5 Effective Ways to Recognize Earned Income

Journal of Light Construction

To understand true profitability, it’s important to look at earned revenue instead of cash received. For example, if you require a 20% deposit at contract signing, and the job is sold at $100,000, the $20,000 check you receive shouldn’t be classified as earned income because you don’t have any costs to record against it.

There are several ways that you can end up with the desired result, which is to see only earned income on your profit and loss statement (P&L). Be aware that if the method used ends up with your having dollars of payments in a liability account, in terms of tax reporting, “cash is cash”; that is, if you file your taxes on a cash basis (check with your accountant on this), any dollars—earned or unearned—that you receive from customers must be reported as income.

This is typically handled at year end by the tax preparer making a journal entry to temporarily classify these dollars as income on the last day of the tax year (December 31 for calendar year filers) and then reversing the entry on the first day of the following year (January 1 for calendar year filers). Doing so properly adds the received dollars to the P&L where they can be included as taxable income, but the reversal keeps things accurate for the following year.

Method 1: T&M Invoicing

In this method, the job is sold with the understanding that actual costs (burdened labor plus actual material and subcontractor costs) will be reported, an agreed-upon markup will be applied, and the customer will pay as the project progresses.

Pros: For contractors who have limited confidence in their estimating abilities, this can be a safe option.

It can also be useful when costs fluctuate wildly due to supply issues.

If payments are scheduled on a regular basis (say, every Tuesday following submission of the invoice on Monday, when all costs from the prior week have been assembled), the customer will be dealing with bite-sized outlays of money, and the weekly payment will be expected and hopefully planned for.

Cons: For the customer, there is no way to have a budgeted cost up front. If things crop up, too bad; they still have to pay.

Also, because invoices are generated as the job progresses, it’s impossible for the contractor to avoid shelling out money before it is reimbursed by the customer. This breaks the rule “Always pay for the project using the customer’s money.” For example, with a contract price, an invoice typically accompanies the signing of the contract. These bucks are designed to cover the startup costs (and accompanying overhead) that inevitably occur prior to what the customer would call “the start of the job.” With T&M invoicing, if state law permits, it’s best to request a “deposit” amount beforehand. This can be sold as a way to “hold your slot in our schedule” or anything else that sounds reasonable. These dollars can then be credited back to the customer on each invoice. The customer will end up paying the same amount, but the contractor won’t have to carry the job between signing the contract and creating that initial invoice that follows the first visible work on the project.

The contractor may feel compelled (by a desire for total transparency or in response to customer demand) to provide detailed information regarding time spent and actual costs incurred. This can be time-consuming, although with the proper preparation, reports can be memorized (a QuickBooks function) and easily run for each billing period. Under no circumstances should the contractor feel compelled to provide paper copies of everything.

T&M jobs have a tendency to go on and on. While there should be an agreed-upon scope of work, T&M projects seem to expand more easily than contract price jobs. One reason may be that with a contract price job, changes are recorded as change orders, which must be reviewed, agreed upon, and paid for by the customer. But with T&M jobs, the creation of change orders may not occur. Such changes may simply be viewed (sometimes by both parties) as an expansion of the existing job rather than as reason to commit to a separate agreement.

Because the customer will see actual costs (the level of detail provided will probably vary from company to company), the harsh fact of the markup amount will be in the customer’s face with every invoice. With contract pricing, the markup is embedded, as it is with virtually any other product we buy, from groceries to tools.

To learn the other four methods, read the rest of this story from JLC here.