7.1 Accounting & Financial Statements

Accounting Methods for Contractors

Contractors need reliable bookkeeping to bid accurately, pay subs on time, and satisfy the Arizona Registrar of Contractors (AZ ROC). Two accounting methods dominate construction:

• Cash accounting records revenue when payment is received and expenses when paid. It is simple and works for very small contractors, but it can distort profitability because a big progress billing received in December looks like income even if the work spanned months.
• Accrual accounting records revenue when earned (when work is performed or milestones are reached) and expenses when incurred (when materials are delivered or labor is used), regardless of when cash moves. Accrual matches revenue to the costs that produced it, giving a truer picture of job profitability and is the method most construction accountants recommend.

Quick Answer: Use accrual accounting to match revenue with the costs that produced it; cash accounting is simpler but can hide true job profitability.

A hybrid used in construction is the percentage-of-completion method, which recognizes revenue proportionally as the project progresses (typically based on costs incurred to date divided by total estimated costs). This smooths revenue across reporting periods and is generally required for long-term contracts under Generally Accepted Accounting Principles (GAAP).

The Three Core Financial Statements

Balance Sheet

The balance sheet is a snapshot. Assets are what the business owns (cash, accounts receivable, equipment, inventory). Liabilities are what it owes (accounts payable, loans, accrued payroll). Equity (or net worth) is the residual: Assets minus Liabilities. For a contractor, underbillings (costs incurred but not yet billed) and overbillings (billed but not yet earned) are construction-specific line items that keep the balance sheet honest.

Income Statement

The income statement (also called the profit and loss statement, or P&L) covers a period. Revenue (contract income) minus direct costs (labor, materials, equipment, subcontractors) equals gross profit. Gross profit minus overhead (office rent, insurance, administrative salaries) equals net operating income. Track gross profit per job to see which projects actually make money.

Cash Flow Statement

The cash flow statement reconciles accrual net income to actual cash. It is divided into operating (job receipts, vendor payments), investing (equipment purchases), and financing (loan draws, owner contributions) activities. A contractor can show a healthy income statement and still go broke if receivables stretch out — the cash flow statement exposes that risk.

The AZ ROC Financial-Statement Requirement

As part of the license application, AZ ROC requires the applicant to demonstrate financial responsibility and the ability to cover project liabilities. The applicant submits a financial statement showing the business has sufficient assets and working capital to perform the work it contracts for. For a new entity, the qualifying party's personal financial resources may supplement the business statement. A license bond is also required as proof of financial responsibility. ROC uses these submissions to screen out applicants who would take deposits and lack the means to complete the work.

Working Capital

Working capital measures short-term liquidity:

Working Capital = Current Assets − Current Liabilities

Current assets include cash, accounts receivable, and inventory expected to be converted to cash within one year. Current liabilities include accounts payable, short-term loan payments, and accrued expenses due within one year. Positive working capital means the contractor can pay near-term obligations; negative working capital signals risk of defaulting on subs, suppliers, or tax deposits. Most sureties look for positive working capital commensurate with annual billings before issuing performance bonds.

Cash Flow Management

Cash flow is the lifeblood of a contracting business. Profitable projects fail when cash is trapped in unpaid invoices or over-purchased materials. Key practices:

1. Bill promptly — submit progress billings the day the billing period closes, not weeks later.
2. Track retainage — the portion of payment withheld by the owner (commonly around 10%) until project completion; budget for the gap between earning revenue and collecting it.
3. Match payables to receivables — negotiate supplier terms that align with when you get paid.
4. Maintain a cash reserve — aim for enough cash to cover a month or two of overhead.
5. Forecast — project cash needs by job so a slow-paying project does not starve the others.

Working Capital vs. Cash Flow — Don't Confuse Them

Working capital is a stock measured on the balance sheet (a snapshot). Cash flow is a flow measured over time (movement). A contractor can have strong working capital (plenty of receivables) and still miss payroll if those receivables have not been collected. The cash flow statement, not the working capital figure, is what tells you whether you can make Friday's payroll.