Virginia Tech and VSCPA Accounting and Auditing Conference

1
Virginia Tech and VSCPA Accounting and Auditing
Conference

• Construction Accounting and Auditing Update 2006
• By C. Michael Wade , CPA and Director of
  Contractors Financial Consulting Services Group
• Brown Edwards and Company,L.L.P.

2
Construction Accounting and Auditing Update for
2006

• Introduction
• Name and firm
• Practice area and experience
• Format of the presentation
• Questions after the presentation please

3
Construction Accounting and Auditing Update for
2006

• State of the Industry
• View point of Ken Simonson Economist for AGC
• Residential real estate markets are cooling due
  to higher costs
• Commercial activity is increasing including the
  Richmond district
• Construction starts are slow in residential up in
  commercial
• Steel increases continue for the future
• Other commodities on the rise
• Delivery delays continue also

4
Construction Accounting and Auditing Update for
2006

• Update on the Virginia Department of
  Transportation
• Public wants better transportation but no tax
  increases
• Budget approved but no long term for
  transportation
• VDOTs 6 year program has significant cuts
  from the original plan passed by Warner
• Virginia relies on Federal Gov. for funding 70
  with other states average of 42
• Senate and House cannot agree on common plan
• The general assembly is still trying to come up
  with something
• September 27,2006 special general assembly
  session and nine new transportation bills will be
  introduced

5
Construction Accounting and Auditing Update for
2006

• A few statistics from CFMA
• Legal form 64 S corps, 25 C Corps and 11 other
  form
• Source of work 67 private and 33 public
• Top 5 challenges of contractors ( percent listed,
  ranking)
• Health care costs 71 ranked 3rd
• Trained field personnel 66 ranked 1st
• Workers Compensation costs 48 ranked 5th
• Future work 47 ranked 2nd
• Insurance costs 44 not ranked
• Shortage of project managers ranked 4th

6
Construction Accounting and Auditing Update for
2006

• Views from the IRS on the Industry
• IRS has release new industry guide March 2005
• Criminal investigations involving contractors in
  2005 .256
• IRS has web site with industry specialization
  including construction

7
Construction Accounting and Auditing Update for
2006

• Surety update and the Bond Market
• Bond Market
• Industry only bonding 40 of their work on the
  average
• Heavy highway bonds more than 80
• Sampled contractors indicate bond credit remained
  the same as in 2004 ( for 2005 year)
• General contractors are bonding less than 20 of
  subcontractors costs
• Most contractors only using 1 surety company.
  Approximately 6 of the industry is uses more
  than one surety company in their programs

8
Construction Accounting and Auditing Update for
2006

• Surety Market
• For 2006 continued tough underwriting guidelines
  for questionable financial results
• Middle market contractors lt100,000 no sign of
  changes
• Surety will be competitive for them
• No significant price pressure ..some increases
• Indemnity still negotiable
• Mega contractors are viewed as most risky due to
  losses in the pass
• Surety promises to sue CPAs on misleading
  financial statements

9
Construction Accounting and Auditing Update for
2006

• Accounting Principles New and Old
• Percentage of Completion vs. CCM
• PCM used when reasonable and dependable estimates
  exist with certain conditions
• Contractual and estimates can be obtained
• CCM use is narrow
• Cannot obtain reasonable estimates under certain
  circumstances and
• Financial position and operating results are not
  significantly different from PCM
• 
  1.16

10
Construction Accounting and Auditing Update for
2006

• Accounting method vs. tax methods
• Accounting methods
• PCM
• CCM
• Tax methods
• PCM
• CCM
• Cash method
• Accrual method
• Tax methods used in financial statements are
  under OCBOA rules

11
Construction Accounting and Auditing Update for
2006

• Provision for Losses on Uncompleted Contracts
• The most ignored rule in construction accounting
• This accounting principle carries the highest
  risk with surety companies
• 80 of suits by sureties deal with this principle
  in some form
• The calculation
• Total projected loss loss to date contingency
  loss accrual on the financial statement presented
• Accrual current liability and cost included in
  contract revenues earned

12
Construction Accounting and Auditing Update for
2006

• Indirect cost allocations
• Cost need to be allocated to Cost of Revenues
  earned and preferably by contract
• Classification of accounts between direct and
  indirect creat the most problems
• Allocations need to be systematic and rational
• Allocation methods are many
• Presentation of these cost outside of Cost of
  Revenues earned cause sureties the most problem
  in estimating true profitability of jobs

13
Construction Accounting and Auditing Update for
2006

• Unbilled Receivable Issues
• Many accountants do not address
• IRS will address in audits along with cost
  capitalized with these costs ( not GAAP)
• The issue is cutoff and consistency with use
• Many times under billing are due to unbilled
  receivables
• It is best separate unbilled amounts for bonding
• Special disclosure needed in the financial
  statement and policy footnote

14
Construction Accounting and Auditing Update for
2006

• Retainage issues
• Recording is sometimes overlooked
• Classification between short term and long term
  is an issue with bonding company
• Do not forget the retainages associated with
  subcontractors
• Need to disclose amounts in the financial
  statement as part of receivable disclosure

15
Construction Accounting and Auditing Update for
2006

• Contingency accruals
• Contract price contingencies
• GAAP Accounting basic contract plus contract
  options, change orders , claims, provisions for
  penalties and incentives. Requires judgment in
  assessing probable outcomes
• Tax- as a general rule everything is included
  even though the all events test has not been
  met. Look back will make up the difference in
  the year it is realized.

16
Construction Accounting and Auditing Update for
2006

• Contract Costing Rules
• GAAP Accounting need to consider warranties,
  project guarantees, maintenance and other service
  agreements as accruable under contract costs (
  cost must be foreseen to be put in estimated
  costs to complete on contracts)
• Tax cannot accrue as part of contract cost or
  others and will be disallowed until cost
  incurred.
• Contingency costs are not deductible for tax
  purposes

17
Construction Accounting and Auditing Update for
2006

• Issues in Financial Reporting Observed By Peer
  Reviewers
• Lack of Contractor statement terminology still
  being found
• Backlog disclosure footnote ( recommended)
• 90 day receivables and composition of AR
• Retainage disclosures and subcontractors amounts
• Provision for losses on contracts not addressed
• Policy statement of costs and allocated costs
• Revenue policy footnote
• Related party disclosure and FIN 46 not addressed
• Statement of Income not reconciled to job
  schedules in work papers ( a real surety risk)
• Calculation for PCM not GAAP under SOP 81-1
• 
  
  1.40

18
Construction Accounting and Auditing Update for
2006

• New FASB affecting the Industry
• FASB 157 Fair Value Measurements
• Guidance on measuring Fair Value Only
• FMV is price that would be received to sell an
  asset or paid to transfer a liability in an
  orderly transaction between market participants
  at the measurement date
• Differences between entry price and exit price
  under FAS 141
• Assets measured highest and best use
• Liabilities measured with nonperformance
  considerations
• Directly effects FMV determination for Business
  combinations FAS 141
• Valuation techniques 1. market 2. Income 3. Cost
  approach
• Input to valuation 1. observable and 2.
  unobservable inputs
• Must prioritize inputs and consider 3 different
  levels
• Effective for F/S issued after November 17, 2007
  for fiscal years beginning after that date.

19
Construction Accounting and Auditing Update for
2006

• FAS 154 Accounting Changes and Corrections of
  Errors
• Supercedes APB 20 and FAS 3 for accounting
  changes
• Old rules required cumulative effect of the
  change in year of change as separate line on the
  income statement
• New rules require retrospective restatement of
  prior years for all statements presented or from
  the earliest practical measurement date
• Change in depreciation, amortization or depletion
  method is now a change in accounting estimate
  effected by a change in accounting principle (
  should only change in recognition of changes in
  estimated future benefits of the asset, patterns
  of consumption , or for information available
  about the future benefits)
• Old rules for correction of errors and changes in
  accounting estimates are the same as old APB 20
• Effective for fiscal years beginning after
  12/31/2005

20
Construction Accounting and Auditing Update for
2006

• FAS 153 Exchanges or Non monetary Assets ( amends
  APB 29)
• APB 29 stated exchanges of non monetary assets
  should be measured based fair market value of the
  assets exchanged ( resulting in possible gain or
  loss) with a general exception for similar
  production assets
• The new rule eliminates the old exception and
  replaces it with a new exception pertaining only
  to assets that do not have commercial
  substance.
• New definition- commercial substance means
  future cash flows of the entity are expected to
  change as a result of the exchange
• This rule will effect and encompass PPE and other
  intangible assets( example under old rules a
  truck for a tractor was exempt now it is not if
  there is commercial substance)
• Effective for fiscal years beginning after
  6/30/2005

21
Construction Accounting and Auditing Update for
2006

• Example
• New asset FMV ( selling price) 10,000
• Old asset FMV (appraisal or credit) 3,000
• Cash or note pay for new 7,000
• Cost basis of old 8,000
• Acc depr of old 7,000
• Basis 1,000
• EntryCost of new asset 10,000
• Acc deprec of old 7,000
• Cost of old asset 8,000
• Cash or note payable 7,000
• Gain on disposition 2,000 (
  3,000-1000)

22
Construction Accounting and Auditing Update for
2006

• FAS 151 Inventory Costs ( amends ARB 43 chapter
  4)
• Applies consistent application of abnormal
  inventory as period expenses ( idle costs,
  spoilage, rehandling and double freight costs)
• Old rules were unclear and could be interpreted
  and used differently ( possible capital vs.
  period costs)
• This statement formalized consistently in the
  international and US community
• Better defines capital vs. period costs also
• Effect on contractors defines a little more the
  rules for inventory capitalization particularly
  in quarry operations or manufacturing operations)
• Effective for fiscal years beginning after
  6/15/2005

23
Construction Accounting and Auditing Update for
2006

• FAS 146 Accounting for Costs Associated with Exit
  or Disposal Activities ( nullifies EITF 94-3
  related to employee termination benefits and
  certain costs for restructuring)
• Old rule states. Liability was recognized at the
  date of an entitys commitment to an exit plan.
• New rule says liability recognized when the
  liability is incurred
• Conclusion liability is not recognized at the
  date of commitment to a plan
• Effect on contractors if businesses are sold or
  liquidated regarding employee liabilities or
  restructure costs (FAS141)
• Effective for fiscal years ending after 12/30/2002

24
Construction Accounting and Auditing Update for
2006

• FAS 144 Accounting for Impairment or Disposal of
  Long-Lived Assets (supersedes FAS 121 and APB 30)
• Two types of Long Lived assets to evaluate
• LL Assets held and used
• For LL assets to be held the rule is .impairment
  loss is recognized if the carry amount is not
  recoverable from its undiscounted cash flows.
  which is measured by the difference of carrying
  amount of the asset and the fair market value
• This rule eliminates goodwill for consideration
• Probability weighed cash flow estimated approach
  can be used to determine FMV
• Assets identified as not being used but not for
  sale ( out of date or business changed)
• You still must depreciate the assets

25
Construction Accounting and Auditing Update for
2006

• LL Assets to be sold
• Value of LL assets held for disposal is the lower
  of the carry amount or FMV less cost of sale
• LL Assets disposed of other than by sale
• Requires depreciation to be abandoned
• Impairment loss be recognized at date of exchange
  of similar asset or distributed to owners or spin
  off (measured by carry valve vs. FMV)
• CPAs need to inquire about the status of
  equipment to apply this standard
• Effective date for fiscal years ending on or
  after 12/15/2001

26
Construction Accounting and Auditing Update for
2006

• FAS 143 Accounting for Asset Retirement
  Obligations
• Statement addresses the recording of obligations
  associated with the retirement of long lived
  assets and the associated retirement costs
• Statement applies to all entities
• It applies to the legal obligations associated
  with retirement of LL assets that result from
  acquisition, construction, development and the
  normal operations of LL assets
• A legal obligation is a obligation that a party
  is required to settle as a result of laws,
  statute, ordinance or written or oral contract.
• Obligations are to be recorded at FMV in the
  period it is incurred if a reasonable estimate
  can be made
• This can be tricky in determining the period it
  is incurred
• If you sold or retired at this moment Would you
  have an obligation?
• For contractors it may include environmental
  clean up etc on sale of related assets
• Concrete and quarry operations. Evaluate and
  book clean up for environmental and reclamation
  purposes???
• Effective date way back when fiscal years
  beginning after 6/15/2002

27
Construction Accounting and Auditing Update for
2006

• FAS 142 Goodwill and Other Intangible Assets
  (Super cedes APB 17)
• Goodwill and other intangible assets no longer
  amortized
• Impairment is now tested annually for fair value
• A two step process (1) screen for impairment (2)
  measures the impairment
• Other intangible assets that have finite useful
  lives will continue to be amortized over their
  useful lives
• Unamortized intangible assets( have no finite
  life) must be tested annually by comparison of
  FMV to carry value
• Specialized disclosures require changes in carry
  value, segregation of amortized and non amortized
  assets and 5 year amortization disclosure
• Effective date way back when .. Fiscal years
  beginning after 6/30/2001

28
Construction Accounting and Auditing Update for
2006

• FAS 141 Business Combinations (Super cedes APB 16
  and FAS 38)
• All business combinations are accounted for by
  the purchase method . Three things to do
• Determine acquiring entity
• Determine cost of acquired entity
• Determine allocation of cost and liabilities of
  acquired entity
• Three requirements Must now separate other
  intangible assets from Goodwill ( must identify)
• Much better guidance on identifying the
  intangible assets
• Disclosures require reasons for business
  combination and allocation of purchase price
• Allocation rules did not significantly change but
  there are changes ( study the examples)
• Effective fiscal years ending after 6/30/2001(
  way back when)
• 
  
  2.10

29
Construction Accounting and Auditing Update for
2006

• Financial Interpretations ( FINs)
• FIN 48 Accounting for Uncertainty in Taxes
• Requires evaluations of uncertain tax positions
  if client is examined by the IRS
• Need to incorporate the tax effect into the tax
  provision
• Evaluation should be based on the merits of a
  technical tax position
• General rule -It is greater than 50 chance it
  would happen on examination
• CPA exposure- IRS examination results in
  additional tax not booked in previous financial
  reports for which you knew of the issue
  misleading financial statements
• Effective date - NOW

30
Construction Accounting and Auditing Update for
2006

• FIN 46R Consolidation of Variable Interest
  Entities
• ( A Simple View Point)
• Rules require three items
• Identification of variable interest entity (VIE)
• Identification of variable interest ( form of
  support)
• Identification of primary beneficiary (PB)
• If all three are present and identifiable then
  VIE is consolidated with the PB
• FIN46R provides test and rules for identifying
  the three requirements above
• USE PPC Related Party Program as practice aid (
  Appendix 2E)
• Effective Now and it effects most all contractors
  is some fashion

31
Construction Accounting and Auditing Update for
2006

• Guidance Related to Natural Disasters ( Technical
  Practice Aid TPA section 5400.05)
• This TPA gives you guidance for the following
  issues-
• Classifications in the income statement for
  losses incurred in a natural disaster (ND) ie
  Hurricanes !!!
• Asset impairment evaluation for ND ( FMV vs carry
  value)
• Liability recognition for non impairment losses
  associated with ND such as additional expenses
  required due to ND ( environmental issues etc)
• Accounting for insurance recoveries ( income and
  reinvestment)
• Additional disclosure requirements

32
Construction Accounting and Auditing Update for
2006

• Engagement Risk For Contractors
• Understanding the Entity and Its Environment
• Understand the construction industry
• Know your client and their financial objectives
  and motives objectives
• Identify the entities business risk
• Many contractors lack proper internal accounting
  controls ( A significant Fraud Risk Factor)

33
Construction Accounting and Auditing Update for
2006

• Auditing Variable Interest Entities
• December 2003 Issuance of FIN 46R
• Issues are common to small and medium size
  businesses
• Note these related Staff Positions
• Para. 13 FIN 46 on reporting VINs
• Calculation of expected losses FIN 46
• Evaluating holders of equity interest to
  determine if they have direct or indirect
  interests FIN 46R
• Implementation issues related to Leasing
  Transactions

34
Construction Accounting and Auditing Update for
2006

• Provisions in Engagement letters to eliminate
  certain accountants liability with the client
• AICPA ethics committee issues new ruling
  interpretation ET sec. 101.01
• Certain types of liability provisions in
  engagement letters violate independence issues(
  i.e. elimination of actual damages from
  negligence or the clients negligence)
• Other liability provisions would not impair
  independence ( i.e. clients knowing
  misrepresentations or willful misconduct or
  fraudulent behavior
• Be sure you research unique changes you are
  making to your engagement letters to assure you
  are not jeopardizing your independence
• 
  2.20

35
Construction Accounting and Auditing Update for
2006

• Internal Control Deficiencies
• Most common deficiencies noted
• Considerations of job site visits as it relates
  to controls on the job site
• Internal control considerations related to
  bidding and estimating
• Lack of sufficient evidence to support estimated
  cost to complete and controls designed to arrive
  at those estimates
• Other Issues
• Lack of competent personnel
• Documentation related to income recognition

36
Construction Accounting and Auditing Update for
2006

• Companies are changing auditors at record rates
• Be advised to conform to the requirements of AU
  Section 315
• Get permission from the client to make inquiry
• Make inquiries with the predecessor
• Allow review of work papers if needed
• Association with press releases in todays
  business environment
• Just a word of caution Dont be associated if
  misleading

37
Construction Accounting and Auditing Update for
2006

• Risk of Fraudulent Reporting and Improper
  Accounting Estimates
• Review all significant of Contracts ( encouraged
  during review engagements)
• Job Site visits to determine the status and
  completion percentage of a contract in progress (
  not required by highly recommended)
• Auditing contract costs
• Components of contract cost related to original
  bid
• Proper classification of costs between contracts
• Sufficient audit procedure on contract costs
• Estimated cost to complete
• Need to consider types of contracts
• Fixed price ( high risk)
• Cost plus ( lower risk)
• Construction management ( can be high risk based
  on contract)
• Design build ( more like cost plus) (lower risk
  but depends on contract)

38
Construction Accounting and Auditing Update for
2006

• Compilation and Review Engagements
• Fraud and illegal acts
• SSARS 12 requires understanding with client in
  the form of an engagement letter
• Need to include separate paragraph in the
  engagement letter addressing your responsibility
  for detecting fraud
• Rise in litigation risk in Compilation
  Engagements related to fraud
• Perform procedures in STRICK CONFORMAMCE with
  SSARS with appropriate documentation
• Re assess client acceptance and continuance
• Talk to client about fraud and their risk and
  yours
• Address in engagement letters

39
Construction Accounting and Auditing Update for
2006

• Industry Developments
• Rising Interest rates, Energy costs , debt levels
  and softening housing market
• Heights risk on issuing financial statements over
  recognition of income and going concern issues
• Viability and liquidation risk
• Overvaluation of assets and working capital short
  falls effecting job continuance and provision for
  loss considerations

40
Construction Accounting and Auditing Update for
2006

• Inventory obsolescence ( as if effects service
  contractors, quarry operators and manufacturers)
• Customers with high levels of debts and negative
  working capital issues
• Signals going concern issues and provision for
  losses on uncompleted contracts
• Impairment and recoverability of assets
• Equipment not in use ( FMV write downs)

41
Construction Accounting and Auditing Update for
2006

• Layoffs and Lack of Qualified Help
• Ability of contractor to complete work going
  concern possible
• Outsourcing ? not considered a big risk to the
  construction industry
• Raising capital and Baby Boomer Transitions
• More difficult for the construction industry
• Consolidators are on the rise again mainly in the
  capital markets
• Be careful of buyers who do not understand the
  industry
• Observation -Pension plans are being liquidated
  or transitioned in to plans more controllable for
  funding by employers

42
Construction Accounting and Auditing Update for
2006

• Mergers and Acquisitions are heating up
• FAS 141 has changed accounting methods for MA
• Internal controls are perceived weaker with MA
  transactions
• Possibility of worsened financial performance
  with contractors consolidated as in the past
• Statistic- 80 of buyers are paying more than
  exit price FMV
• Attacks on IT
• Fraud risk to accountants
• Know your clients computer controls

43
Construction Accounting and Auditing Update for
2006

• Improper Accounting to be aware of
• Revenue recognition ( percent complete
  measurements)
• Accounting for insurance contracts ( self
  insurance arrangements with under funded
  liabilities)
• Business combination accounting ( to much value
  on amortizable intangible assets)
• New Bankruptcy laws
• Positives easier collection of debts
• Negative harder to rid debt under ch. 11
• Word of caution screen the law firms and get
  approved by the bankruptcy trustee before you
  pick up your pencil!!
• 
  2.40

44
Construction Accounting and Auditing Update for
2006

• THE END
• If you have questions or concerns I would be glad
  to talk to you individually