Construction contractors face unique challenges in managing cash flows. A competitive industry environment often results in tight margins, and it’s crucial that contractors have sufficient working capital and cash flow to complete jobs. Although a contractor may see a rising bank account balance and assume things are going well, there may still be significant cash flow needs lurking beneath the surface. For construction contractors, a more detailed contract by contract analysis is necessary to determine if certain projects will negatively impact future cash flows. Without the ability to timely report and review a contract analysis, a contractor can be faced with what is known as “job borrow”. Job borrow occurs when the estimated costs to complete a contract exceed the remaining contract balance to be collected. In other words, the contractor expects to experience negative cash flow for the remainder of the job. This means that the contractor is in essence “borrowing” cash flow from some jobs to cover the costs to complete other jobs. Below we discuss how a proper understanding and application of construction accounting principles can help contractors identify and avoid this potentially serious problem.
METHODS TO RECOGNIZE REVENUE
Generally accepted accounting principles typically require construction contractors to recognize revenue from long-term contracts over the life of the contracts. Using the “cost-to-cost” method, a contractor divides total costs to date on a job by the total costs expected to be incurred on the job to determine the percent complete. This percentage is then applied to the overall contract price to determine revenue earned to date. If a contractor has earned more to date on a contract than they’ve billed to the customer, the job is considered to be “underbilled”. Alternatively, if billings exceed revenue recognized to date, the job is considered to be “overbilled”. In many cases (but not always) contractors would prefer their jobs to be slightly overbilled. This way cash receipts from a particular job can be used to cover the costs on that job. In a perfect world, this would mean that each job would essentially “pay for itself”. However, problems can arise if a contractor overbills their jobs to the point of experiencing job borrow.
High overbillings may not seem like a major issue if the job in question is still expected to be profitable and the contractor has a strong working capital position. However, a consistent pattern of job borrow could lead to a snowballing scenario where a contractor frequently finds themselves needing to overbill new jobs to cover costs to complete jobs that have already been fully billed. This puts the contractor at risk of a serious cash crunch if major unexpected costs arise or backlog declines. If these situations occur, it’s possible the contractor may not have enough cash available to cover remaining costs on jobs in progress. Unanticipated issues are common in the construction industry, so it’s crucial for contractors to avoid putting themselves in a situation where poor cash flows could require them to raise additional capital.
RISKS ASSOCIATED WITH JOB BORROW
Due to the serious risks, it is crucial for the contractor to identify potential job borrow before it becomes a problem and take the steps necessary to avoid related cash flow difficulties. As with nearly all aspects of a construction enterprise, the availability of timely, accurate information is crucial to financial success. Having an accurate and up to date Work in Process (“WIP”) schedule allows contractors to identify potential issues such as job borrow ahead of time and take the steps necessary to eliminate or mitigate the related risk. Obtaining and using this information requires a proactive approach at all levels of the organization to regularly monitor and analyze performance on contracts.
IDENTIFYING JOB BORROW
If job borrow is identified, it is important to get to the root of the issue in order to take appropriate corrective action. Are margins on contracts sufficient to cover operating expenses? If jobs aren’t earning enough to cover overhead, the contractor may need to rethink the bidding process. Are budgets being used to monitor job performance, and have results been in line with estimates? If contract costs are consistently exceeding expectations, the contractor must identify the reason why. Have repeated collection problems with any particular customers slowed the receipt of payments? The contractor may need to consider whether enough internal resources are being dedicated to the credit and collection function and possibly reevaluate certain customer relationships.
The cash flow challenges faced by firms in the construction industry are unique, and addressing these challenges requires a unique approach. In our experience, the most successful and profitable contractors are those that have appropriate processes and systems in place to identify and act on cash flow issues in a timely manner. These include maintaining accurate and relevant financial records, facilitating frequent communication throughout the organization, and taking early actions to mitigate risk. Working with an experienced construction CPA firm can help to implement these processes and put construction contractors on the path to financial success.
If you have questions and would like to speak with one of our construction accounting professionals, please contact us.
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