are $16,000. Small has issued progress bills to its customer of $22,000.
Using the completed contract method, these amounts would appear in the accounts as follows. These are balance sheet accounts so nothing has been reported in income.
It should be clear that the percentage completion method, where it can reasonably be applied, yields a much more representative measure of income in an interim period than does the completed contract method.
The two methods differ as well in how and when losses are recognized. Where a project will generate a loss over all, both methods require that the estimated loss be recorded in the current period. However, where there is a current period loss on a contract that is anticipated to be profitable in the long run, only the percentage complete method reflects the loss in the current period.
The following chart is a summary of how losses are treated:
A holdback is an amount held back from payment by the purchaser because of contract terms or as requirement of the provincial Mechanics’ or Construction Lien Acts. A holdback protects the purchaser from deficiencies in the work and against claims from sub-trades for amounts not paid by the prime contractor.
For bookkeeping purposes, a holdback included in an amount that has been billed to a customer is simply revenue to be received after a period of time has elapsed or certain events have occurred. Similarly, a holdback included in an amount that has been billed to a contractor by a sub-contractor or other supplier is simply a project cost that will be paid in a future period.
However, it is normal practice to set up holdbacks receivable and holdbacks payable in separate accounts, in order to track them separately and to distinguish them from amounts currently receivable or payable.
EXAMPLE – HOLDBACKS
A construction company is about to issue a progress invoice to a customer for $800,000. The contract provides that each billing is subject to a 10% holdback.
Concurrently, the company has received an invoice for $75,000 from one of its trades. The sub-contract agreement provides that payments are subject to a 7% holdback.
GST is ignored in this example.
Special income tax and GST/HST rules may apply to holdbacks, as discussed below.
Income Tax Reporting
No one wants to recognize income and pay income tax earlier than they have to. Thus, it would be nice if every contract could be accounted for in calculating income subject to tax using the completed contract method as it defers the recognition of income for the longest period possible.
However, the CRA will normally only allow the completed contract method to be used where it is anticipated that the contract will be complete within two years of the date it commences. Where a taxpayer elects to use this ‘Completion Method’, it must be used for all contracts of this duration and it must be applied consistently from year to year.
For income tax purposes, a contractor not using the completion method is permitted to change to it at any time without prior approval, provided the method has never been used before. A contractor using the completion method can change to the more accurate percentage completion method at any time, without prior approval, but having done so is precluded from ever using the completion method again.
Income Tax Treatment of Holdbacks
The CRA accepts that a statutory or contractual holdback that has been billed by a contractor is not actually receivable until such time as the holdback conditions have been released.
Therefore, it is acceptable for income tax purposes to reduce income for holdbacks billed that have been included in sales revenue but for which the holdback period has not expired and the holdback conditions have not yet been met. Such an adjustment is then taken into income in the year in which the related holdbacks become receivable.
EXAMPLE – HOLDBACKS
At the end of its taxation year, a construction company reviewed the sub-ledger supporting the $150,000 of holdbacks receivable in its accounting records. It determined that the holdback conditions had been met for $30,000 but that the customer had simply not yet made payment. For the remaining $120,000 either the underlying holdback conditions had not yet been met or the holdback period had not expired.
In computing its income for income tax purposes the company can deduct $120,000 from the income otherwise reported in its financial statements.
Similarly, amounts held back from billings from sub-contractors are not included in costs until the earlier of the time payment is made to the sub-contractor or the holdback becomes legally payable because the holdback conditions have been met or the holdback period has expired.
Goods and Services Tax (GST)
Most construction contracts relate to the supply of goods and services and, generally, most contractors and sub-contractors are GST registrants. The general rules that apply to GST – collect it on revenues, pay it on inputs, remit the difference – apply to contractors. These general rules were discussed in greater detail in our GreenLearning article “Sales Taxes in Canada - What You Need to Know”.
There are a few special issues that can apply to the construction industry, though.
The general rule is that GST/HST is accounted for at the time consideration becomes due or the time that it is paid, whichever is the earlier. There is a special timing rule that applies to a holdback where that holdback relates to the construction, renovation or repair of either real property or a marine vessel and the holdback arises under either a written contract or by virtue of a provincial or federal law.
Where a holdback meets these tests, GST/HST is due on the holdback only on the earlier of the day that the holdback is actually paid or the day that the holdback period expires.
EXAMPLE – GST on HOLDBACKS
A construction company is about to issue a progress invoice to a customer for $800,000 for the renovation of a building. The contract provides that each billing is subject to a 10% holdback. Concurrently, the company has received an invoice for $75,000 from one of its trades. The sub-contract agreement provides that payments are subject to a 7% holdback.
When the billing comes in for the holdback, the remaining GST will be included and accounted for at that time.
Supplies to Governments
Where goods or services are provided to a government, the special rules relating to such supplies should be kept in mind.
The federal government and its agencies pay GST. The provincial governments of the harmonizing provinces of Newfoundland and Labrador, Nova Scotia, New Brunswick, Ontario, and PEI also pay GST. The governments of British Columbia, Quebec and the Nunavut Territory pay GST. No other provincial or territorial government, or its agencies, pays GST.
Retail Sales Taxes
The way in which provincial retail sales taxes apply to contractors can be confusing.
The general rule is that retail sales taxes do not apply to the supply of real property, which includes anything that is fixed permanently to land. As a result, where a contractor has a contract to construct a building or to supply goods and services which become a permanent fixture to real property, the contractor does not charge retail sales tax on its contract billings, but pays retail sales tax on any taxable goods or services acquired in the process.
Alternatively, the contractor may have a ‘supply and install’ contract or a ‘supply only’ contract, which does not involve real property – such as repairing machinery. This is a contract under which the contractor is hired to acquire goods and install them on the customer’s facilities or simply to provide the goods to the customer. The contractor is then providing taxable goods or services, which means the contractor 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 sound practice always to check the published information available for the province in question and, where there is doubt, to confirm your understanding with the retail sales tax authorities.
It is important whether a tradesperson is employed or self-employed and the courts have developed criteria to be used in making this assessment.
Payments made to self-employed contractors must be reported using the contract payments reporting system.
Special accounts may be required for contractors. Generally, the ability to track revenues and expenses by project is important.
How and when contract profits are recognized varies with the type of contract.
Certain contracts can be accounted for using the completed contract method for income tax purposes.
Special rules come into play in applying sales taxes to contractors.