In a study of thousands of construction company audited financial statements testing the profit projected on work in progress (WIP) reports over five years to the final reports of completed project profits, I found the average difference to be a little over 1% profit bleed. This suggests that industry-wide reported annual profits in any given year were likely overstated by more than a percent, which is huge when you consider that construction industry profits are low to begin with.
This “profit differential (bleed)” is one of the main causes of the frequent, sudden, catastrophic failure of construction concerns large and small, old, and new. The exaggeration of WIP profits is unfortunately too common and, for the most part, caused by misplaced optimism, unaware management, and, in rare cases, deliberate deception. I probably don’t have to tell you that it is almost impossible for outside auditors to test WIP because they are not construction estimators, and by the time they are conducting an audit, the projects are two or three months, further along, making it just about impossible to verify the claimed percentage complete in prior months. To rectify this exposure, the responsibility for accurate timely WIP reporting should be assigned to the CFO who can then organize the reporting process to prevent the overstatement of WIP reporting which can, and often does, lead to fatal self-deception.
An Accurate Guide Not a Comfortable Cushion
The Work in Progress reports determine whether we are over-billed or under-billed on the jobs underway. This is an important piece of information that, if inaccurate, can make bank accounts looks good when most of the jobs are halfway to completion only to have profitability falls apart when several of the jobs simultaneously near completion. This can also explain why some projects run out of money before they get to the punch list. Not knowing where we stand on costs during progress creates cash flow problems that research shows often prove fatal.
Accounting for WIP
Accurate construction accounting depends on the correct calculation of over/under billings. On the balance sheet, over-billing is a short-term liability and under-billing is a short-term asset and if they are wrong the information is misleading.
There are three primary contributors to contractors being caught off guard by cost overruns.
- Failure to monitor field progress accurately
- Misunderstanding up-front billing
- Failure to accurately account for WIP
Monitoring Field Progress
If you base your percent complete solely on the cost of the work completed versus the cost of work left to complete you won’t get an early warning when the job is slipping and in danger of going over budget. The WIP report needs to show you where your costs are likely to end up at the completion of the project long before that future is locked in.
This blog is not intended to be a short course in construction accounting. Rather, I am trying to alert management to the considerable risk incurred when not utilizing their CFO (King of Cash) to manage the accurate monitoring of field progress. The CFO is usually the most qualified and disciplined manager to resist careless or optimistic WIP reporting which is a critical risk control component in keeping construction companies out of trouble.
The primary cause of the sudden, unexpected failure of construction companies is that management is unaware that their company is about to run out of cash and therefore take no corrective action. The Research Question: How could this happen repeatedly in a highly sophisticated legacy industry like construction? The Finding: Because of the highly complex ongoing layered nature of construction work in progress, accounting data can easily move 1% either way toward profit or loss for innocent (or nefarious) reasons. However, there seems to be more inclination to overstate rather than undertake percent complete. Although WIP is considered by some to be a minor or unimportant adjustment, this accounting exposure can prove suddenly fatal to the company as a going concern.
I recommend you take the time to understand the importance of an accurate WIP report and make sure your CFO has the authority to make it happen. Your very survival may depend on it. Next week we will define a fail-safe method to assure accurate WIP reporting
For more info on work in progress accounting, read more at: https://simplarfoundation.org/?s=work+in+progress+accounting
For a broader view on role and duties of a CFP, read more here: https://simplarfoundation.org/?s=cfo
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Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.