Contractor Accounting software can do so much to simplify and help management monitor not only profitability but effectiveness of estimating, accuracy of data entry, timeliness of billing, and any gaps in their business processes. Unfortunately, many contractors do not achieve some of the key benefits from new construction accounting software due to staff reluctance to give up the spreadsheets they have always relied on for various reporting and job tracking data. This is a tendency that contractors need to outgrow.
Construction Audits: Introduction
Construction audits have a lot in common with most other industry audits. Every audit goes through a planning phase where the auditors gain an understanding of the company, its industry and internal controls. Combine this with the preliminary analytics and the auditor is able to determine what areas have the highest potential risk for material misstatements, and develop tests accordingly.
The reporting aspects of audits are very similar as well. Although the financial statements and related disclosures as well as the communications to those charged with governance may differ slightly in terms of content due to differences in Generally Accepted Accounting Principles (GAAP) requirements, they are still provided at the end of every audit along with an opinion. What separates the construction audits from other industries are the areas of focus when performing substantive testing, specifically, the contract reports.
The contract reports are the lifeblood of a construction company. These reports provide detail on the current jobs that the company has under contract including expenses to-date, revenues earned, cash flows, and job progress. Essentially, it’s a month by month total of job activity that affects costs of revenues earned, accounts receivable, accounts payable, over/under billings, provision for loss and estimated revenues. Because of this, the contract report of all accumulated cash, expense and adjustments to the original estimate and related accounts demand the most attention in terms of testing.
Through our experience performing audits within the construction industry, we have had the benefit of observing how Foundation and Timberline accounting software are implemented into company accounting processes and have noticed one common theme among all of the companies. Surprisingly, no one used the accounting software to produce the contract reports, and instead opted to prepare these outside of the software using Excel.
While the reasons for why each company doesn’t use the accounting system to create the contract reports may vary, it is mainly due to the company not being as proficient with the software and choosing instead to rely on processes that, while old and time-consuming, provide reliable data. This does not affect the overall structure of the tests associated with the contract report; however, it does add one additional step. Before any testing is started, the auditor must first confirm that the current year revenues and current year expenses per the reports created in Excel agree to the revenues and costs of revenues earned sold reported on the trial balance.
However, the accuracy of the contract reports is not just important for the audit. These reports provide Management with the tools necessary to monitor activity on the contracts, assess the reasonableness of costs, monitor profitability, assess unusually low or high profit contracts, etc. And because they have such a large impact on the company as a whole including management’s decisions, the accuracy of these reports are an essential part of the success of a business. If these balances do not agree, it could indicate some sort of deficiency in the accounting records or internal controls. As examples, a contract change order or revision is missing from the report, job costs are not being correctly classified, or even the contract report in excel is calculating income and expenses incorrectly. This can happen through either bad data input or using incorrect formulas. In addition, working outside the accounting system does not allow for a company to realize the benefits of the control environment built within the solution or the efficiencies of having the accounting system “work for the company” by providing the critical information without additional manual steps.
If you were to ask your customers what they consider the contract value, amounts due and percentage completion of their jobs to be as of the year end, would they agree to your records? Confirmations are a great resource for validating large, riskier contracts with customers. Confirmations request that each customer confirm their respective contract values including approved change orders, amounts billed, amounts remitted to the company, amounts outstanding and percentage of the job completed. Although the contract report contains all of this information, the accounting system can assist in ensuring that the balances are accurate. If not actively updated within the system, the contract value and approved change orders should always be readily available to confirm the accuracy of expected revenue.
Within the accounting system, the accounts receivable subsidiary ledger for the individual job as well as the job cost report can assist in confirming all other balances including over or under billing, total job costs and total billings on the contract. It is important to note that if the customer reports different values than the confirmation it is not necessarily a cause for concern. Often these can be associated with timing differences such as the Company sending out billings at year end that the customer has not received. Still, by having a third party confirm these balances, it helps to erase uncertainties as to the accuracy of some of the information included in the company’s records.
For high risk jobs, more attention is given. Those could include situations when there are significant over or under billings, significant changes in job profit from prior year, estimated losses, as well as significant jobs between 20% and 80% complete as they generally include the most uncertainty within the revenues and estimated costs to complete estimates.
Jobs selected for confirmations are also tested for proper job costing. The auditor gathers a list of all expenses related to each high risk job and will select a sample of all job costs. Generally, this list is provided using a job cost report produced from the accounting software. The job cost report should list all expenses (including allocated overhead) associated with each job. Total for job expenses should tie back to each individual job on the contract reports and the total for all jobs should agree to the total cost of revenues earned balance on the trial balance. This report allows management to identify costs that have not been assigned to jobs due to input error or expenses that have been classified to the wrong job.
Because each job has its own gross profit margin, any unclassified or misclassified expense could significantly affect total expenses and subsequently estimated revenues earned and job profits for the year. Because of this, the auditor will select a sample of job costs to be vouched back to its original documentation (e.g. purchase order, receiving report, inventory, and canceled check). Using the original documentation, the auditor agrees the amount, job, and account classification to the record in the job expense detail. This test is used to confirm that expenses are going to the correct job so as not to distort the true profit on a job.
Analytics for Contractor Data
Analytics is the discovery and communication of meaningful patterns in data. These processes are a reliable and efficient resource for analyzing groups of data and are quickly becoming more prevalent within the auditing world. For the contract reports, analytics are performed to get a better understanding of the company as well as to identify potential areas of concern.
Through analytics, the auditor will review the company’s over/under billings. Although it is generally considered a positive aspect to have over billings on jobs in terms of cash flowing a job, the auditor will look at larger overbillings to ensure the company is recording expenses to the correct job. On the other hand, large under billings may indicate that the job is potentially underperforming or that Accounts Receivable is not staying current due to late job reporting or releases.
Current year estimated revenues earned are a significant estimate under the percentage of completion method. Because of this, the auditor must analyze the company’s estimates to ensure that they are reasonable and not materially misstating the financial statements. A lookback analysis is performed to do just that. During the lookback analysis, the auditor will consider if there are any significant changes from prior year job profit estimates to current year estimates. Are the changes reasonable or does the auditor need to consider adjusting the estimated revenues earned in the current year?
Some auditors are even performing analytics on job costs in place of sampling by taking the bid job costs multiplied by the percentage complete and comparing the expected balance to actual as of the report date. Any large variances are then tested further to determine if they are reasonable. Lastly, contract losses are reviewed for proper expense recognition in the current year.
Because of its ability to assist management in the ongoing monitoring of jobs throughout the year, contract analytical procedures can and should be used by management on a regular basis. They allow management to assess each job individually for such things as whether the jobs are being properly cash flowed or whether they are progressing as expected. Analytics may also indicate if the estimation process for contracts needs to be reviewed. Additionally these analyses can be performed quickly. However, it is important to note that, if the company is preparing the contract reports outside of the accounting software, the contract reports must be reviewed for completeness (revenues and expenses agree to the trial balance) for the analytics to be effective.
Other Contract Testing
Other testing can include reviewing original contracts and approved change orders, recalculating the contract report, tracing amounts billed per the contract report to the accounts receivable subsidiary ledgers, and many more until the auditor gains that level of comfort that the balances represented are free of material misstatement.