Articles

Audits Are A Valuable Performance Evaluation Tool For Construction Contractors by Robert C. Aldir, CPA


Posted on October 20, 2014 by Robert Aldir

The construction sector is showing signs of recovery nationwide, where total industry spending rose 7.8 percent over the same period last year, according to the U.S. Census Bureau. The trend is equally positive in Florida, where the construction sector led job growth over the past year with an 11 percent increase in Miami’s construction employment alone.

 

This turnaround is evident in a wide range of residential, commercial and public-private projects that extend across the tri-county area. Construction contractors are limited only by their abilities to assure property owners, builders and governments that they can complete contracts on time and on budget.

 

Audited financial statements shed light on a contractor’s ability to finance operations, operate profitably, stay on budget and complete a project on time. They are a valuable tool for contractors that are in the running for new projects.

 

Sureties Require Audits

Increasingly, private project owners are requiring construction contractors to obtain the same performance and payment surety bonds as required by federal, state and local agencies. This mitigates the risks of default, delays and cost overruns within a contractor’s control. Doing so helps project owners to narrow their selection of contractors to those with a proven ability to satisfy the terms of a construction project on time and on budget.

 

One of the requirements of obtaining a surety bond is an audit of financial statements and business operations. An audit also requires an evaluation of the contractor’s internal controls, the accounting practices and systems used to recognize revenue and estimate and track costs and invoices, and the contractor’s track record of claims and cost overrun collections.

 

Sureties use audited financial statements to evaluate the contractor’s ability to enter into a contract at the bidding price and pay suppliers and laborers as stipulated in the initial project bid. A surety will also evaluate the financial structure of the contractor to evaluate its ability to complete the contract. Without a surety bond, a construction contractor’s ability to compete in the construction industry can be limited.

 

Compliance with Effective Internal Controls

When hiring for construction projects, builders and property owners generally require assurances that selected contractors have a proven track record of effectively managing their contracts and businesses. Contractors that seek consistent operating performance typically implement formal policies and procedures to avoid irregularities. With these internal controls in place, contractors may properly estimate, recognize and manage contracts.

 

In addition, effectively designed and implemented internal controls can assist contractors in increasing operational efficiencies. These efficiencies may result in increased operating cash flows and working capital and improved collections on contract receivables. They can also help define roles and responsibilities within the organization that are intended to reduce the likelihood of fraud.

 

Appropriate segregation of duties between personnel in accounting and operations is a characteristic of effective internal controls. For example, an accounting department may receive cost invoices and enter them into its accounting information system. However, approvals for the payment of such invoices should be performed by the operations department (generally, at the project management level) and, depending on the complexity of the contract and the amount of costs involved, the engineering department may also need to approve payment of certain invoices. By segregating the duties of accounting recognition and approval of invoice payments, a contractor can mitigate the risk of fraud and more effectively manage its operations.

 

Accounting Methods

Construction projects are among the most complex financial-reporting endeavors, which can be further complicated by up-front cost estimates, front-load and delayed billing, deferment of gross receipts, retainages, variable fixed and unit prices and guaranteed maximum prices.

 

The way contractors account for revenue is unique to the construction industry. Because most projects are based on contracts of one year or more, contractors typically estimate future costs and ensuing profits up front and recognize profit as the project progresses toward completion. Recognizing revenue using the Percentage of Completion method allows a contractor to account for profits as they incur costs during the course of the project, rather than at the time of contract completion. This requires careful measurement of project progress through continuous evaluation of total estimated costs versus those incurred as each stage of the project is completed. The ensuing calculation provides timely information about profitability, a project’s progress and if overrun indicators need to be addressed.

 

An audit performed by a CPA with proper industry expertise provides a contractor with the opportunity to demonstrate compliance with acceptable methods of contract accounting, profitability on contracts and the ability to estimate costs on contracts.

 

Change Orders

A construction audit involves looking back at past performance. Change orders can provide significant profit to a contractor’s bottom line. However, if costs are not properly estimated, a project can quickly go from a profit to a loss. Proper internal controls can help contractors avoid pitfalls in the cost estimation process when negotiating change orders.

 

Closing Thoughts

Audited financial statements are becoming an important diagnostic tool in the construction industry. They provide critical information and assist in identifying the construction companies which have proven track records. In addition, audits provide contractors an opportunity to critically assess their systems of internal control and financial reporting and address unidentified risks that they may face.

 

Retaining the assistance of an experienced accounting firm can help contractors demonstrate their profitability, compliance with acceptable methods of contract accounting and ability to estimate costs on contracts while presenting their financial results to key stakeholders in the industry.

 

The Audit and Attest Services practice at Berkowitz Pollack Brant has extensive experience providing audit, review and compilation services to construction contractors.

About the Author: Robert C. Aldir, CPA, is an associate director in the Audit and Attest Services practice of Berkowitz Pollack Brant. For more information, call (305) 379-7000 or e-mail info@bpbcpa.com.