2020 Solution #1
Promote Your CFO
To a Trusted Member of Your Management Team
2019 Risk # 1 – Catastrophic Collapse
Unexpected Catastrophic Failure of Contracting Firms Both Large and Small
As we discussed in 2019, construction contracting is the second riskiest industry in the U.S. surpassed only by restaurants. However, construction contracting is perhaps the only industry that experiences unexpected, sudden, catastrophic failure of legacy firms both large and small. As an illustration, remember this story we covered in 2019:
Britain’s oldest building firm R Durtnell and Sons has collapsed, putting more than 100 jobs at risk. The Kent-based firm was founded in 1591 and specialised in heritage restoration work. At the time of its collapse it was working on a £22m project to refurbish parts of the Royal Pavillion Estate, according to the BBC. The company, which has been run by 13 generations of the same family, started building in the time of Elizabeth I when it constructed timber framed houses. The business built Poundsbridge Manor in Kent in 1593. (BBC, August, 2019)
After studying this catastrophic phenomenon for more than 40 years, here’s what I have observed:
- I’ve seen overhead costs reported and accepted that were 50% of the previous month’s, and no one even sensed that there must be an error.
- I’ve watched sales reported improperly, and no one even realized that no billing went out on one of the largest projects that month.
- I’ve had contractors tell me that, as their business gets larger, they can no longer pay attention to the numbers each month.
A Case Study
I was hired by a surety to complete the unfinished projects of a contractor who had suddenly collapsed after building his company to $70 million in revenues in less than nine years. A study of the company’s history revealed the following:
- In order to grow that rapidly, year after year the company took on more and larger projects which were of course booked as “in progress” at the end of each year. (using the percent of completion accounting method)
- While these projects were “in progress,” on each year-end financial statement most, if not all, showed substantial profits for that year which also resulted in substantial cumulative net worth.
- The percent of completion method used to book jobs in progress at year ends ignored the fact that many earlier jobs, when finally completed, lost money.
- Those losses, however, were bundled with the more substantial (percentof completion) profits of the multiple new jobs that had not been subjected to final accounting.
- In other words, the fact that many of the jobs actually lost money was hidden by the constant accumulation of new projects’ profits (percent of completion accounting)that obscured their ultimate losses until the projects were completed the following year.
- Finally, the cash ran out and an analysis revealed that over the previous five tears years, 65% of all projects lost money. It became obvious that the losses were obscured by the (percentage-of-completion) estimated profits of an always greater amount of work in progress. During this time the ongoing jobs were shown to be earning their originally estimated profits, but many would eventually be reported at a loss. The contractor didn’t do anything about his losing projects because he didn’t know what had occurred until they were finished.
2020 Solution #1
Promote Your CFO to a Trusted Member of Your Management Team
I have been observing this risk and offering this solution for almost 30 years. With the astounding failure of R. Durtnell and Sons fresh in our minds, now is the time for the industry to take action to mitigate these completely avoidable disasters.
The basic problem most contractors have with evaluating contract profitability is that they leave the accounting to the bookkeepers and accountants. That’s not to say that bookkeepers and accountants can’t do accounting work but rather that too many contractors avoid accounting like the plague. They don’t like it. They don’t do it…
If we are going to account for all the money that passes through our hands (if only to know how much we get to keep), we need to participate directly in the selection and use of our accounting and bookkeeping systems. They must make sense to us and fill our needs as a tool to run the business. They must be accurate, and we must make sure they are accurate. (Construction Contractors Survival Guide, Thomas C. Schleifer, Wiley, 1990, p.93,94)
Step by Step Solution
Step 1.Personally, select a CFO you will trust for his accounting knowledge and personal integrity. Do not evaluate him or her on how much they know about construction because it tends to cause many CEOs to ignore their CFOs over the years. The excuse being, “They don’t know construction” or “They don’t understand what’s going on in the field. Respect and trust your CFO because he or she can provide you with accurate numbers that that you need to run the business and listen to what they say the numbers mean.
Step 2.Work with him or her at least monthly to measure financial data that coincides with your professional instincts and don’t rest until you both agree. In other words, make sure the numbers make sense and understand that your CFO in probably right most of the time. They have an unbiased perspective
Step 3.Utilize the numbers as active management tools for making decisions not just report cards that are “too little/too late”.
Step 4.Understand that percent of completionaccounting methodology is good enough for statements but must make sense to you to be good enough to use in managing your business. Your CFO can help you with that if you trust him or her.
Step 5. Remember that the key to success is getting financial information on time so work with your CFO to design and execute accounting procedures that deliver accurate information on a minimum of monthly basis. Do not settle for anything less.
Step 6. Assemble a board of directors or advisers who will be responsible to all stakeholders for timely, accurate financial information. Function as if you were a public company even if you are not. Read More (link this with the board of director article in the manual.)
At first you may find the suggestions above somewhat self-evident. But take a second look at your own beliefs and conduct before it’s too late. Catastrophic collapse is always sudden and unexpected because construction accounting has been obscuring the truth rather than revealing it. Only self-aware and well-informed CEOs can change that, but not without a trusted CFO.