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:

• Bidding and estimating
• Job costing
• Materials and purchasing
• Jobsite management
• Labor management
• Equipment management
• Revenue and billing
• Cash flow management
• Financial reporting

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:

• Tracking bid spreads
• Using standardized bid summaries
• Comparing actual costs incurred to estimated costs in order to determine the accuracy of the estimated cost-to-complete

• Ensure more accurate estimates of costs-to-complete.
• Identify jobs with the potential for profit fade.
• Provide insight into how to better prepare the next bid so that your firm is awarded the next contract.

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:

• Accounting software designed specifically for construction contractors
• A strong job costing module that includes job phases and an adequate number of cost codes or cost types
• The ability to automatically update the GL simply by posting costs to individual contract cost ledgers
• The ability to track unexpended costs by cost type or code

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:

• Proper training of jobsite personnel to cost items accurately and in accordance with the original estimate
• The ability to prevent the unauthorized moving of costs between jobs
• Allowing cost adjustments to be made only by authorized personnel and reviewed by an appropriate level of management

MATERIALS AND PURCHASING

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

• Using pre-numbered purchase orders
• Matching receiving reports and vendor invoices to purchase orders prior to payment
• Prequalifying material suppliers prior to accepting quotes and issuing purchase orders
• Requiring estimators to obtain more than one quote

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:

• Job numbers, phase codes, etc. communicated to the job foreman using work or purchase orders
• Accurate labor reports and equipment usage reports
   (may include only quantities and not dollar amounts) posted by phase and job number
• Estimated quantities provided and used as a guide to code labor, material, equipment usage, and other costs

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:

• Good workmanship
• Safety awareness
• Clean housekeeping
• Effective and timely communication between the field and project manager and the home office
• Proper security of trailers, lock boxes, and equipment at all times

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:

• New employee orientation programs
• Regular jobsite safety meetings
• A written personnel manual
• Established policies/procedures for:
   - Background checks
   - Pre-existing injuries
   - Drug testing
   - Sexual harassment

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:

• Use an internal rental rate system for equipment cost allocations.
• Submit equipment usage reports weekly with job labor reports.
• Base internal allocations on actual equipment usage or on a percentage of the published AED or Blue Book rates.
• Monitor over or underallocations and adjust on a timely basis.

REVENUE AND BILLING

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

• Billings are prepared in a timely manner.
• Line items and quantities are correct on payment applications.
• Payment applications are mailed to the correct addresses.
• Reports from the jobsite are received in a timely manner and verified for accuracy.
  
• Contract payment terms are reviewed by authorized personnel in order to take advantage of advances on retainage.
• Whenever possible, signed change orders are obtained from the contract owner and the GC before work is started.

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:

• A copy of the contract
• Latest pay requests mailed
• Major invoices from sub-subcontractors and suppliers
• Invoices issued by the owner
• Copies of approved change orders
• Other correspondence

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

• Billing registers must be maintained and reconciled to the GL on a monthly basis.
• Percentage-of-completion schedules should be prepared to compare progress billings to earned revenues.
• Journal entries should be made monthly to record under or overbillings so that revenue is recognized when earned, not when billed.

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:

• Job fade that will never be billed or collected
• Unapproved change orders
• Lack of coordination between field and office management when preparing and presenting progress billings to the owner or GC

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

• Revisions to contract values should be made when signed change orders are obtained.
• Estimated costs-to-complete should be continually updated.
• Percentage-of-completion adjustments should be made on a monthly basis.
• Historical comparisons of completed contracts to original estimates of gross profit should be provided to management. (It is often helpful to group the comparisons by project manager, location of project, or type of construction activity.)

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:

• Annual and monthly cash flow budgets
• A written policy on accounts receivable follow-up

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:

• Internal financial statements are prepared on a monthly basis and completed no later than the end of the following month. (Timely financials are needed by management to make proper decisions.)
• Financial statements are adequately supported with subsidiary ledgers, such as accounts receivable and payable ledgers.
• Other financial statement accounts are supported with schedules, such as bank reconciliations for cash balances and amortization schedules for notes payable.
• Current and deferred taxes are recorded when preparing internal financials to reflect an accurate financial statement position.

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    Web Site: 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