I have been wrong in my criticism of contractors for ignoring financial statements in the day-to-day running of their businesses. Their instincts, as it turns out, have served them well. They saw something flawed in relying on interim financial statements that were only estimates that could be, and were, manipulated. Contractors knew how the story would end because they wrote the book. That’s why they didn’t trust their own financial statements to serve as reliable management tools.
Look in the Mirror
Imagine trying to determine your company’s actual cash position and immediate cash needs by using estimated financial statements rather than hard financial data. If the amount of job completion was overestimated at any stage to front load invoicing and improve early cash flow an exact matching of expenses would be impossible, and interim profits would invariably be overstated. These “estimated profits” would, of course, lead to an artificially inflated calculation of the company’s capital position on the resulting balance sheet.
So, any contractor relying on their own financial statements to manage day-to-day operations might well be unable to monitor their actual cash position and suddenly find themself short of available cash.
A Highly Complex Business Transaction
The construction industry is permitted to use estimates rather than hard data to produce financial statements. This anomaly in generally accepted accounting principles is brought about by the very nature and complexity of the construction financial transaction.
- Contracting for a fixed price that will be paid to the contractor in partial payments as the project progresses makes it almost impossible to match the portion of the final price to the exact portion of the expenses used to get the project to the stage in question.
- Calculating the exact amount of expenses (materials and labor) that it took to get a project to an arbitrary stage of completion is virtually impossible. This number can only be arrived at through an educated estimate.
- Exact matching of the estimated expenses to the estimated completion percentage to arrive at an accurate earned income amount is therefore impossible.
People Who Live in Glass Houses
The entire process of construction accounting and auditors’ creation of certified financial statements depends heavily on the correctness of four inputs: the contract price, the direct costs to date, the estimated cost to complete the remaining work, and the amount billed to date. These inputs significantly affect the precision and accuracy of financial statements.
- Contract Price
The contract price is the total value of the contract at the end of the accounting period in question. This value includes the original contract amount and any signed change orders to date. But what about unsigned change orders, change orders in progress, and pending change orders? Whether they are calculated into the total price is often determined by the person preparing the ledger, so different accountants can often arrive at different contract prices.
- Direct Costs to Date
The direct-costs-to-date entry includes the costs recorded to date in the contractor’s accounting system. These costs include payroll and payroll-associated costs, vendor and subcontractor invoices that have been received and approved, and miscellaneous costs and expenses charged to the project. The amount input in this entry will be inaccurate if invoices have not yet been received, or invoices have not yet been approved and recorded, or are in dispute. Unfortunately, this often happens.
- Estimated Cost to Complete
The estimated cost to complete the remaining work is a critical input and one of the most challenging estimates to calculate in construction accounting. The percentage of work completed cannot be determined exactly but must be estimated, and so must the cost of completing the work. The amount is often calculated using the following formula: original estimated total cost minus (-) cost to date equals (=) cost to complete. This is an estimate, not an actual figure.
- Amount Billed to Date
The amount billed to date is the total amount the contractor has invoiced its clients for the work that has been put in place. A weakness in this amount is that much of the work in place, although invoiced, may not have been accepted by the designer or paid for by the owner. This entry can be audited mathematically, but it is challenging to confirm the exact value until payment is received and recorded.
Shouldn’t Throw Stones
Estimates of estimates. I am not prepared to admit that interim construction financial statements in their current format are virtually useless as day-to-day management information documents. My apologies to all the contractors I might have criticized over the years for not utilizing their financial statements more effectively.
For more information on Generally Accepted Accounting Principles, read more at: GAAP
For a broader view of construction accounting, read more at: ACCOUNTING
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