Evaluating contractor financial statements: recognizing the guy in the black hat

RMA Journal, The, July-August, 2005 by Gregory J. Meis

Although most dealings with contractors turn out well, it's the occasional bad guy who could get you into trouble. It's important to be aware of assumptions you may be tempted to make regarding the percentage completion method of accounting, and this article discusses three of the most common.

If you have been a commercial lender long enough, sooner or later you will likely be faced with a loan request from a contractor. On March 1, 2005, the U.S. Census Bureau announced that private construction spending was estimated at a seasonally adjusted annual rate of $805.7 billion. This amounted to 6.7% of the 2004 Gross Domestic Product of $11,988.9 billion.

The construction industry is fraught with well-documented perils, such as cyclicality and seasonal volatility, thin margins, high leverage, and low barriers to entry. However, one of the most frequently overlooked challenges in lending to the industry is the sometimes counterintuitive results produced under the percentage completion method of accounting. Misconceptions abound, and lenders have frequently been under the delusion that their contractor loans are far more secure than they really are. This article highlights three of the most common and, potentially, fatal assumptions made in the analysis of a contractor's financial statement.

Fatal assumption #1: A contractor's revenue signifies something more than a multiple of the amount of money spent on a particular contract.

For most commercial enterprises, the revenue line of the financial statement commonly represents the value an enterprise realizes for services rendered or products delivered to a customer. Conceptually, this is also the goal of the percentage completion method of accounting (PCM), but under PCM, both the user and the preparer of the financial statement rely far more on the integrity of management and its ability to predict construction costs accurately than they would for the typical commercial enterprise. See, for example, Figure 1. Go For Broke Contractor, Inc. (Go For Broke), has been awarded a $1 million contract to erect a building. Construction is scheduled to start in year 1 and the building is projected to be completed approximately 2.5 years later. At the inception of the contract, Go For Broke estimated that its gross profit for the entire contract would be 10%, or $100,000. Unfortunately, the company realized too late that its total costs to complete the contract would actually be $1.2 million and not the $900,000 that it had estimated in its initial bid almost three years earlier. What had Go For Broke missed?

[FIGURE 1 OMITTED]

As Figure 1 shows, the initial stages of the contract appeared to go as planned. Revenues in year 1 were $444,444 and costs of sale were $400,000, resulting in a gross profit of $44,000. Revenue, cost of sale, and consequently gross profit had been determined by applying the anticipated gross profit percentage for the entire job to the portion of the job completed, leading to an interim estimate of profits to date. Assuming no contract amendments or revisions to the contractor's original cost estimate of $900,000 on the $1 million contract, for every dollar the contractor spends, Go For Broke's reported revenue on the contract would increase by $1.11 ($1,000,000 / $900,000).

Go For Broke learned that time can often be the enemy of promise. In years 2 and 3, as the actual costs to complete the contract were incurred, the contractor's original cost estimate was revised upward. First, in year 2, it was revised to $950,000 from the original $900,000; in year 3, it was revised to $1,200,000 from $950,000. So, what started off as a contract potentially worth $100,000 to Go For Broke became a nightmare $200,000 loss at the gross margin level--that is, before operating, interest, and other expenses.

As shown in the foregoing example, once a contract is executed by all parties, literally all a contractor has to do to increase its reported revenue is to spend more money on that contract. This is provided, of course, that the contractor has not yet exceeded its original estimate of the total costs to complete or revised its initial estimate of the costs. For example, by increasing the money spent in the first year of the contract in Figure 1 from $400,000 to $450,000, the contractor could hypothetically increase its reported revenue from $444,444 to $500,000 and its reported gross margin from $44,000 to $50,000. This puts an entirely different perspective on the old adage that "You have to spend money to make money" or, more to the point, "You have to spend money to report revenue."

A good contractor would have recognized the loss much earlier than did Go For Broke or, had the costs been beyond the contractor's control, it would have initiated change orders to be compensated for the cost overruns. But what if the lender does not happen to be dealing with a "good" contractor?

Two reports that can help are work in progress and accounts receivable aging. In a case like Go For Broke's, likely one of two things will occur: 1) the contractor will not have invoiced, in which case the cost in excess of billings account will grow; or 2) the contractor will have invoiced but, since the customer won't be paying these bills, receivables delinquency will rise. Either way, cash won't be coming into the business. As the gap between recorded revenue and cash flow begins to widen, it's possible to take corrective action, provided, of course, that the lender moves decisively and the borrower cooperates in that effort.