Laying a Strong Financial Foundation for Construction Firms
October 19, 2017
EisnerAmper senior audit manager Mike Stuhltrager discusses the myriad business and financial issues construction firms should be up to speed on. Mike touches on everything from the latest construction accounting regulations to infrastructure spending. He shares that his advisory role is as much about process improvements as it is about revenue recognition and lease accounting.
DP: Let’s start with regulations. That’s as good a place as any to start. Anything that your construction clients should be up to speed on?
MS: Well, there really are two main regulations coming down the pipeline that I think will affect all of our construction clients, along with probably all of our clients in general, but there’s something that I think should be looked at now. Revenue recognition is a significant change with ASC 606, and what they’ve done is create this change to develop a single principal-based revenue standard for U.S. GAAP and IFRS, which are international standards. What that does is increases the comparability across industries and capital markets, and it is going to require better disclosure on the financial statements.
DP: Why is this significant?
MS: Contractors spend a lot of time trying to measure revenue recognition on an ongoing, daily basis. Operationally, they’re always looking at their revenue recognition procedures, not only as how it gets disclosed on the financial statements but operationally how they’re measuring revenue as they go throughout the process.
DP: What’s the biggest change?
MS: It includes identifying certain performance obligations and assigning transaction prices to each one of those performance obligations. It is not too far off from what contractors do today, but some contractors might be doing different types of work where within one contract they might need to now need split them and measure them separately. The way in which contractors measure their performance and their percentage completion on a contract might actually change.
DP: When is this going into effect?
MS: For 2018 (public companies) and 2019 (private companies). It’s quickly approaching –especially if you’re doing comparative statements or something where you’re going to look back two or three years.
DP: What is the second regulatory issue?
MS: The change in lease standards (ASU 2016-02), but it addresses off-balance-sheet financing concerns related to operating leases. Traditionally, companies that have operating leases run them through their profit and loss statements and then show them as an REM expense. This is going to be a total divergence from that. If you have a lease that extends greater than 12 months, you have to reflect it as a capital lease. So you’d have an asset, you’d have a liability, there’d be an interest component to that, there’d be another expense component to that, there could be REM expense, but that’s going to drastically change the presentation of their financial statements and, from an operating standpoint, how it’s measured—even though nothing has really changed. That’s going to have a significant impact. A lot of contractors lease equipment and run them through operating leases, but the whole goal of this new standard is to reflect the liabilities of the company that extend beyond a 12-month term. There are some exceptions but, generally, it’s going to have a significant impact on the financial statements.
DP: They definitely sounds like a couple of things to keep an eye on. Tell us about you. What do you do day-to-day for your clients where you can add value to their construction practices?
MS: What I find is I spend a lot time working on processes with clients. Construction moves quickly and there are all of these variables. Often when I talk to clients they have struggles, they’re seeing issues, they’ve got failures within the process. They’re seeing them now, but they’ve happened months ago. Once that happens, there’s no way to recover the losses you’ve already incurred.
What I often spend my time with now is working on the process itself—making sure there’s a rigorous system in place so that they’re constantly measuring performance. A big area of concern is an indirect pool of costs. Some companies don’t spend the time to directly cost-out items that should be directly cost, but are easy to throw in to an indirect pool of costs. Labor on project managers are a really good example. They might manage 15 or 20 jobs, but why can’t you take their hours and break them down and cost them like anybody else in your company? What happens is you can take that indirect pool of costs and narrow that down and make that a smaller category of costs so that you now know more of your direct costs in your job. I think that’s better for managers and for operators to understand how they’re bidding their work and how they’re performing on that work, so that they know going into the next bid process here’s our true margin on that.
DP: It’s a lot more than just crunching numbers. It’s also a lot of process improvements and qualitative analysis, in addition to the quantitative.
MS: I‘d say that’s something that we spend more time on throughout the middle of the year: talking implementation of new ideas, new measurement tools and financing strategies. Generally at year-end we’re more compliance driven.
DP: A lot of good stuff. Does that bring to mind any recent client case studies, any interesting projects – obviously without mentioning anyone by name—that you’ve recently worked on?
MS: I had a commercial specialty trade contractor that was a growing business. At the time I think he had gone from $10M to $15M in revenue, which is a significant change for a specialty trade contractor of what he was doing. When he went through that change he added three different project managers—he couldn’t do all the project management himself. He was very good at what he did, and he maintained good cost controls, but as he added these project managers he didn’t have a process in place. He often went by his gut. He would say, “Well, I feel we’re going to do well on this job.”
We started having this conversation because we saw that there was an issue with a lack of oversight on the project managers. That started to come through on profitability. At first, he saw it as one big issue. “Oh, well, I can just tell that my cash flow is limited and it’s sort of coming through on my operations. I’m not sure exactly where it’s at.” Well, it turns out that he wasn’t very familiar with the accounting system he was using. He didn’t understand its capabilities.
When we got in there and talked with him, we went through the canned reports from the system. It had a lot of great reports, but what it didn’t have was a real WIP schedule using a cost-to-cost approach. It had a billings-to-billings approach but no cost-to-cost approach. So even though he had estimated his costs at the beginning of the job, he wasn’t tracking them on an ongoing basis to adjust for any potential overruns.
DP: What happened next?
MS: The owner wasn’t enforcing any need for his new project managers to think about those issues. We went to the software developer and created some new internal reports. One was a WIP report that reflected the total cost incurred, total estimated cost to complete that job, billings and other important numbers. We added a column for the assigned project manager. On a weekly basis, the owner would look at a WIP report that showed him all of this activity. He recognized that one of his project managers had significant cost overruns on his jobs. He could then go operational and follow the project managers around a little. He determined that his labor was just running over about 50% off of their estimates. He ended up removing that project manager, and it helped him save on potential future losses.
DP: So you diagnosed a problem and you treated it.
MS: It was a really great learning process. The client learned a lot because he wasn’t used to a process that robust. He also discovered that most companies fail while they’re growing, not when they’re losing business. I learned a lot about the industry as well. Based on the process and outcome, it was a really enjoyable time working with him.
DP: What’s unique about the construction advisory services area relative to other industry niches?
MS: Construction involves all these new moving pieces and, as a result, there’s just an increased risk factor. For example, financing can be difficult to procure or property voting can be threatened quickly. Some of those issues are controllable and some aren’t. Nothing is canned. If you use canned methods you’re not going to properly analyze the problems or forecast what you need to do. Construction is a risky business that requires a lot of detail. You have to look at it constantly in order to alleviate as much risk as you can through what you can control.
DP: Thanks, Mike, for this great expertise and insight on this topic.
MS: You’re welcome, and thanks for having me.
DP: And thank you for listening to the EisnerAmper podcast series. Visit EisnerAmper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.