The usefulness of financial statements for contractors is heavily dependent on accurate job schedules. Accurate job schedules require the following:
- Up-to-date contract amounts, including change orders
- Reliable estimates of total projected job costs
- Accurate and timely recorded job costs and billings
- Reconciliation of total costs and revenues to the company’s underlying general ledger
The following is a discussion of two basic steps we perform during an annual audit or review that establish the basis for determining the accuracy of a contractor’s financial statements. These steps should also be an ongoing focus of management as a primary control over accurate financial reporting.
Contractors maintain detailed ledgers of job costs and revenues on a job-by-job basis. We determine whether the company’s detail schedule of all job activity reconciles to the respective job revenue and cost accounts in its general ledger. This step is a proof that the population of jobs on the job schedule is a complete representation of all jobs with activity during the fiscal year. This step is also the foundation for the supplemental schedules that support the company’s financial statements. It sounds simple, but often can be complex.
The majority of construction software packages today include transaction entry controls where transactions to the job ledgers can only be entered into specific general ledger job cost accounts, and vice versa. If in place, these controls generally allow for the quick identification of general ledger accounts which should reconcile to the job schedules. However, job schedules typically span more than one year and include cumulative revenues and costs that were closed out in a prior year in the annual general ledger closing process. The job schedules must accurately account for the prior year activity in reconciling to current year general ledger amounts.
Other complications arise when jobs are indicated as completed in one year, but residual lingering activities are recorded in a subsequent year. These items must all be considered in the reconciliation process.
For companies reporting on the percentage of completion method of accounting, balance sheet entries are generated from the jobs in progress schedule for “billings in excess of costs and estimated earnings” and “costs and estimated earnings in excess of billings”. These accounts represent the adjustments to actual job billings to properly recognize revenue under the percentage of completion method of accounting. These adjustments are often very significant. Their accuracy can only be assured if the population of jobs from which they are calculated is known to be complete.
Management should reconcile the job schedules to the general ledger on a monthly basis as a primary control to indicate that all job activities have been properly considered in measuring the company’s financial performance.
Several procedures help us determine the historical reliability of management’s estimates of total job costs. We typically analyze a “lookback” schedule where we compare jobs that were in progress at the end of the prior year to their current status, including contract amounts and profitability. We also re-compute the prior year revenue recognized based on the current year updated information. Ideally, the current year job data is closely aligned with revenues and profit recognized in the prior year based on estimates available at that time.
In the construction world, it is presumed that management can appropriately estimate its job costs and revenues in order to properly use the percentage of completion method of accounting. It is not only likely, but probable that estimates will change. The key is to manage the variability such that changes relate only to events beyond management’s control or changes for which the company has successfully negotiated change orders and adjusted its revenues accordingly.
Adequate contingencies should be maintained where construction activity is less predictable. This requires the constant monitoring of job activities, close coordination between accounting and job management teams and implementation of internal controls over the estimating function at the initiation of the job and throughout its progress. Documenting these monitoring activities and explanations for variances is very important for external audit or review purposes, but it also provides better accountability for management. The benefits include better financial reporting and typically greater job profitability as management can adapt more quickly to needed changes. Benefits can also include a better basis for tax projections throughout the year.
From an audit or review standpoint, the more we can demonstrate through these analyses that management’s estimates are reliable, the less overall work we have to do to determine the fairness of presentation of the financial statements. If the estimates are historically less reliable, we have to perform much more extensive additional work. Thus, better demonstrated and documented estimates can result in lower professional fees as well.
These steps sound pretty simple, but, in our experience, can have a profound impact on the profitability of construction contractors.
Our construction professionals bring valuable insight based on in-depth knowledge and first-hand industry experience. If you would you like to understand more about preparing for an audit or planning for your tax responsibilities, contact Jim Hazel at Jim.Hazel@elliottdavis.com.