HOW TO GAIN REPORTING ACCURACY IN THE WORK IN PROCESS SCHEDULE

Transcription

1 HOW TO GAIN REPORTING ACCURACY IN THE WORK IN PROCESS The process needed to arrive at the Over/Under Billing adjustment is difficult to estimate at best, but project review meetings add value to this vital entry on contractors' financial statements. BILLY G. STOCKTON, JR, CCIFP tion projects is the lifeblood of a company's financial statements. But analyzing those financial Financial statements reporting involves ofmuch construc more than meets the eye. The process of arriving at the Over/Under Billing adjustment takes input from different staff members. Formal project review meetings can help gain a more accurate assessment of each month's Work in Process Schedule. The Over/Under Billing adjustment to sales is arguably the most important entry made to a contractor's financial statements. This entry is derived from analyzing many aspects of the projects on the contractor's Work in Process Schedule. Some of these aspects involve estimated project financial figures. As with all forecasts, they are in a gray area and vary over time. These forecasts vary in accuracy and are used until the project is completed and all the numbers are finalized. Each construction project is unique, and starts as a concept. This concept becomes concrete and steel and a finished, tangible product. Until that time, we must use estimates. The use of these forecasts or "guesstimates" is required by GAAP for most contractors in preparing their financial statements. Where they are required, these estimates must be accurate and be backed by solid reasoning. After all, the contractor's banks, sureties, and other institutions rely on this information. One reliable procedure to configure the Work in Process Schedule is the use of a project review process. The project review process Once a month each contractor's Work in Process Schedule is reviewed on a job-byjob basis. These projects fall into one of two categories: those that carry an Over/Under Billing and those that do not. The jobs that have Over/Under Billings are projects that are not financially complete. They either have cost left to incur, unbilled Contract Amount, or both. Those jobs that do not possess an Over/Under Billing are BILLY G. STOCKTON, JR., CCfFP is a consultant with Shaker Computer and Management Services, fne. in Latham, New York, a software and col/sulting provider to the construction industry. He speaks at industry conferences and serves on various association comtnittees. Mr. Stockton is a member of the Construction Financial Management Association and the Association of Certified Frnud Examiners. He may be reached at billys@shakercom.com. SEPTEMBER/OCTOBER2007 CONSTRUCTION ACCOUNTING AND TAXATION 31

2 SECTOR HAS SOME DIFFERENT OR UNIQUE ASPECTS. SO A TOPIC LIST WILL DIFFER FROM COMPANY TO COMPANY. 32 either financially and operationally complete, are under contract but have not started yet, or have an amount equal to their earned revenue. The Over/Under Billing calculation is earned revenue less Total Billing. Earned Revenue is the Cost Percent Complete of the job times the Contract Amount. The most common calculation for Cost Percent Complete is calculated as the Total Incurred Cost divided by the Estimated Cost at Completion. These are typical, mechanical accounting processes. Booking the total Over/Under Billing Adjustment for the company is a debit for all under billings as an asset, a credit for all over billings as a liability and the net of those figures as a debit or credit to sales. Here lies the trap. Arriving at the Over/Under Billing for any given job involves what we will call the Four Components previously mentioned: Total Incurred Cost, Total Billing, Contract Amount, and Estimated Cost at Completion. The first two are simple totals (incurred cost and billings). These are hard numbers with proper documentation. The last two (Contract Amount and Estimated Cost at Completion) can be subjective figures, prone to error or mismanagement. This is especially true for the Estimated Cost at Completion, in which we will go into greater detail later on. These two subjective figures can have a huge impact on the financial statements in any given period. If a Contract Amount is overstated or the Estimated Cost At Completion is understated, then Over Billing can be too low or Under Billing too high. These estimated figures always reconcile to actual cost and actual billings at the end of the project. Unfortunately, the prior periods could be materially misstated if the figures for the Contract Amount or Estimated Cost at Completion are incorrect along the way. Arriving at the Four Components involves two very different methods. The Total Incurred Cost and Total Billings come directly from the accounting software. These numbers reconcile to the Cost of Sales and Revenue accounts in the general ledger and are taken as is. After all, it is the system's job to calculate and compile these figures. The Contract Amount and the Estimated Cost at CONSTRUCTION ACCOUNTING AND TAXATION SEPTEMBER/OCTOBER 2007 Completion take analysis and experience to arrive at an accurate estimate. There are many things to take into consideration during the Project Review Meeting to arrive at these two figures. It can be difficult to arrive at the Contract Amount and the Estimated Cost at Completion due to their very nature. These details will be discussed in the Suggested Topics section of this article. Project review meetings Each month the Project Manager, the Supervisor, and the Financial Person conduct the Project Review Meeting in preparation for the month-end financial closing. This meeting typically takes one hour per Project Manager. Most project management staffs can complete these meetings in a single day. The Project Manager should have a draft of the Project Review Form for each of his projects completed. The Supervisor and Financial Person should have copies as well. Access to the accounting system is important to address gray areas during the meeting. The suggested topics developed below indicate the parts of each project that should be addressed. Each industry sector has some different or unique aspects, so a topic list will differ from company to company. The Project Manager, his Supervisor and the person responsible for the Work in Process Schedule are the three people that should be at every Proj ect Review Meeting. At that meeting the project review form must be addressed and its elements analyzed. Attendees. Project Managers should be involved in a financial review of each of their projects every month. These Project Review Meetings are a best practice and should involve the Project Manager, his Supervisor, and the Financial Person responsible for the Work in Process Schedule. These three people bring different, but necessary points of view to the meeting. Other people can be present, but at least these three are required each month. The Project Manager knows the job better than anyone else. He is involved with the project on a day-to-day basis and is directly responsible for it. The Project Manager's Supervisor is there for two main reasons. He is responsible for the work of every Pro- SCHEOULE

3 ject Manager under him, so this is a perfect time to go through each project. The Supervisor can also identify issues brought forth in the meeting and make any required operational and financial decisions. Both of these people fully understand the operational side of the project and probably most of the project accounting. The Financial Person is there to "translate" from operations to accounting. He understands the dynamic of what is happening on the project from an administrative and accounting perspective and how that will impact the general ledger. Getting these three people together for the project review meetings forms a consensus on how that job is reported financially on the general ledger via the Work in Process Schedule. All three of these people have differing roles with varying degrees of operational and financial experience. We have to remember that accountants are not project managers and project managers are not accountants! Project Review Form. Every project that is on the Work in Process Schedule should be analyzed by that Project Manager. This review includes both operational and financial aspects. This analysis is synthesized in a Project Review Form. At a minimum this form should contain the job name, the job number in the accounting system, the month and year of the project review meeting, the amounts of the Four Components with some breakdown of what comprises those figures, and a gross margin calculation. The job name and the job number are selfexplanatory, and should be prominent on the form. The Four Components should appear so that the Financial Person can easily identify them and enter those numbers into the Work in Process Schedule. It is a best practice to use the construction accounting system to generate the Work in Process Schedule. When doing this, the form is used to enter the figures into the construction accounting software. There are other items that companies may desire on the Project Review Form. These items can include committed cost, detailed breakdowns of Contract Amount and costs (both incurred and Estimated Cost at Completion), change orders of differing statuses, original and revised bud- gets, previous month's figures, and comments or remarks. Preparation Each attendee at the Project Review Meeting has his own particular tasks that must be completed before the meeting. Project Manager. Every Project Manager should analyze and review each job prior to his Project Review Meeting. This includes looking at several operational and financial reports and documents. Although one size does not fit all, there are typical items that are used. The Change Estimate (CE) log is a list of all potential changes to the proj ect. These CEs are numbered and a good percentage of these potential changes become change orders. This log contains all approved and pending change orders. These figures are used with the original contract value to arrive at the Contract Amount component. A Billings History Report will give the Project Manager the breakdown and a total of all the billings on the project. The total amount is the Total Billing component. The Project Manager also looks at his job cost report for the project. This report from the construction accounting system is a detailed Work Breakdown Structure (WBS) for the project. Each cost object or cost code on the job cost report should contain the budget for that item, Incurred Cost, Committed Cost (outstanding pur- THE 2007 I 2008 BUILDING BLOCKS TO CONSTRUCTION WEALTH A 2-day Construction Accounting & Job Costing Training Forum Specific to your Regional Conditions Presenting Construction Expert Speakers including Certified Public Accountants. Multiple Break-Out Sessions. Forum Discussions. Participate with Q&A, Applied Training, Networking and MORE! Locations: Sacramento, Los Angeles, Seattle, Las Vegas, Dallas, Chicago, Orlando, Manhattan EVERY PROJECT MANAGER SHOULD ANALYZE AND REVIEW EACH JOB PRIOR TO HIS PROJECT REVIEW MEETING. SEPTEMBER/OCTOBER 2007 CONSTRUCTION ACCOUNTING ANDTAXATION 33

4 34 chase orders and subcontracts), the Estimated Cost at Completion and associated cost savings or overrun. When the Project Manager analyzes the items on the report, he will be able to make projections by cost object or cost code. Taking the total of all the items will give the total Estimated Cost at Completion Component for the project. Other items to review can include material status logs, a revised project schedule, manpower reports, Labor Trend Reports, etc. Large, critical projects often require several hours of preparation before the actual project review meeting. For example, a $50M job with 400,000 labor hours and zero subcontracts will probably require the help of project engineers and the project accountant to sort through the large volume of data prior to the meeting. Supervisor. The Supervisor also should come prepared for the project review meeting with any questions or items to review. An Aged Receivables Report for a given Project Manager is frequently used during these meeting to address any unpaid accounts receivable invoices. An accounts receivable Retainage Report should also be reviewed to determine if it is appropriate to bill and receive any retained funds. These reports are very important in determining the timing of lien rights (lien laws vary from state to state). The Supervisor should use these reports in conjunction with other information to make sure that lien rights are addressed. The Supervisor should also be aware of any pertinent contract conditions that should be addressed during the meeting. Financial Person. All through the course of the month the Financial Person is looking at project-related accounting as part of his/her normal duties. He is most familiar with the financial details that affect both Job Status and the General Ledger of the construction accounting system, and the interaction between the two modules. Prior to any given project review meeting, the Financial Person should run a draft of the Work in Process Schedule with current Incurred Cost and Total Billings. Accounting tests should be conducted to identify any jobs that are potentially under CONSTRUCTION ACCOUNTING ANOTAXATION SEPTEMBER/OCTOBER 2007 billed, have costs that exceed the budget, have billings that exceed the contract value, etc. The jobs that exhibit warning signs need to have questions asked during the project review meeting. Suggested topics Topics in a range of subject areas must be addressed at the Project Review Meeting. Financial. Many topics in the financial area must be addressed. Total cost. Although this item comes directly out of the Accounting System, the breakdown of the cost is important to determine how much risk remains in the project. For example: If you are 50% cost complete but that was most of your subcontracted work, significant risk can remain. If the remaining 50% is subcontracted work, then the profitability risk is decreased. Total billings. This is another of the four components that is taken directly from the accounting system. Total Billings should almost always be less than or equal to the Contract Amount. Anticipated backcharges or future credit change orders are examples of when this may not be true. Every company strives to make sure that Total Billings are greater than or equal to earned revenue on the project. This helps create better cash flow on the project. If this is not the case, it needs to be investigated. Contract amount. This is typically comprised of the original contract amount and approved change orders. Depending on the treatment of unapproved change orders this will vary. There are two critical things to look for with this item. One is to make sure that a cost budget exists for each change order included in the Contract Amount. Without a corresponding budget, the project would show an artificially high gross margin. The other is to address any change order cost that is incurred, and make any appropriate changes to the Contract Amount and/or Estimated Cost at Completion. Not addressing this type of incurred cost makes the gross margin inappropriately too low. Inclusion of unapproved change orders should be scrutinized very closely. This impacts the project's earned revenue, and can be an object of mismanagement. There are situations when including unapproved change orders in the Contract Amount is

5 appropriate, but they need to be looked at closely. Estimated cost at completion. This is the Project Manager's estimate of job costs at completion at a particular moment in time. It is based on the Project Manager's forecast based on committed costs, production, productivity, and the Project Manager's general sense of the job. The forecast is the Project Manager's best guess at where the final cost will end up for the project on a cost code by cost code basis. This is the most critical item in the project review meeting. It is also the component that causes contractors the most problems in creating an accurate Work in Process Schedule. If a Project Manager is too aggressive in forecasting cost savings early in the job, the gross margin will be overstated early in the project. This causes the project to "lose money" at the end of the job as the Total Cost eclipses the Estimated Cost at Completion. As this happens, the job loses gross margin dollar for dollar with the additional incurred cost. On the other side of the coin, a Project Manager may not show cost savings on the job. He may want to keep this additional gross margin hidden in case other cost codes have unforeseen overruns. This is called "sandbagging" or keeping a "reserve." Although this may help the Project Manager look better during and at the end of a job, it hurts the company's financial reporting and planning. An accurate Estimated Cost at Completion is best for all involved. Committed cost. This incorporates the Total Cost as well as any outstanding purchase orders and subcontracts. All these costs are committed: If you have incurred the cost or created financial obligations in purchase orders or subcontracts, you know that money will be part of the Total Cost of the job. This is a big help in arriving at the Estimated Cost at Completion. Over/Under Billing. The Over/Under Billing for a job shows when a project has billed more or less than its earned revenue. When a job is under billed it means that the customer has been invoiced less than what the contractor believes he has earned on the job. This can be an indication that the Estimated Cost at Completion is too low, there are operational issues on the job, or the Project Manager has not invoiced the cus- tomer enough. Either way it is an issue. An under billing is a warning sign in most circumstances, but not all. Over billing. Although all contractors strive to be over billed on projects, the presence of an over billing does not prove that a project is healthy. Characteristics of under billings above may exist and the job is in an over billed position. What this means is that the Project Manager was still able to bill over the earned revenue, but the earned revenue may be too low. Reserve for loss. When a job is projected to show a net loss, the entire net loss is required by GAAP to be realized in the period that it was first projected. Every job with a Reserve for Loss should be analyzed very closely. This is especially true for those jobs with a low percentage of completion. This gives the Project Manager the opportunity to address problem areas and possibly reduce the anticipated net loss. Aged receivables. Any overdue invoices should be addressed. If any of these invoices are deemed to be a collection problem, the Financial Person is there to determine if a reduction in project billing or an allowance should be created in the general ledger. Retainage. The outstanding Retainage should be analyzed. This is to see if it is appropriate to bill for any retention and to address the timing of collectability. Warranty reserves. Most contracts have a 12-to-1S-month warranty on workmanship and materials. A warranty reserve for each project needs to be present on either the Work in Process Schedule or on the General Ledger. Lack of any reserves would cause a dollar for dollar direct margin loss for the company for each warranty call back. Allowances and contingencies. Many contracts contain allowance and contingency amounts for unforeseen, unspecified, or for certain scope of work that may or may not be known at the time of the contract signing. These amounts are usually material in nature and must be addressed in the project review meeting. Financial reporting problems arise when the Allowance and Contingency Contract Amount is there, but a Budget does not exist for the job. It is also important to know when an allowance and contingency will not be used, so the Contract Amount THE FORECAST IS THE COMPONENT THAT CAUSES CONTRACTORS THE MOST PROBLEMS IN CREATING AN ACCURATE. SEPTEMBER/OCTOBER 2007 CONSTRUCTION ACCOUNTING AND TAXATION 35

6 and Estimated Cost at Completion can be adjusted accordingly. Operational. Not all discussion in the project review meeting is strictly related to financial topics. There are several operational issues that should be addressed that can impact project accounting and the company's financial statements: Labor/Manpower: A labor shortage or potential stoppage of work can increase labor costs or possibly delay completion of the contract. Schedule: Were the schedule to slip past the contract completion date there can be increased general condition costs, the need to pay overtime, cost escalation, or liquidated damages. Lien rights: If the customer is overdue for payment, lien rights need to be addressed. This is typically not an avenue that anyone wants to use, but it is a tool at the company's disposal. Backcharges (Customers/Subcontractors/Suppliers): Customers can backcharge contractors and contractors can backcharge subcontractors and suppliers for work done on behalf of the other. There are many different ways to handle backcharges, but in doing so it is important not to distort job costs and/or revenues. If backcharges are assessed, the Project Manager must be aware of them and handle them on a timely basis. Liquidated Damages: Some time-sensitive contracts contain financial assessments called Liquidated Damages (sometimes called LD's). LD's are a form of penalty for each day that a contractor finishes the contract beyond the contract completion date. LD's can go as high as six figures. It is critical that the company know the projected completion date of these types of contract and the potential exposure to LD's. Equitable Adjustments/Claims: Sometimes projects do not perform as planned, and companies need to submit an Equitable Adjustment or Claim for additional funds. There is specific accounting treatment for these situations per GAAP. These should be few and far between for most companies, and they are hot button items that get constant attention. Some claims do not go all the way to the judicial system, and are settled through mediation or arbitration. Litigation is usually a last resort. The effects of the operational items can be on the project financials or be on the generalledger, depending on where the company feels they are most appropriate. An example is potential warranty cost. It can increase the Estimated Cost at Completion on the project or a reserve can be set up in a liability account. All of these items seem to provide a very daunting and cumbersome list to review for each project, every month. This is not the case at all. In reality, the projects that are reviewed are easier to recall in each subsequent project review meeting. Once up and running full steam, one Project Manager's slate of jobs should take about one hour per month. The use of project review meetings to analyze the financial status of each project on a company's Work in Process Schedule is a best practice. It allows for employees with different responsibilities and experiences to review and provide input to how these projects are financially reported. This analysis makes for more accurate reporting on the Work in Process Schedule and financial statements, and helps the people that depend on them. 36 CONSTRUCTION ACCOUNTING AND TAXATION SEPTEMBER/OCTOBER 2007