Construction Accounting Risk at Macro and Project Levels
By Nate Budde, Construction Executive
Payment Challenges and Failure Rates in Construction Industry Are High
Historically, construction industry participants have had a remarkably challenging time getting paid, getting paid on time and even staying in business. Since the vast majority of construction materials and labor is furnished to a job on credit, and the number of project participants can be large (resulting in a very complex and interconnected payment chain), any slight hiccup in payment anywhere on the project has compounding ripple effects. These ripple effects can be enough to sink construction companies operating on razor-thin margins.
Most companies both extend credit and need a line of credit of their own. In many situations, payment of their own bills must wait until payment is received from those higher in the contracting chain. Everyone on the project has to wait for money to make it down from the parties above. The further down-the-chain a project participant is, the more opportunities there are to experience hiccups or abuses in the payment process. And, because of the interconnectedness of the payment chain mentioned above, any little inconvenience, delay or dispute about any component of the work can impact payment for everyone on the project, whether or not that party was directly involved.
It’s no wonder that the construction industry is extremely volatile, and subject to astronomical failure rates – higher than nearly every other business sector. Even successful construction industry companies are restricted by cash-flow concerns and thin margins – which are compounded by the exceptionally long time to payment.
Besides the structural framework of construction payment, there are other practical concerns. Payment abuses, or the manipulation of leverage and legal positioning also routinely cause frustration and directly lead to less working capital.
PROTECTION IS AVAILABLE TO CONSTRUCTION INDUSTRY PARTICIPANTS
Because of the obstacles to payment on construction jobs, statutory security devices were developed to essentially guarantee payment (given proper use and application). These statutory security devices, mechanics liens and bond claims are available to construction participants and allow the improved property itself to be used as collateral for payment. The laws are complex, strict and occasionally demanding, but the protection to virtually guarantee payment is available.
With the availability of this extremely powerful payment protection, it seems like payment problems in construction should be nearly non-existent, or at the very least, the burden of bearing the financial risks associated with construction projects should be placed on the parties at the top of the payment chain. Clearly, however, this is not the case. This lack of general and proper application of the security provided by these tools makes construction accounting more difficult, since the payment risk becomes amplified.
BENEFITS OF SECURITY INSTRUMENT USE IN CONSTRUCTION ACCOUNTING
There are numerous positive effects security rights can have on A/R, cash on hand, bad debt to write-off and even company value. Accordingly, the accounting department of any construction company should be aware of mechanics lien laws’ existence and a proponent for their routine application for protection.
First, the consistent application of security rights results in a much cleaner A/R funnel. Construction companies can be much more sure regarding the ability and amount of outstanding credit accounts that will be collected, as well decreasing their DSO to provide more clear visibility into the financial health of the organization.
Second, to the extent that there remain outstanding uncollected A/R accounts, a debt being secured allows for more certain and accurate reporting of company profits. Generally accepted accounting principles allow companies to calculate outstanding bad debt (and therefore determine A/R worth) using different methods. These required principles are not, however, strictly defined. The constant is that the principles used should be “conservative.” Given that information, and the fact that secured accounts receivables consistently outperform unsecured receivables, it is likely perfectly allowable to segregate secured and unsecured debts, and apply a different allowance to calculate the company’s amount of outstanding bad debt. This would likely result in increasing the accuracy of any accounting report regarding A/R.
PROJECT-SPECIFIC ACCOUNTING IN CONSTRUCTION AND ASSOCIATED TEMPTATIONS
There is often an enormous number of documents exchanged and required on a construction project, and some of these documents are specifically accounting-centric. While it’s easy to get lost in the big picture of construction accounting (given the huge need to accurately project the money-in vs. the money-out relative to the business’s health as a whole), the payment-to-payment and project-specific day-to-day accounting cannot be forgotten or left to languish.
In order to get paid at all, construction participants must provide an accurate accounting of the progress of a project compared to plan, and an accurate breakdown of the justification for the payment requested. This is generally done through a pay application (or draw) and an associated schedule of values.
A schedule of values is a start-to-finish list of work items on a project (broken down into their component parts and with corresponding values) that, in total, represent the entire project from beginning to end and the entire contract price. According to the standard AIA documents, “The schedule of values shall allocate the entire contract sum among the various portions of the work.”
A schedule of values (SOV) is used as management tool in monthly pay app processing and provides a means to evaluating a project’s completion percentage related to the original plan. Since cash flow is determined by the SOV, it can be of crucial importance to contractors in making sure the cash-flow keeps moving and their bills get paid.
Because the cash-flow on a project can be determined in part by the SOV (payments are made according to the values and timetables set forth by the schedule, upon completion) there can be a temptation for contractors to “front-load” the SOV so that the majority of the payments come in at the start of the project and they get the cash quick. Contractors may attempt to front load the SOV by artificially increasing the values of the early project activities and devaluing the work at the end. This is called overbilling, and while this may be tempting – who wouldn’t want to get more of the money earlier? – it is a bad idea, and one that should be avoided in construction accounting.
One practical reason to avoid overbilling is that the owner and architect must sign off on the SOV and will be looking to avoid this exact behavior. Being caught attempting to fudge the numbers for the company’s benefit is never looked upon with favor. That is far from the only reason to avoid front-loading the SOV, however. Doing so can create other significant problems down the line. If a payment issue arises on the project, justifications can be tricky when the values on the SOV do not mesh with the payments made down the chain. This is especially true since most SOVs require that only a certain amount is allowable for contractor profit and overhead.
Additionally, if there is a dispute regarding the a subcontractor’s work (but the contractor has loaded too much into the value of that work in the SOV) it will be difficult to argue that the full amount should be able to be collected by the contractor when some is supposed to go to the sub whose work is disputed.
The moral of the story here is that construction accounting is difficult on both a week-to-week project basis, and a company-wide business reporting level, but proper application of best practices can smooth out the processes, clear up payment and make sure that a company is in the best possible position to be paid fairly, and understand an accurate picture of the company’s financial health.