Presented by Laura Anne Pray, CPA Audit Manager

Transcription

1 Presented by Laura Anne Pray, CPA Audit Manager 1

2 Construction Industry at a Glance One of the largest contributing segments of the American economy Employees Gross National Product Raw Materials High Rate of Failure Economy downturns Incompetence/lack of experience Accounting related problems 2

3 Accounting Related Failures Inability to adequately estimate project profitability Insufficient billing procedures Lack of formalized accounting processes and procedures Lack of timely and accurate financial information for completed contracts 3

4 Organization Formation Sole Proprietorships Simple Difficulty raising capital Limited protection Corporations Offer protection from personal liability (this can be circumvented) High cost to form and maintain a corporation C corporation Taxed at corporate rates Double taxation S corporation Pass-through entity IRS requirements Limitations on the S corporation loss deductibility Partnerships General Limited unlimited liability limited liability for some Pass-through entities Limitations on the loss deductibility Limited Liability Companies Offer protection from personal liability, however laws vary by state Taxing options Sole Proprietor Partnership Corporation *Need to consider surety bond coverage* 4

5 Accounting Standards Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Section provides guidance on accounting for contracts of commercial organizations engaged wholly or partly in the contracting business Section 910 provides additional accounting guidance, much of which originated from the AICPA Audit and Accounting Guide, Construction Contractors 5

6 Unique Accounting Considerations Percentage of Completion (POC) Recognize income throughout the life of the contract Most often is the REQUIRED method Completed Contract defers income recognition until a contract is substantially complete should be used only in those rare instances when the POC method cannot be used *FASB ASC establishes a strong preference for the POC method* 6

7 Revenue Recognition Percentage of Completion (POC) Completed Contract These are NOT alternatives POC will be used except in rare circumstances Lack of dependable estimates (normal business & inherent hazards) If financial results would not vary materially between the two methods The length of the contract DOES NOT affect the method chosen 7

8 Other Unique Accounting Considerations Accrual method MUST be used for billings and costs Costs, revenue and earnings must be summarized by profit center Allocable cost categories: Direct costs Indirect costs Construction period interest 8

9 Other Unique Accounting Considerations Costs in excess of billings on contracts in progress (underbillings) are recorded as assets. Billings in excess of costs (overbillings) are shown as liabilities. Losses expected to be realized MUST be recorded in the period they become known Investments in Construction ventures 9

10 1. Contract Costs 2. Progress Billings Top 3 Accounting Areas 3. Revenues Easy Right?!? 10

11 Cost Accumulation Rules Must accumulate costs PER CONTRACT Direct costs Indirect costs Capitalization of interest costs *Critical requirement - direct impact on revenue recognition and cash flow* 11

12 Direct Costs 1. Materials Capitalized for both GAAP and tax purposes Direct purchases Bulk purchases Leftover materials 2. Labor Payroll for workers, supervisors and others charged directly Payroll taxes, workers compensation insurance and fringe benefits* Common base for allocating indirect costs 3. Subcontractor costs Total billing (not just amount paid) 4. Other direct costs Easily identifiable to specific contract Short-term equipment rental Travel 12

13 Subcontractor example Assume that a general contractor has a subcontract agreement with a landscape contractor that allows the subcontractor to bill $20,000 per month during the five-month life of the project. Assume further that the contractor pays only 90% of this amount, or $18,000 per month, with the remaining unpaid retainage due upon the owner's acceptance of the landscaping. The general contractor should record how much in contract costs as the monthly bills are received and paid: DR. CR. Contract costs $20,000 Cash $18,000 Accounts Payable to subcontractor 2,000 13

14 Indirect Costs More complex/less straight-forward Risk of submitting inaccurate bids Costs overruns Lost profits 2 Step process: Determining which costs Determining method for allocation 14

15 Common Indirect Costs Rent, utilities, depreciation, and other costs related to construction facilities, such as storage buildings and assembly plants. Rent, depreciation, repairs, and other operating costs of general construction equipment used on many jobs Compensation, fringe benefits, workers' compensation insurance, and payroll taxes for indirect labor, such as foremen. Quality control and inspection. Small tools and general construction supplies. Contractor's liability insurance. 15

16 Components of an Overhead Pool Identified costs are included in a pool(s) to be allocated Labor burden Equipment ownership Operating costs Allocation depends on type of work & costs incurred Sole benefit for construction activity, include all Not related to construction activity, include none Portion related to construction activity, consider that portion only 16

17 Method of Allocation Various methods allowed Direct labor hours Direct labor costs Combination of labor hours and material costs Must be systematic, rational & CONSISTENT* Overhead burden rates Divide overhead or cost pool by total allocation base (i.e. total direct labor costs or material costs) Overhead or cost pool is applied based on the burden rate to the base for each contract *Indirect costs and estimating processes change over time. Accordingly, contractors should periodically consider the appropriateness of the allocation method used and revise the process as necessary to maintain accuracy. 17

18 Allocation Example the use of Direct Labor to allocate overhead of $17,500. Allocation based on direct labor costs of $59,000 Burden rate: $17,500 $59,000 = 29.66% Direct Labor Burden Rate = Allocated Overhead Contract A $ 23, % $ 6,822 Contract B 4, % 1,186 Contract C 32, % 9,492 $ 59,000 $ 17,500 18

19 Construction Period Interest Construction of an asset for use by a company or for sale or lease Capitalize interest costs as part of the asset s cost Applicable to contractors with substantial outstanding debt used to finance ongoing construction activities 19

20 Equipment Costs Must establish a method to allocate equipment costs to specific contracts Costs include depreciation, repairs, maintenance, taxes, interest, and insurance Method for allocating: Charging the cost of equipment used on the job to the contract as a direct charge and charging costs that cannot be specifically identified to overhead. Allocating depreciation directly to the job and charging other equipment costs, such as repairs or maintenance, to overhead. Charging all equipment costs to overhead and allocating the costs along with the other overhead expenses. Charging all equipment costs to an equipment cost pool and allocating to jobs. Utilization of usage rates for allocation base (hours, days, miles, etc.) Consider the equipment variance *FASB ASC indicates that it is proper to allocate idle equipment costs to jobs. 20

21 Precontract Costs Anticipatory costs To obtain a contract Purchase assets for a contract Learning/start-up costs If recovery is probable treat as deferred costs separate from construction in progress If recovery is not probable, expense directly to construction costs Learning Costs are charged to existing contracts Start-up costs are expensed as incurred (GAAP) 21

22 Cost Capitalization Rules GAAP and Tax are generally the same (Handout) Tax rules are more specific about the types of indirect costs that can be capitalized This can create a variance between the two Recommendation is to use the same cost rules when practical Consider costs in cost-plus contract 22

23 Estimating Revenues and Costs Critical to the accurate reporting of the POC method Crucial to recording provision for anticipated losses 23

24 Estimating Costs Periodic comparison of actual and estimated costs Include all significant costs elements Method for estimating costs needs to include the same elements as the actual cost accumulation method (overhead) Take into consideration price escalation and wage increases Periodic review of estimated costs to complete 24

25 Estimating Total Contract Revenue Consideration of Basic contract price Change orders Options and Additions Claims 25

26 Basic Contract Price Consider all contract clauses that affect revenues Fixed-price (lump-sum) with no provision for adjustment are the most basic Adjust estimates as the contract progresses Include all items the contractor has risk for or were included in determining project fee Materials required to be purchased to the customer s specifications Use of customer s employees paid by the customer 26

27 Options and Additions Step 1: New contract analysis Product/service differs from original contract Price of new product/service negotiated on it own Product/service are similar to original contract but price and costs differ significantly Treatment Options Combined with original contract (for new contracts only) Treated as a separate contract (for new contracts only) Change order 27

28 Change Orders Modifies contract provisions If a change order is priced and both parties have approved the scope and price estimated contract revenues would include the price of the change order. If a change order is unpriced but both parties have approved the scope treatment varies with the accounting method If a change order is priced but the parties have not approved the price or the scope it would be evaluated as a claim 28

29 Unpriced Change Orders with Approved Scope Percentage-of-completion method Probable that costs will be recovered by changing the contract price, the costs should be charged to contracts in progress Recognize none of the costs in the income statement until pricing has been approved; or Recognize costs incurred and equal amounts of revenue in the income statement. Probable that change order will generate additional gross profit, recognize only if realization is assured beyond a reasonable doubt Cost for which recovery is not probable (which may be all or only a portion) charge to current operations. Completed-contract method probable that the costs will be recovered, included in contracts in progress. Cost for which recovery is not probable (which may be all or only a portion) charge to current operations. 29

30 Claims made against the Owner Unforeseen circumstances (2 options) include the claim in revenues in the period it is made if the costs have been incurred AND: 1. Legal opinion states reasonable basis supporting claim AND 2. Costs are NOT the result of deficiencies in contractor performance AND 3. Costs are identifiable and reasonable AND 4. Claim is objective and verifiable If criteria is not met DO NOT record Only record revenue from claims when awarded 30

31 Anticipated Losses GAAP requirement regardless of which revenue recognition method used Record a loss provision if Total costs incurred to date + costs to complete exceed estimated total contract revenues Include loss in contract costs Disclose in the statements Accrual is reversed when the project is substantially complete 31

32 Anticipated Losses POC loss is recognized in the period determined, and revenues would be recorded based on the percentage of completion. Completed-contract method loss is recorded in the period it is determined, but no revenues related to the contract would be recognized and costs would be deferred. Provision for Losses (loss a/c) Accrued Losses (liability a/c) DR. $XX,XXX CR. $XX,XXX 32

33 Percentage of Completion Method Two Key accounting considerations 1. Determining the percentage of completion Input method: base POC on completion efforts for a contract Output method: base POC on pre-established milestones 2. Determining revenues and costs to be recognized Apply POC to total estimated costs Apply POC to total estimated gross profit 33

34 Determination of the POC Cost-to-cost Method Costs incurred to date are compared to the estimated total costs to be incurred = Costs incurred to date. ESTIMATED total costs to be incurred Do not perform calculation until ALL costs have been accrued Overhead costs have been allocated Construction period interest has been capitalized Estimated costs must be complete and accurate Disregard uninstalled materials (tax difference) Unless specifically produced, fabricated or constructed for a project 34

35 Determining Revenues/Costs Recognition Use the POC to recognize revenue, costs and profits Alternative A apply the POC to total estimated contract revenue and total estimated contract costs Alternative B Apply the POC to total estimated Gross Profit from the contract Produce the same Gross Profit however may produce different revenues and costs Dependent on what was used to determine the POC 35

36 Determining Revenues/Costs Recognition Assume that costs of $120,000 have been incurred on a fixed-price contract for $200,000 expected to yield gross profit of $40,000. Total estimated contract costs are $160,000. Using the cost-to-cost approach, the percentage of completion is 75% (or $120,000 $160,000). Revenue and cost to be recognized under the two methods would be as follows: 36

37 Determining Revenues/Costs Recognition Alternative A Revenues (75% of the $200,000 total contract revenues) $ 150,000 Costs (75% of the $160,000 total contract costs) (120,000) Gross profit $ 30,000 Alternative B Gross profit (75% of the $40,000 total contract gross profit) $ 30,000 Costs incurred 120,000 Revenues $ 150,000 37

38 Determining Revenues/Costs Recognition Different answers would be obtained if other methods were used to compute the POC. Assume the percentage of completion is 60% based on direct labor hours: Alternative A Revenues (60% of the $200,000 total contract revenues) $ 120,000 Costs (60% of the $160,000 total contract costs) (96,000) Gross profit $ 24,000 Alternative B Gross profit (60% of the $40,000 total contract gross profit) $ 24,000 Costs incurred 120,000 Revenues $ 144,000 38

39 Completed Contract Method 2 Key items: 1. Determining point of substantial completion Remaining costs/risks are insignificant Be consistent in criteria for determining this Disclose criteria 2. Capitalization of general and administrative expenses to contracts MAY be allowed Must provide a better matching of the costs and revenues Will be rare 39

40 Review of Contract Estimates Comparison of prior year and current year POC Job Profit Margin Analysis by contract type, category, regions, market, etc. Gain/Fade Analysis Over/under billed report 40

41 Common Problems Accumulation of Contract Costs Revenue Recognition Loss Contracts Unused Materials Retentions Investment in Joint Ventures/Partnerships Deferred Taxes 41

42 Revenue Recognition: The Future ASU No Revenue from Contract with Customers Establishes a single principles-based process 5 Step Approach 1. Identify the contract with the customer. 2. Identify the separate performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the separate performance obligations. 5. Recognize revenue when (or as) the entity satisfies each performance obligation. Effective calendar year

43 Industry Benchmarks Liquidity Profitability Sales Borrowing Assets Industry specific performance ratios 43

44 Liquidity Company s ability to meet obligations as they come due Operating cash flow Current ratio Quick ratio Accounts Receivable Days Accounts Payable Days 44

45 Profitability Measure of whether trends in profit are favorable for the company Profits Gross profit margin Net Profit Margin 45

46 Sales Measure of how sales are growing and whether sales are satisfactory for the Company Selected Resource Indicators (Growth Rate %) Sales Adjusted Net Profit before Taxes Borrowing Gross Fixed Assets 46

47 Borrowing & Assets Borrowing: Measure of how responsibly the Company is borrowing and managing debt Interest Coverage Ratio Debt-to-Equity Ratio Debt Leverage Ratio Assets: Measure of how effectively the Company is utilizing its gross fixed assets Return on Equity Return on Assets 47

48 Key Performance Indicators Billings in excess (overbillings) of Costs to Total Assets Costs and earnings in excess of Billings (underbillings) to Total Assets Months in Backlog Direct Materials to Sales Direct Labor Ratio Subcontractor expense to Sales 48

49 Other items to consider What information are you giving your bank and bonding agent? Accurate interim financial information Review of industry benchmarks Direct correlation with economic downturns and surety industry losses Ability to explain fluctuations Be proactive! What are you using internally to evaluate your contracts and contract progressions? 49

50 Contract Approaches Traditional Bid Method Construction Management Approach Design-build Method **Key to success is a properly drafted contract regardless of which method is selected** 50

51 Traditional Bid Method Architect/Engineer designs project Competitive lump-sum bids for the General Contractor Lowest bidder wins 51

52 Risks related to Traditional Method Expectation to meet the proposed price Cost vs. Competition Include recovery of costs AND profit in each bid Develop a thorough understanding of the plans and specifications for each contract Know your competitors Utilize your accountant and their experience 52

53 Construction Management Approach Beneficial when timing of project completion is important Utilizes a Construction Manager Good for larger more complex projects 53

54 Risks & Rewards related to Construction Management Approach Risks Cost overruns Unmet deadlines Lack of price protection Rewards Fast-track approach 54

55 Design-build Method Description & Pros Single contract for design and construction services Joint venture opportunities Useful for large construction projects Promotes efficiency, innovation and quality Decrease in litigation Cons Burden of costs and risks transferred to the design-build team Public concern over lack of competitive bidding process 55

56 Joint Ventures & Risk Management Combine resources with 1 or more contractor(s) Bid on more complex projects Move into new geographic area Job specific or permanent Advantages Financing Distribution of risk Disadvantages Loss of control More complex accounting requirements Consolidation Method (>50% control) Equity method (between 20% and 50% control) Cost method (< 20% control) Variable interest entities (contractor is primary beneficiary) 56

57 Construction-Related Associations American Institute of Architects (800) Associated General Contractors of America (800) Building Owners and Managers Association Int'l (202) Construction Industry CPAs/Consultants Association (480) Society of Industrial and Office Realtors (202) Associated Builders and Contractors, Inc. (202) Construction Financial Management Association (609) Design-Build Institute of America (866)

58 Questions 58

59 Thank you for joining us! Additional Information: «Melbourne Office «Orlando Office Laura Anne Pray, CPA Phillip Hayes