A contractor’s financial statements are only as accurate as the work-in-process (WIP) schedule, and the WIP schedule is only as good as the estimated costs to complete.
If estimated costs to complete are too low, the balance sheet and income statement will be overstated. If estimated costs to complete are too high, the opposite is true, understating working capital and net income.
“It ain’t over ’til it’s over”
While accounting personnel may do their best to continually update job-cost reports with up-to-the-minute detail, as well as how and when open jobs may finish, in the end, you simply don’t know how profitable contracts in progress will be until they are finished.
The process of estimating and presenting costs to complete on contracts in progress is as much an art as it is a science. The actual estimation process involves making accurate calculations as well as ensuring that everyone responsible for providing input has timely and complete information. They also must have the ability to project what needs to happen to finish a job, particularly from a labor perspective.
But as jobs proceed, literally anything can happen. Unexpected rushes or delays, scheduling or coordination complications (or simplifications), design modifications or other production issues can either throw a huge wrench into the works or help the job run far more smoothly than was ever dreamed. Either way, it may impact estimated costs to complete, the related gross profit and the company’s bottom line.
Stories abound of contractors who understated costs to complete, whether knowingly or not. They may have felt pressure to show better results in order to obtain bonding and bank financing, or they may have honestly thought they could finish jobs better than the underbillings foretold. Unfortunately, ma ny of these stories had bad endings, and the surety, banker, owner or other contractors were left holding the bag due to desperate the actions of a few.
Even contractors who try their best to fairly present what they believe their WIP schedule is can get into trouble. People make mistakes. Even the best contractors may inadvertently omit things or have based estimates on incorrect information, causing problems running or completing jobs. This can quickly result in lowering profits or completing jobs at a loss.
Competence and integrity
Knowing that the cost-to-complete estimation process is both crucial and in a constant state of flux, it would seem prudent to develop a philosophical approach to determining what those estimates should be.
While we can calculate what we think are the physically most accurate cost-to-complete figures, they may not be the best ones to show on the financial statements. Developing the best approach to estimating and presenting costs to complete is where competence and integrity – the two components of trustworthy financial statements – meet.
One approach – a poor one – is to intentionally underestimate costs to complete in order to obtain necessary bonding or financing. Deliberately showing more profit than is reasonably expected ca n give a contractor the working capital and equity needed to get that next job bonded and a line of credit renewed. Including too few hours to complete a job or showing too many units produced to date can be difficult to catch in an audit or a review, which some contractors see as an attractive option.
However, this approach should never be used. It puts those relying on the company and its financial statements at risk for loss, including bankruptcy, if the offending contractor does not perform. Even innocently optimistic estimates can fit into this category, especially when contractors habitually experience profit fade. The surety may conclude, and rightly so, that these businesses do not know how to run jobs profitably. Such contractors will be the first ones cut off by their sureties, particularly in conservative credit and risk markets.
A second approach would be to simply accept the numbers pulled together from everyone’s input and to report them as they are. But, as noted earlier, even this choice is not necessarily the most accurate or appropriate because people are not perfect. Significant mistakes could make the reported gross profit materially incorrect and misleading. And mistakes that substantially overstate income could be dangerous to those relying on a company’s financial viability.
A third approach would be to conservatively estimate the open jobs profit, within a reasonable range. In this instance, contractors begin with their best estimate of where they believe jobs stand but then allow for the possibility of unexpected hurdles in completing the job.
Typically, profitable contractors have net overbillings and experience profit gain. When contracts are signed and jobs are placed on the WIP schedule, they are shown making the minimum amount of pr ofit expected. Only as work is performed and hurdles are crossed will these contractors increase overall job profit. They will have a better handle on unexpected contingencies toward the end of the job, and not until the job is finished will all anticipated job profit be added to the contract.
Profitable contractors also know what their gross profit is from all jobs – completed contracts, contracts in progress, and time and material jobs – because they reconcile their job profit with their monthlyfinancial statement income using an earnings-from-contracts schedule. This is crucial to knowing why and how you are (or are not) making money.
Sureties take greater comfort with these contractors since they bring jobs in on budget (or better) and are more likely to give them the bonding they request. The IRS also does not take issue with such practices because they eventually acquire the tax dollars due using look-back provisions.
Conservatively reporting job profits also encourages business owners to run their companies leaner. If year-end bonuses are determined, in part, based upon either open job profits or overall company income, then showing both conservatively would help the company not over-reward profit achieved on the job.
Can contractors be too aggressive in conservatively stating open-job profit and overbillings? How much net overbillings is too much?
CPAs in public accounting must opine on the fair presentation of financial information “in all material respects” during the audit process. Even in reviewed financial statements, CPAs state that they “are not aware of any material modifications” for the financials to conform with GAAP. So while costs-to-complete are estimates, and estimates can and do frequently change unexpectedly by material amounts, it must still be within a reasonable range to pass muster with a contractor’s outside CPA.
Conservatively estimating job profit can pose difficulties when construction companies are bought and sold. Too much billings in excess would lower a company’s book value, and an owner would not get his fair share in a buyout utilizing book value as part of the computation. This problem could be rectified using a true-up following the completion of jobs open at the buyout date, similar to the look-back calculation.
Other potential problems may involve the mindset of the project managers. If profits are conservatively stated on a consistent basis, project managers could potentially bring jobs in less efficiently than they might if their feet were held closer to the fire.
Persist!
Finally, temptations may arise to materially overstate or understate profits. This is exactly when we need to hold to the principles and practices we know will work to ensure the fairness of the estimates.
For additional information or guidance related to this article, contact Jovana Krajewski at jkrajewski@vlcpa.com or 800.887.0437.
