Understanding Construction Financial

StatementsDate 11/12/08 and

2:45 p.m. – 3:45 p.m.

Presented by: Warren Hennagin, C.P.A., M.S.-Tax, CCIFPGlenn M. Gelman & Associates

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OVERALL AGENDA

• Review of Revenue Recognition on Contracts in Progress

• Review of Sample Contract Schedules• Special Revenue Areas (C/O’s/Claims)• Review of Key Financial Statement

Elements• Surety and Banking Credit

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Revenue Recognition on Contracts in Progress

• Revenue recognition is a problem when there are long-term construction contracts.

• Consider the following example:

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ACME General Contractor has been awarded a $100,000 contract which is now

in progress. This is the only job in progress at month-end. The activity on the job at month-end is as follows:

Costs incurred $40,000Billed $0Contract amount

$100,000

Expected costs at completion

$80,000

50% complete

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Example 1: Your month-end financial

statement, using appropriate accounting method will show:

RevenueDirect CostsGross Profit

$ 50,000$ 40,000$ 10,000

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Example 2: How would your answer change for the same contract that had billed $80,000 at month-end?

RevenueDirect CostGross Profit

$ 50,000$ 40,000$ 10,000

What you bill does NOT affect the revenue earned!

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“Costs in Excess”

• Costs in excess is an asset account unique to construction accounting.

• Has characteristics of inventory & a/r, but is really neither.

• Represents money which will be recouped as the contract progresses to completion, PROVIDED THAT THE TOTAL ESTIMATED COST IS ACCURATE!

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Costs in Excess – “Good” Asset?

Often viewed suspiciously by 3rd party users (savvy ones) of the financial statements:

• Often is indicative of an overly aggressive estimate (GP overstated)

• Inventoriable costs may be included prematurely in job cost

• Could indicate that unapproved amounts (c/os or claims) are included in contract amount

• Drag on project cash flowsOther reasons for underbillings:• Mid-month billing cutoff period

(i.e. Caltrans)

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“Billings in Excess”

• A liability to the owner (or general contractor) to perform work which has been billed and paid for in advance.

• Overbilled contracts are desirable to maximize cash flow.

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Billings in Excess – “Bad” Liability?

Generally is viewed as a good liability:Schedule of values is “front-loaded”Estimate is conservativeShould help project cash flow (assuming billed a/r is collected)“Best of Class” are generally overbilled

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Percentage of Completion Method

• Measuring progress towards completion under the percentage of completion method:

– Cost-to-Cost• Most common method. Uses ratio of costs-to-

date to total estimated cost to determine extent of progress toward completion.

– Units of Production• Used with uniformity of output, such as cubic

yards in place, units installed.

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Percentage of Completion Cost-to-Cost Method

In order to use cost-to-cost method, you must know the following:

1. Contract value 2. Costs incurred to date3. Estimated costs to complete

Includes : Base contract, +- contract options and additions, +-change orders, +- claims, +-incentive and/or penalty provisions

Include: Direct costs (materials, labor, subcontractors) & indirect costs (contract supervision, supplies, depreciation)Exclude: General & admin expense, selling expense

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Accounting Method ComparisonExample 1 – Underbilled Contract

% of Completion

Revenue

Cost

Gross Profit

$611,000

$550,000

$61,000

Underbilled = $611,000 - $500,000 = $111,000

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Accounting Method ComparisonExample 2 – Overbilled Contract

% of Completion

Revenue

Cost

Gross Profit

$389,000

$350,000

$39,000

Overbilled = $500,000 - $389,000 = $111,000

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Accounting Method ComparisonExample 3 – Loss Contract

% of Completion

Revenue

Cost

Gross Profit

$600,000

$700,000

$(100,000)

Overbilled = $750,000 - $600,000 = $150,000

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Work in Process Schedules

Let’s review sample job schedules in your materials.Compilation of individual job calculations reviewed earlier.Scrutinized by banks/bonding companies.Best in class contractors prepare monthly.Consistency in gross profit reporting is key!

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SAMPLE WIP SCHEDULE

CONSTRUCTION CO., INC.CONSTRUCTION CONTRACTS IN PROGRESS

for the year ended December 31, 20XX

______________________________ (1-2) (2-9) (9/2) (8-6) (9+10) (3x5) (10-11) 1 2 3 4 5 6 7 8 9 10 11 12 Total Total Estimated Estimated Under Contract Gross Profit Job Estimated Estimated Gross Costs to Percent Billings (Over) Revenue Costs Total Prior Current No. Job Description Contract Costs Profit Complete Complete To Date Billings to Date to Date to Date Year Year 128 Radiology Lab $ 384,555 $ 309,555 $ 75,000 $ 13,424 96 $ 376,413 $ (8,282) $ 368,131 $ 296,131 $ 72,000 $ 60,588 $ 11,412 129 1st Baptist Church 1,362,363 1,227,363 135,000 267,692 78 1,040,313 24,658 1,064,971 959,671 105,300 0 105,300 130 Ronald Inc. 1,464,156 1,314,156 150,000 800,445 39 556,300 15,911 572,211 513,711 58,500 0 58,500 131 Carbide Corporation 1,137,309 1,005,309 132,000 130,914 87 942,177 47,058 989,235 874,395 114,840 0 114,840 $ 4,348,383 $ 3,856,383 $ 492,000 $ 1,212,475 - $ 2,915,203 $ 79,345 2,994,548 2,643,908 350,640 $ 60,588 $ 290,052 Revenue and costs recognized in prior year 271,459 210,871 60,588 Current year $ 2,723,089 $ 2,433,037 $ 290,052 Costs and estimated gross profit in excess of billings $ 87,627 Billings in excess of costs and estimated gross profit (8,282) $ 79,345

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SPECIAL REVENUE

AREAS

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Change OrdersS P E C I A L R E V E N U E A R E A S

• Modify scope of contract– Work to be performed– Contract price

• Legal changes• Approved or Unapproved• Result from changes in

– Materials– Labor required

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Accounting for Change Orders

• Depends on underlying circumstances, which may differ for each change order.

• Many change orders are unpriced: – Scope of work to be performed is defined, but

adjustments to contract price is to be negotiated later.

• To record revenue from unpriced change orders, recovery should be deemed probable.

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Accounting for Change Orders

• Some factors to consider in evaluating whether recovery is probable:– Customer’s written approval of the

scope of the change order– Separate documentation for change

order costs that are identifiable and reasonable

– client’s favorable experience in negotiating change orders

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Accounting for Change Orders

• If the unpriced change order is deemed probable– Contract revenue should be increased to the extent that

costs are incurred– No gross profit on unpriced change order should be

recognized.– Gross profit on a change order can be recognized only

in circumstances which realization is assured beyond a reasonable doubt. (when change order has been priced and signed by both parties after year end date)

• If change orders are in dispute or are unapproved in regard to both scope and price, they should be evaluated as claims.

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Claims

• Amounts in excess of the agreed contract price that a contractor seeks to collect from customers or others for customer-caused delays, errors in specifications and designs, contract termination, change orders in dispute or unapproved as to both scope and price, or other causes of unanticipated costs. (defined by AICPA Audit & Accounting Guide)

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Recognition of Claims

• Recognition is appropriate only if it is probable that the claim will result in additional contract revenue and if the amount can be reliably estimated.

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Both probable and reliably estimated are satisfied by the existence of ALL of the following conditions:

– The contract or other evidence provides a legal basis for the claim; or a legal opinion has been obtained, stating that under the circumstances there is a reasonable basis to support the claim.

– Additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractor’s performance.

– Costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed.

– The evidence supporting the claim is objective and verifiable, not based on management’s “feel” for the situation or unsupported representations.

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Recognition of Claims

• If the forgoing requirements are met, revenue from a claim should be recorded only to the extent that contract costs relating to the claim have been incurred. No gross profit relating to the claim should be recognized.

• The amounts recorded should be disclosed in the notes to the financial statements. If the total claim amount is more than the costs incurred, the entire claim should be disclosed in the notes.

• In practice, recording revenues from claims only when the amounts have been received or awarded. Total cost would reflect costs associated with claim, but total contract revenue would not reflect any revenue associated with claim.

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Review ofFinancial Statements

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Comparison of Audit, Review & Compilation

Type of Engagement

Procedure and Scope difference

Audit

Review

Compilation

Approach, scope, procedures well defined under Generally accepted auditing standards (GAAS). Included confirmations, test of system, and extensive contract evaluation.Literature requires “performance of inquiry and analytical procedures.” No requirement to gather evidence to corroborate inquiries and analytical procedures unless become aware that information is incorrect.

Literature defines compilation as “presenting in the form of financial statement information that is the representation of management without undertaking to express any assurance on the statements.” No requirement to make inquiries or to perform ANY procedures to validate the information.

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Comparison of Audit, Review & Compilation

Disclosure requirements are IDENTICAL for all 3 types of engagement.

Type of Engagement

Cost

Audit 100%

Review 50%

Compilation 30%

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Key Balance Sheet Assets

Accounts ReceivableRetentionUnbilled

Costs & Profit Greater Than BillingsInventories/Deferred Contract CostsInvestments in Joint Ventures

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Key Balance Sheet Liabilities

Accounts PayableBillings in Excess of Costs and ProfitDeferred Income TaxesAccrued ExpensesOverall Classification of Assets/Liabilities Associated with Contracts

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Income Statement

Contract CostsGross ProfitGeneral & Administrative ExpensesOther Income/ExpenseIncome Tax Expense

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Review of Footnotes to Financials

Summary of Significant Accounting PoliciesReceivablesLine of CreditBacklogChange in EstimatesJoint VenturesContingencies

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Supplemental Schedules

Job Schedules- Open and ClosedGeneral & Administrative ExpensesOther Income/Expense

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RULES OF THUMB!RULES OF THUMB!

Sureties provide credit based upon working capital, generally 10 times amount of working capitalAccounts receivable over 90 days50% of inventoriesPrepaid expensesStockholders or officers loans receivableCash surrender valueDeferred income taxes

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Window Dressing for Success

Good Working CapitalCurrent Accounts ReceivableNo ClaimsConsistent Profit ReportingNew Work to Replace Work-OffManaged OverheadSTRONG CASH POSITION

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Surety vs. Banking Credit

SURETY BOND CREDITBonding Company is similar to“co-signer”Applicant needs to qualify for credit.Bond claims are unexpected byBonding companiesContractor required to reimbursebonding company for any losses

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Surety vs. Banking Credit

SURETY BOND CREDIT

Types of Bonds

Bid BondPerformance BondPayment Bond

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Surety vs. Banking Credit

BANKING CREDITApplicant will qualify for line of creditcapacity based on financial strength

ofcompany.Size of line of credit will drive needfor either audit/review/compilation.Typically line of credit renewedannually.

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QQUESTIONSUESTIONS

CCOMMENTSOMMENTS

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Glenn M. Gelman & AssociatesGlenn M. Gelman & Associates

Founded in 1983, is one of Southern California’s leading and most respected CPA firms, offering full service public accounting and business consulting. The Firm specializes in the construction industry.

• Accounting• Auditing• Management, business &

entrepreneurial consulting services

• Litigation support• Personnel recruitment• Computer systems

design, implementation & on-site training

1940 E. 17th Street, Santa Ana, CA 92705 (714)667-2600

www.gmgcpa.com whennagin@gmgcpa.com