written by Kami Bailey
Lending to contractors presents special challenges for banks due to the complex nature of contractor accounting. This is especially important to remember now as activity in the construction industry is continuing to increase with the current economy.
Methods for Contractor Accounting
Contractors can use one of two accounting methods: the completed contract method or the percentage of completion method. Many contractors use the former method for tax purposes and the latter method for book purposes. With the percentage of completion method, revenue and costs are recognized as the job progresses, based on engineering estimates or the percentage of costs realized compared to estimated costs.
Unfortunately, recognition of revenue isn’t necessarily a true reflection of the contractor’s cash flow. While 25% of a contract may have been billed because the job is 25% complete, the contractor may have only spent 10% of the money. This results in what’s known as billings in excess of cost. Conversely, a contractor may have done work it hasn’t billed yet, which is known as cost in excess of billings. The former is listed as a liability and the latter is listed as an asset on the balance sheet.
Meanwhile, with the completed contract method of accounting, all costs accumulate on the balance sheet as work in process until the job is complete, at which point revenue and expenses are recognized.
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The Job Status Report
The best way for a lender to analyze a contractor’s financial statements and make an informed lending decision is to receive and monitor a summary of jobs or job status report, preferably on a monthly basis. This job summary should include:
- Contract name, number and amount.
- Percentage complete.
- Amount of revenue and cost recognized to date.
- Profit or loss recognized to date.
- Estimated cost to complete.
- Estimated or actual profit or loss.
Any good contractor should be able to compile this monthly job status report — easy-to-use templates are readily available online. As you analyze the job status report, pay especially close attention to the following areas:
Percentage of contract completion — If most or all of the jobs have a high percentage of completion, such as 90 percent or higher, this may indicate that the contractor has little if any backlog and, hence, future revenue.
Conversely, if you see low percentages of completion compared to revenue recognized — such as 20 percent completion but 50 percent revenue recognized — this likely indicates that the contractor is front-ending jobs. While this is good news for cash flow, you need to make sure the contractor isn’t using revenue from the job for other purposes, like to finish another job or buy new equipment.
Percentage of accounts receivable that is retainage — This is the portion of payment customers hold back until a job is completed and a certificate of occupancy is issued. It’s usually between 10 percent and 20 percent of the total, which represents the profit on many jobs.
Retainage should be recorded as billed but reported separately in the accounting records from progress billings currently due. It should only be recorded as a current receivable after the job is finished and a certificate of occupancy is issued. This will be disclosed on audited financial statements.
Purchased but uninstalled materials — Materials that have been purchased and charged to a contract but not installed yet should not be counted toward the percentage of contract completion. Instead, they should be excluded from actual costs before computing the percentage of completion.
Accuracy of contractor projections — How well did the contractor estimate costs and revenue when bidding the job? What was the end result — a profit that met or exceeded projections or one that came up short, perhaps even resulting in a loss?
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Based on the answers to these questions, you may need to carefully assess the competency of a contractor’s estimator, as well as the contractor’s ability to manage the job. In addition, assess the contractor’s history of completing jobs on time and on budget while paying all subcontractors in a timely manner.
Please contact us if you have more questions about contractor accounting and the complexities that can be involved with lending to contractors 417-881-0145.
Contact The Whitlock Co. to request a consultation. We serve Kansas City, Springfield, and Joplin in Missouri.