Construction Contractors Advanced Issues

Go beyond the basics of many issues the construction industry brings to the accounting profession. Get hands-on advice on the accounting, audit and tax issues that make the construction industry a high-risk client. Address difficult issues such as look-back calculations, measuring progress of construction contracts and overhead allocations. Enhance your skills today to reduce the risk of your next construction engagement.

Objectives:

• Recognize and understand the pitfalls that small contractors face with construction issues
• Evaluate and rework your audit process to avoid common deficiencies in construction engagements
• Improve how you address construction issues

Prerequisite: Completion of the AICPA course Construction Contractors: Accounting, Auditing and Tax, or experience in providing services for construction contractors.

VALUE AID!: Audit Risk Alert - Construction Contractors Industry Developments

Chapter 1

Nature and Significance of the Construction Industry

Learning Objectives

• Understand the significance of construction as an industry.
• Be familiar with the various types of construction contractors.
• Be aware of the players involved in the construction industry and the roles they play.
• Be familiar with the four basic types of construction contracts.
• Review the role of the surety.
• Review the basics of contract accounting.
• Provide an accounting standards update applicable to the construction industry.

Introduction

The construction industry is a phenomenal industry. The players in the industry can range from a small service contractor with revenues of less than $500,000 to multi-faceted contractors who well exceed the billion-dollar threshold. It is an industry with a very easy entry, yet it is a tough industry to survive in. It is an interesting industry for any CPA. The range in size of the contractor fits well for any size accounting firm to service.

However, many CPAs do not realize the opportunities available when dealing with a contractor and their need for the services that CPAs can provide. Contractors go into business for themselves because they know how to manage the construction process or build a project, but many do not understand what it takes to properly run their businesses. They may not understand all the labor issues. They may not understand all the licensing requirements. They may not understand all the aspects of their job costs. They may not understand the surety requirements. They may know very little about internal controls. They may not understand why a cash flow projection should be considered when bidding a project. Given the complex issues contractors face, opportunities should abound for the CPA.

Yet with such opportunities, the CPA to the construction industry must understand the risk that they face. The CPA must gain an understanding of who the end-users of the financial statements are; the components of internal controls that go beyond what standard audit programs address;

Players in the Industry

Just as it is important for us to understand the type of contractor we are dealing with, it is also important that we understand who the contractor is dealing with. This understanding should play a major role in determining client acceptance criteria and who may be affected by the advice we have given to our client.

• Project owner – Who are the parties that our client serves?
• Architect and engineer – Where are the plans coming from? What is the reputation?
• Other contractors – What type of subcontractors do we use? What is the capacity of the subcontractors we utilize? Are the subcontractors bonded?
• Surety – What does the surety look at? What is the reputation of the surety? What is our reputation with the surety?
• Bond agent – What is our relationship with our bonding agent? What avenues of bonding does he provide?
• Lawyer – What experience does the lawyer have with construction law? Experience with labor law?
• Banker – Who is loaning the funds for the project? What agreements does our client have in place to fund his cash flows?

Players within the Contractor Client

• Owners of the company – What is their character? What is their reputation? What is their attitude?
• Controller/bookkeeper – What is their experience? What is their skill? How reliable are they in providing us the information.
• Estimators – What is their experience? What is their ability? How effective are they?
• Project managers – What is their experience? What is their capacity?
• Labor force – Is the labor force unionized? What is the skill?

Types of Contracts

Not only are there many types of contractors and players in the construction industry, there are also many types of construction contracts. The type of contract is very important to the contractor and CPA alike. From the contractor's point of view, there are advantages and disadvantages to all types of contracts. From the CPA's point of view, the different types of contracts may lead to different ways of looking at a contract to properly recognize revenues. There are four basic types of contracts:

• Fixed fee or lump sum – This contract is one in which the price is not usually subject to adjustment because of the costs incurred by the contractor. Owners prefer fixed-price contracts because they feel it limits their exposure due to the contractor's cost overruns. The disadvantage to the owner is the length of time it takes to complete a fixed-price contract. The delay is due to the finalizing of plans and the process of seeking competitive bids.
• Time and material – Time and material contracts generally provide for payments to the contractor on the basis of direct labor at fixed hourly rates. These rates are adjusted by the contractor's added overhead and indirect costs. The charges to the owner also include materials with certain markup in pricing.
• Cost plus – Cost plus contracts provide for reimbursement of allowable costs plus a fee as defined by the contract. The purpose for using the cost plus contract is due to the essence of time at hand for completion. This is the fastest and typically more costly of contracts for a project owner.
• Unit price – Unit price contracts are those contracts under which the contractor is paid a specified amount for every unit of work performed. It is very similar to a fixed-fee contract, but it varies if the number of units required differs from the engineer's report of bid package. Contracts are usually awarded based on the total of the unit prices applied to the units supplied in the bid package. The method of determining the contract price will vary, as the bidding contractors will compete on different pricing and structural strategies.

It is interesting to see the changes. Some mergers took place, certain names dropped out of the top six, and some ratios improved. By comparing the 2004 and the 2002, one would assume the surety business is improving. However, look at the statistics from the remaining ninety-four sureties:

• 18 of the Top 100 had net loss ratios in excess of 70%
• 8 of the Top 100 had net loss ratios in triple digits
• The highest net loss ratio of Top 100 was 462%
• The highest direct loss ratio of Top 100 was 728%

Keep in mind, surety is supposed to be underwritten to a 0% loss ratio. To underwriters, surety is not considered an insurance product. That being said, in the real world, most sureties have losses and it would be safe to assume that sureties budget some form of a loss ratio. We would estimate that a budgeted surety target loss ratio can be anywhere from 15-25%.

These statistics are very important to the contractor. It is important that the CPA be aware of this, as much of the surety's evaluation comes as a result of the financial statements. Based on the surety losses, it caused small or emerging contractors to have a more difficult time meeting underwriting requirements. This made many smaller contractors turn to different avenues, such as the Small Business Administration.

Large contractors with jumbo contracts (greater than $250 million) had to be creative in their surety approach. It has become a common practice that contractors form joint ventures on large contracts to share the bonding risk. Joint ventures will be discussed later in this course.

Today, the surety market is experiencing much success. The surety underwriter restrictions put in place from 2001 to 2006 have paid off. In addition to the restrictions, sureties are seeing dramatic increases in contract prices primarily due to the sharp rise in material costs such as steel, asphalt and copper. The impact of the rising materials costs permits premiums to rise much greater than the risk associated.

Because of the surety success we are seeing the surety underwriters loosening some of the tight restrictions. The financial information is still being requested without change. What does change is the manner in which the sureties extend credit based on the financial information received. The manner in which this is done is discussed later.

Contractors will be asked to document their financial stability and profitability, as well as their ability to meet current and future obligations. To meet more detailed underwriting, contractors may be expected to provide the following information:

• Independently audited financial statements within 90-120 days
• Interim financial statements
• Aging of accounts receivable and payable
• Analysis of overhead costs
• Equipment schedules
• Profit and loss statements
• Outline of complete bank agreements (line of credit, turnaround to collect, etc.)
• Up-to-date work-on-hand reports
• Comprehensive business plan, forecast, or strategy (both short-term and long-term)
• Resumes of key employees and management
• Personal and corporate indemnity

CPAs should be aware of these requirements and can be of great assistance for the small contractor in providing the information for the surety. The more upfront the contractor is with the surety, the better the relationship between the surety and the contractor. The better the relationship between the contractor and surety, the better the odds the contractor has at increasing his or her bond program.

When a surety evaluates a contractor, the surety looks for certain warning signs in order to minimize the surety's risk. Some of the risks and warnings signs for sureties are listed below.

• The contractor's accounting/financial reporting system – The surety likes receiving timely information from the contractor. The contractor's inability to produce standard financial statements and job profit/loss reports is not a strong sign for the surety.
• Turnover of personnel – The leadership of the contractor is crucial. A contractor's experience and capacity within the industry relieves the surety of certain concerns. An important consideration regarding the leadership is the contractor's successor in the event of death or disability. A plan of succession is important.
• Changes in the contractor's business – The change may be dealing with the type of construction engaged in by the contractor or it could be dealing with the size of the contracts the contractor is pursuing.
• Maximized lines of credit – This warning sign informs the surety that the contractor has no where else to go in the event of problems on the job. The risk of filing claims only increases that much more.
• Poor estimating and project management – The evidence of varying bid spreads of significant degrees concerns the surety that the contractor's estimating department is inexperienced or proves their lack of ability. A continual downward trend of profit fade on jobs and diminishing gross margins is of concern especially if the contractor does not have a contingency plan on improvement or the contractor lacks the balance sheet strength to overcome the negative trends.

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