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Internal Controls For Estimating, Planning, Executing, And Financial Reporting
By Robert A. Davidson and Bryan Hinton


Equipment… Tools… Parts… Materials… Craftsmanship… Deadlines

Everyone knows these are issues subcontractors must deal with every day.

What most of us don't think about, however, are the business skills necessary to run an efficient and successful subcontracting operation.

These skills include estimating and planning jobs, executing and managing jobs, and reporting job progress. These are the real criteria for success.

This article examines the internal controls needed to ensure that your firm will master these critical skills.

INTRODUCTION

Running a successful contracting operation requires stringent internal controls for the following functions:

Due to the specialized nature of these functions, the chief financial officers, controllers, and outside auditors of subcontractors must have specific experience in the construction industry. To provide an overview of the scope and depth required, take a few moments to review the "Internal Control Questionnaire" found on pages 16-19. "No" answers indicate areas where internal controls may be needed.

BIDDING AND ESTIMATING

Every subcontractor competitively bidding jobs must be able to accurately estimate project costs. In order to do this, the original bid estimates must include the same cost components that will be charged to the individual job cost ledgers. Additionally, construction industry accountants must ensure that the bid estimates are reviewed by an appropriate level of management, that calculations are reviewed prior to the estimate being submitted, and that the estimates are double-checked against contract specifications, plans, and drawings. Accountants should also verify that labor and burden rates are adequate when compared to actual cost.

Other strong controls for bidding and estimating include the following:

Taking these steps can yield the following benefits:

JOB COSTING

Accurate job costing begins with a job numbering system that provides specific identification of individual jobs.

A proper job costing system also has the appropriate personnel setting up estimated job costs in the accounting system on a timely basis.

Regarding job costing software, a good system will include the following key features:

The job costs in the subsidiary ledger should be reconciled to the control number in the GL on a monthly basis.

After that reconciliation, job cost reports should be provided to management and project managers on a timely basis for their review.

Key internal controls for job costing include the following:

MATERIALS AND PURCHASING

There are several key internal controls for the materials and purchasing function within a construction company:

Once purchase orders are issued and deliveries begin, the accounting department must ensure that discounts are taken and that unit prices reflect the original estimates.

At the end of a project, someone should perform a post-completion audit of materials prior to final payment. This audit should include a comparison of quantities purchased to original bid quantities.

Jobsite Management

In order to provide proper internal controls, the following procedures should be in place at the jobsite:

One of the biggest challenges facing construction companies today involves field management of the various changes in the work scope and conditions occurring at most jobsites on a daily basis.

Consequently, jobsite conditions that differ from what was originally expected must be adequately documented and communicated to the project manager in a timely manner.

Additionally, changes in the work scope initiated in the field by customers should require approval (in the form of written and signed change orders) before additional work is begun.

Experienced superintendents and foremen - who have the knowledge necessary for the jobs they are assigned - also help to facilitate proper jobsite management.

In addition, job diaries and photographs can provide necessary documentation; such documentation should be maintained and transmitted to the home office on a daily basis.

REMEMBER: One objective of proper control is the timely communication of potential change orders and claims.

Indications of proper jobsite controls include:

LABOR MANAGMENT

To maintain an excellent control environment, performance bonuses should never be based on jobs-in-progress. Performance-based bonuses should be paid on completed contracts only.

This does not prohibit subs from making the traditional year-end bonus accruals. However, such bonuses should not be paid until the jobs are complete and the actual gross profit is known.

Additionally, subs with good internal controls have written performance compensation plans and review employee compensation annually. Other key controls for labor costs include:

EQUIPMENT MANAGMENT

Good control of construction equipment mandates a written capitalization policy to ensure that repairs and maintenance costs are properly expensed as incurred. For equipment-intensive subs (such as excavation contractors) where repairs can run into the tens of thousands of dollars, the potential for tax savings in this area is tremendous.

Subs with large amounts of equipment should also determine whether their estimated useful lives are reasonable and should maintain monthly fixed-asset depreciation schedules.

To be certain that equipment usage is properly charged to the correct individual contracts, companies should do the following:

REVENUE AND BILLING

Before mailing requests for payment to an owner or GC, subs should have controls in place to ensure the following:

THE MESSAGE HERE IS CLEAR: Never wait until the end of the job to "settle up."

Accounting for billings on contracts requires an organized billing file system. Files should include:

In addition, several other billing controls should be in place:

Best-of-class subcontractors scrutinize jobs with large underbillings on a monthly basis. Remember, underbillings are rare and overbillings should be in the bank. Always keep in mind that underbillings shift project financing to the subcontractor.

Items that contribute to underbillings include the following:

And, there are some additional controls that should be instituted for the billing and revenue function:

Monthly meetings between the accounting department and project managers are recommended to help determine the status of contracts-in-progress. This is a good time to discuss the status of change orders and to decide when approval is needed. Management should also review contract backlog to monitor workflow and to verify that company resources are available when necessary.

CASH FLOW MANAGMENT

The old adage that "cash is king" is especially true in the construction industry. When determining the strength of a balance sheet, sureties, bankers, and other users of financial statements look closely at the "cash" account. Bonding companies want to see non-borrowed cash greater than 20% of equity.

Subcontractors that want a competitive edge will have the following:

Chief financial officers and controllers of subcontractors should also consider converting contract schedules to the cash basis to provide management with an accurate cash position by contract. (You can see a sample contract cash flow analysis on page 20.)

FINANCIAL REPORTING

A contractor's working capital position is crucial and can be monitored with accurate internal financial statements. In order to achieve accuracy in financial reporting, adequate internal and external accounting assistance is required.

Retaining a qualified, independent CPA firm with extensive construction experience can be very helpful. Why? Because such firms can help with ideas to improve financial reporting, which can result in increased bonding capacity.

A knowledgeable external CPA can also assist the subcontractor's internal accounting staff with accounting issues, and help develop accurate internal financial statements to ensure that the following procedures are in place:

The ability to prepare accurate percentage-of-completion schedules is a crucial step in the creation of internal financial statements:

All subcontractors need to prepare contracts-in-progress and completed-contract summaries.

Revenue, direct costs, and gross profit should be reconciled to the GL on a monthly basis.

Contract schedules that do not agree with the GL may be misleading and typically result in inaccurate financial statements.

Owners and managers of construction companies need to be able to recognize when financial problems arise. Contract schedules that are timely and accurate can be used to help indicate early on when a problem has developed in a job.

After obtaining accurate internal financial statements, key ratios for liquidity, profitability, leverage, and efficiency should be prepared and reviewed quarterly by management. (These ratios, along with explanations of what each indicates, can be found in Appendix B of CFMA's 2001 Construction Industry Annual Financial Survey.) Trends can help to identify problem areas or situations that will require attention.

CONCLUSION

Good internal controls are vital for subcontractors: Such controls are key to remaining competitive in today's environment and they require accountants who are specialists in the industry. However, the good news is that, once instituted, they help make everyone's job easier!

Robert A. Davidson co-founded Davidson & Golden, PC in Brentwood, Tennessee. The firm provides audit, tax, and consulting services to construction companies nationwide.

Robert received a BS in Accounting from Middle Tennessee State University. Frequently published in industry newsletters and journals, he sits on the Editorial Board of the Journal of Construction Accounting and Taxation and works as a technical review editor for the Miller GRAS - Construction Section and the AICPA's Construction CPE Course. Former Chairman of the AICPA's National Construction Industry Conference, Robert was one of the highest-rated speakers at this event. He lectures on accounting/construction topics throughout the country for such organizations as CFMA and the AGC. He has also written a CPE course titled, "Advanced Accounting and Taxation for Contractors."

Robert is a member of CFMA, the AGC, and the American Road and Transportation Builders Association (ARTBA).

Phone: 615-661-6599
E-Mail: rdavidson@davidsonandgolden.com
website: www.davidsonandgolden.com.

Bryan Hinton is an Audit Partner with Davidson & Golden, PC in Brentwood, Tennessee. Bryan specializes in merger and acquisition consulting and due diligence.

Bryan graduated from David Upscomb University in Nashville with a BS in Accounting. He spent six years with an international construction company and has twelve years' experience in public accounting. Published in The Journal of Construction Accounting and Taxation, Bryan teaches classes on advanced accounting for the construction industry and has spoken at the AICPA's National Construction Industry Conference.

Bryan serves on ABC's National Tax Committee. He is also a member of the AICPA and the Tennessee Society of Certified Public Accountants.

Phone: 615-661-6599
E-Mail: bhinton@davidsonandgolden.com
website: www.davidsonandgolden.com

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