The New Accountability

1

• The New Accountability
• Part 1 Contractors Accounting and Tax Update

• James C. Lundy, CPA
• Partner
• Davidson, Golden Lundy
• Charlie Woodman, CPA
• Risk Finance Advisory
• Willis National Construction
• 2011 Willis Construction Risk Management
  Conference
• April 21, 2011

2
Construction Industry - Current Trends and
Observations

• The recession is not over
• Certain sectors hit harder than others
  residential, retail, commercial building,
  hotel/motel, churches
• Certain sectors have held steady healthcare,
  infrastructure, education, utility
• Its not just a recession, its a correction.
• Concern about construction materials price
  volatility and inflation fuel, asphalt, PVC,
  steel, cement, aggregates, copper, etc.
• Escalator clauses are becoming more common
• How strong is the guarantee behind your price
  quote?
• Supply bonds
• Lower profit margins
• 30 to 100 reductions
• Increase in bidders and bid spreads

3
Construction Industry - Current Trends and
Observations

• Increase in mergers and acquisitions
• Strategic acquisitions
• Buyers market - Steals - not Deals
• Increase in self performed work
• Too many contractors
• Construction period or Gap financing
• Extended period warranties
• Overbilling vs. warranty reserve
• Reporting issues
• Generally, survivors are winners - construction
  fortunes have been made by being aggressive
  during recessions
• Bankers and sureties are concerned

4
Overview of Financial Reporting for Contractors

• Financial reporting is the responsibility of
  Owners, CFOs, Management, Controllers and
  Independent CPAs - all share the risk
• Economic crisis has resulted in more reliance on
  statements
• More scrutiny and analysis on financial reporting
  than prior years
• Management, CPAs and Controllers have personal
  liability if intentionally misleading
• Reliance by various users on financial
  statements
• Sureties
• Banks and finance companies
• Regulatory boards - licensing
• Owner and prime contractor prequalification
• Suppliers
• Stockholders (owners)
• Joint venture partners
• Unique methods and disclosures
• Real world suggestions
• Timeliness - delaying year end statements longer
  than 75 days is unacceptable monthly and
  quarterly reporting - 30 days
• Honest communication is key
• Surprises damage credibility job fade, claims,
  losses
• The surety and bank are your Partners

5
Revenue Recognition

• Commandments of Construction Reporting
• Underbillings are bad
• Unrecognized loss (fade) of poor cash flow
  management?
• Historical support for underbilling recognition
• Dumb or dishonest?
• Professional skepticism
• Overbillings are good, but should be in the bank
• Positive ratio of non-borrowed cash to
  overbillings
• Current Accounting Under SOP 81-1 Percentage of
  completion method is required
• Cost to cost unless another method is more
  conservative
• No gross profit estimates in excess of historical
  without tangible documentation
• Soft fade/gain analysis type of work, location,
  customer
• Use caution when segregating and combining
  contracts
• Accurate phase coding is required

6
FASB / IASB Preliminary Document on Revenue
Recognition

• Exposure Draft issued June 24, 2010 (Topic
  605-35) final statement due in 2011 (replaces
  SOP 81-1 after 30 years)
• Revenue recognition FASB proposes major changes
  to the way contractors account for revenue
  recognition. Under the proposal, contractors
  would be required to adopt new financial
  reporting techniques that may be more subjective
  compared to the current method, percentage of
  completion (POC).
• Purpose Recognize revenue to depict the
  transfer of goods and services in an amount that
  reflects the consideration expected to be
  received for those goods and services.
• A balance sheet approach that emphasizes
• Unconditional obligation to pay
• Legal title
• Physical possession

7
Comparisons
Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard
  Current StandardRevenue Recognition - Construction-Type and Production-Type Contracts ASC 605-35 (Formerly SOP 81-1) Current StandardRevenue Recognition - Construction-Type and Production-Type Contracts ASC 605-35 (Formerly SOP 81-1) Proposed StandardRevenue Recognition from Contracts with Customers Topic 605 Proposed StandardRevenue Recognition from Contracts with Customers Topic 605
  Sub paragraph   Sub paragraph  
Profit Center 25-3 Basic presumption is that each contract is the profit center for revenue recognition, cost accumulation, and income measurement. Segmented is allowed under certain strict conditions. 12-16 Evaluate distinct performance obligations within each contract for separate revenue, cost accumulation, and income measurement. Combined obligations are allowed when activities are interdependent.
Method of Recording Revenue 25-51 Recognize income as work on a contract progresses. Incurred costs in relation to total estimated costs or other such measure of progress toward completion. Presumes ability to estimate total contract costs. 25 Recognize income when it satisfies a performance obligation by transferring a promised good or service to a customer. The transfer occurs when the customer obtains control of that good or service.
Variable Contract Prices 25-60 Use most conservative estimate of revenue that is assured and likely to occur. When in doubt, use lowest probably level of profit until results can be estimated more precisely. 41 If the transaction price cannot be reasonably estimated, do not recognize revenue. If transaction can be reasonably estimated, recognize revenue from satisfied performance obligations when it can be estimated. Recommended to use weighted probability measures to determine transaction if entity has sufficient history of similar transactions.
8
Comparisons
Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard
  Current StandardRevenue Recognition - Construction-Type and Production-Type Contracts ASC 605-35 (Formerly SOP 81-1) Current StandardRevenue Recognition - Construction-Type and Production-Type Contracts ASC 605-35 (Formerly SOP 81-1) Proposed StandardRevenue Recognition from Contracts with Customers Topic 605 Proposed StandardRevenue Recognition from Contracts with Customers Topic 605
  Sub paragraph   Sub paragraph  
Contract Costs 25-34 Accumulated in same manner as inventory and charged to operations as related revenue from contracts is recognized. Includes direct and indirect costs. 58 Same as current standard with exceptions for procurement, mobilization, and inefficiency
    Procurement    Costs 25-39 Costs should be expensed unless they are recoverable under an active contract 59 Costs of obtaining a contract, including bid and proposals, and negotiations are expensed when incurred.
    Mobilization    Costs 25-41 Costs may be deferred and included in contract costs on receipt of anticipated contract. 57 Recognize these costs as an asset when they related directly to a contract, generate or enhance resources used for satisfying performance obligations, and are expected to be recovered. Amortize this asset ratably over the duration of the project.
9
Comparisons
Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard Comparison of Key Features of the Proposed Standard vs. Current Standard
  Current StandardRevenue Recognition - Construction-Type and Production-Type Contracts ASC 605-35 (Formerly SOP 81-1) Current StandardRevenue Recognition - Construction-Type and Production-Type Contracts ASC 605-35 (Formerly SOP 81-1) Proposed StandardRevenue Recognition from Contracts with Customers Topic 605 Proposed StandardRevenue Recognition from Contracts with Customers Topic 605
  Sub paragraph   Sub paragraph  
Change Orders        
    Approved 25-25 Contract Price Adjusted, cumulative catch up of revenue 17-19 Contract Price Adjusted, cumulative catch up of revenue
    Unpriced 25-87 If recovery probable (events necessary for recovery likely to occur), recognize revenue to extent of cost until approved. If changes are in dispute, evaluate as a claim. 41 Evaluated as variable consideration
    Claims 25-31 Reorganization appropriate only if probable that the claim will be sustained and amount can be reliably estimated. Record only to the extent of contract costs. In practice, not typically recorded until amounts have been received or awarded. May record as adjustment to contract if realization is beyond a reasonable doubt. 41 Evaluated as variable consideration
10
Issues

• Why convergence with IFRS / US GAAP better
  information for users
• A new focus on control and separation during the
  earnings process
• But
• Is the contract a continuous transfer of
  assets? Confusion over what satisfies
  performance obligations
• Has the customer gained control of the work in
  process? If yes, percentage of completion
  method will be required
• Interpretation that title of control does not
  transfer until contract completion, will require
  revenue recognition on the completed contract
  method
• Possible split of the revenue recognition model
  between goods (transfer upon sale of product),
  and services (continuous transfer through
  performance of tasks or series of tasks).
• Leading to a new definition of construction
  contracts as a continuous delivery or process?

11
Other Issues

• Specialized assets completed contracts progress
  billing percentage of completion (and Work In
  Process)
• Warranty costs result in revenue deferral vs.
  cost accrual
• Warranties are an emerging issues
• Change from cost to cost to units / labor hours
• Uninstalled materials and timing
• Unpriced change orders recognize profits?
• Performance bonuses estimated at reporting date
• Acceptance by sureties? A sometimes skittish
  lot.
• Tax?

12
Updates

• New proposals to retain the current accounting
  principle SOP 81-1 for measuring revenue during
  the progress of a contract
• Continue to pursue a carve out provision for
  revenue recognition with FASB for the
  construction industry
• FASB wants to understand how the proposal will
  impact contractors income tax reporting
• At this point FASB still plans to issue the new
  revenue recognition accounting standard in the
  second or third quarter of 2011, but admits
  significant issues on the proposal still exist.

13
Changes to Lease Accounting Could Impact
Contractors Finances

• On August 17, 2010 FASB and IASB (Topic 840)
  draft accounting standard on lease accounting
  which attempts to ensure assets and liabilities
  arising from lease transactions are recognized in
  the statement of financial position (Balance
  Sheet).
• Currently (FASB 13)leases accounted under one of
  two ways operating lease or capital lease.
• Capital (or financing) leases transfer
  substantially all of the risks and benefits of
  ownership to the lessee as if the lessee borrowed
  the money to purchase the property. Capital
  leases are treated similarly to a purchase of the
  underlying asset. On Balance Sheet Recognition
• Operating leases are all other leases that are
  not classified as capital leases and are
  generally treated as rental of property, and the
  effects are recorded as rent expense over a
  straight-line basis over the term of the lease.
  Off Balance Sheet, with disclosure
• A lease is deemed to be financing if
• Ownership transfer
• Bargain purchase options
• Lease term gt than 75 of assets useful life
• NPV of future lease payments is gt 90 of FMV of
  asset

14
New Lease FASB Discussion Paper (Topic 840)

• FASB is going to fix SFAS 13, and make it more
  like IAS 17. Once again a balance sheet emphasis.
• The preliminary conclusions of the board are
• A lessee obtains the right-to-use an asset
• The lessee creates a corresponding liability
• Lease options do not require separate accounting.
  These include
• ? Renewal options
• ? Contingent rental arrangements
• ? Guaranteed residual value requirements
• The results of these preliminary conclusions will
  result in leases
• - All being treated uniformly
• - Not being capital versus operating leases
• - Being treated as a single transaction
• - Being treated as purchases of the asset
• ?

15
New Lease FASB Discussion Paper (Topic 840)
Cont

• The Accounting
• A liability is recorded
• - Based on the present value of the lease
  payments
• - Payments reduce liability to zero
• A corresponding asset is recorded
• At cost (present value of lease payments)
• Identified separately from owned assets
• Amortized over the shorter of
• - The lease term
• - The economic life of the asset

16
New Lease FASB Discussion Paper (Topic 840)

• Changes can affect liability and asset
  (impairment)
• Option to buy
• Option price is included in liability
• Exclusion of asset from owned assets not required
• Topics not addressed in this opinion paper are
• Impact on exploration and use of natural
  resources agreements
• Treatment for non-core assets (such as airplanes
  for non-airlines)
• Short-term lease contracts
• In summary, the discussion paper indicates FASB
  is working to treat virtually all leases
• under the existing capital lease rules, and
  significantly reduce off-balance sheet financing
  by operating leases.

17
Changes to Lease Accounting Impact

• These changes could have a significant impact on
  construction entities that do a lot of financing
  through operating leases.
• Due to the impact of the lease accounting
  changes, we will likely see lessees desire
  shorter term leases to reduce both the increased
  leverage and the impact of the increase in
  first-year lease costs. Lessors may be inclined
  to charge a higher price on leases to offset the
  additional risk they would be subjected to with
  shorter term leases.
• These changes likely will not become effective
  until 2012. There are some actions that can be
  taken now to quantify and possibly reduce the
  impact
• Determine if this is going to have a major impact
  on your business. If you lease a significant
  amount of assets, this accounting change is
  likely to have a larger impact on your
  financials.
• Quantify the impact of the proposed changes by
  considering all existing and potential future
  operating leases.
• Review and analyze how your corporate agreements
  (e.g. loan documents, compensation agreements,
  etc.) are affected and if the agreements can and
  should be amended to take into consideration the
  changes solely due to the changes in lease
  accounting.

18
Updates

• The AGC issued a formal comment letter to FASB
  detailing its concerns. These issues may be hard
  to resolve in this short time frame.
• Accounting for lease transactions Under FASBs
  proposed model, all operating leases would be
  classified as capital, which could redefine the
  underwriting processes and covenants in the
  banking and surety industry. This will have a
  significant impact on contractors balance
  sheets, working capital, and leverage
• No real effect to cash flow or existing tax law
• May change job costing due to depreciation and
  capital cost charges
• Operating ratios EBITDA
• Proposing differentiation between equipment
  leases and real estate leases
• How this impacts accounting for services such as
  cranes, scaffolding, and other sub-contractor
  arrangements
• The need to separately address short-term rental
  arrangements or leases with terms less than a
  year or an operating cycle
• Other ramifications
• FAR Rents are allowed but interest and financing
  charges are disallowed
• Sales taxcapital lease vs. rent classification
  creates sales tax consequences

19
FASB Interpretation No. 48 (FIN 48)

• FIN 48- FASBs latest pronouncement in accounting
  for income taxes.
• Released July 13, 2006 / Effective Date for Years
  Beginning on or After December 15, 2006
• FIN 48 interprets FAS 109
• Intent is to decrease the diversity in accounting
  for uncertainty in income tax financial statement
  positions.
• Prior to recognizing the benefit of a tax
  position for financial reporting purposes, the
  tax position must be more-likely-than-not (MLTN)
  of being sustained solely on its technical merits
  (excluding detection risk)
• Tax positions recognized are reported at the
  largest amount that is MLTN to be sustained

19
20
FIN 48 As Applied

• Evaluate each position for recognition. In order
  to recognize any amount of the benefit, the
  position must be MLTN of being sustained
  assuming
• The position will be examined
• The examiner will have full knowledge of all
  relevant info
• Evaluation based solely on technical merits
• No offset or aggregation of positions
• Should assume resolution in the court of last
  resort
• May Not Take Into Account Audit Risk or The
  Likelihood of Being Audited
• Sage Input
• Overblown reaction by CPA profession?
• Is it a reasonable method with substantial
  authority or frivolous?
• Is it more likely than not (gt50) that the IRS
  will disallow?

20
21
Surety analyst email statement

• There has been some discussion about FIN 48
  recently and I wanted to let everyone know how we
  see it affecting us as a Surety. First, keep in
  mind that a FIN is an interpretation and
  clarification of pre-existing GAAP CPAs were
  already required to disclose these issues.
  Simply stated, FIN 48 states that if an entity
  takes a tax position that is more likely than
  not to fail a tax examination, they must book a
  liability and include a disclosure reflecting
  such. Second, I think it is a good rule for the
  Surety, as users of the financial statements. It
  forces entities with whom we do business to
  disclose and quantify unreasonable tax positions,
  which will assist in our underwriting. A far
  more important issue is the necessity to disclose
  off balance sheet tax liabilities of pass through
  S-Corporations and LLCs.

22
Other Financial Reporting Items

• Going Concern Opinion
• Losses, significant debt and significant backlog
  reductions
• SAS 59 - Exposure draft issued to enhance - FASB
  issued Project Update on 10/21/09
• Look forward 12 months or longer
• FASB 165 Subsequent Events
• Establishes cutoff date for evaluation of
  subsequent events
• Recognized and unrecognized events
• Concerns and issues with holding financial
  statements liability to CPAs if delay results
  in damages to user

23
Most Commonly Missed Disclosures and Format Errors

• Will the disclosure affect the conclusions of the
  user?
• Formatting errors
• Balance sheet segregation and disclosure of
• Retainage receivable and payable
• Claims receivable and payable
• Unbilled receivables
• POC adjustments
• Loss contract accrual
• FIN 46 consolidation
• Joint venture partial consolidation results in
  correct working capital recognition
• Would the consolidation affect the users
  conclusion?

24
Most Commonly Missed Disclosures and Format Errors

• Accrual for self-insurance deductibles /
  liabilities
• Accounts receivable
• Aged receivable issue (over 90 days)
• Claims and unapproved change orders (recognition
  of income to cost incurred)
• Detailed and comprehensive disclosure of claims
  and unapproved C/Os
• Facts and basis for the claim
• Revenue recognized, if any
• Detailed calculations, discounts and assumptions
• Arbitration or court dates
• Separate line item reporting on contract schedule
  to prevent POC cost to cost recognition

25
Most Commonly Missed Disclosures and Format Errors

• Significant changes in contract estimates
• SOP 94-6 disclosures for current and cumulative
  impact to revenue and gross profit
• Loss contract accrual calculation
• Backlog
• Key consideration in going concern determination
• Backlog gross profit calculation on contract
  schedule
• Backlog subcontracted - bonded?
• FIN 45 off balance sheet guarantees
• Surety bonds issued and outstanding

26
Most Commonly Missed Disclosures and Format Errors

• Equity with characteristics of liabilities (FAS
  150)
• Mandatory buy sell liability
• Callable preferred stock
• Subordination agreements
• Tax liabilities of pass through entities (S-Corp
  LLC)
• Not in SOP 81-1, but
• Current and deferred liabilities
• Management intention to distribute cash
• Consideration of accrued distribution

27
Tax Update on Rent-A-Captives / Segregated Cell
Arrangements

• Sponsored Facilities
• Rent-A-Captives
• Agency Captives
• Carrier Captives
• Key Insureds and Captive Owners are usually
  unrelated entities.

28
IRS View of Cell Taxation

• In 2005, the IRS asked the industry how cell
  captives should be taxed and the industry
  responded.
• In 2008, the IRS stated how it would test the
  presence of insurance and the deductibility of
  the premium by the insured. It advised how it
  was considering treating the cell for tax
  purposes, but asked for comments before it made a
  final decision
• Rev. Rul. 2008-8 insurance is determined on a
  cell-by-cell basis if there is insurance, the
  insured can deduct it.
• Notice 2008-19 the IRS currently intends to
  treat each cell as its own insurance company and
  all elections will be made on a cell-by-cell
  basis but, the IRS is seeking comments before it
  makes its final decision. The final rules will
  not go into effect until the first taxable year
  beginning more than 12 months after the date the
  final decision is published.
• The Notice does not state how the cells will be
  taxed in the interim.

Cell Rent Session / 28
29
Proposed Treasury Regs (9/14/2010)

• A Domestic Cell (or series in a series LLC) will
  be taxed as a separate entity.
• The same applies to a Foreign Cell (or series),
  if the Cell (series) would be an insurance
  company.
• Each cell gets its own EIN and files its own
  return.
• Each cell makes its own elections.
• Effective when regulations are finalized.

Cell Rent Session / 29
30
Grandfather Rule in Proposed Treasury Regs
(9/14/2010) if all below are met

• There is a grandfather rule if all tests are
  met
• The cell company was established before September
  14, 2010
• The cell conducted business (if a foreign cell,
  more than half its business was insurance) before
  September 14, 2010
• If foreign, the cell classification is relevant
  technical requirement
• No cell owner treats the cells as a separate
  entity for any taxable year
• The cell and cell company had a reasonable basis
  for their historic treatment
• Neither the cell, cell company, nor owner was
  under audit for the cell treatment on or before
  September 14, 2010
• Grandfathering ceases if 50 or more of the vote
  or value of the cell company or cell is owned by
  those other than those who owned them on
  September 14, 2010

Cell Rent Session / 30
31
Other

• Foreign Bank Account Reporting
• New amnesty
• Not as generous as last years
• Signal for aggressive enforcement in the future
• Tax treaty partners

32

• The New Accountability
• Part 2 Compliance and Audit Discussion

• James C. Lundy, CPA
• Partner
• Davidson, Golden Lundy
• Charlie Woodman, CPA
• Risk Finance Advisory
• Willis National Construction
• 2011 Willis Construction Risk Management
  Conference
• April 21, 2011

33
Why Cost Accounting is So Important

• It Helps In
• Bidding
• Determining problem projects
• Supporting change order pricing
• Claims process
• Reconciling job costs to financial reports
• Making better decisions
• Making expansion less frightening
• Todays focus Supporting Audits
• Commercial
• Governmental
• Tax

34
What is a Contract Compliance Audit

• Compares costs billed to costs incurred
• Compares costs billed to allowable costs
• Compares fees (formula and rates) to contract
  provisions
• Confirms contract procedures were followed
• Confirms owners administrative procedures were
  followed
• Assures that owner is not overpaying especially
  on reimbursable costs
• Keeps contractor accounting staffs on edge
• Keeps forensic accountants and the DCAA (and like
  kind agencies) employed

35
If Youre Not Prepared What Can A Contract
Compliance Audit Do

• Create tension
• Cause ill will and jeopardize relationships
• Distract employees and incur significant cost
• Highlight contract vagaries
• Lead to penalties and fines
• Cause future contract / bid disqualification or
  debarment
• The biggest failures
• disorganization
• poor contract negotiation or understanding of
  terms and conditions
• inability to support or defend cost allowability,
  cost determination, and information / data
  processes

36
Success Strategies

• Adhere to planned project procedures and document
  any deviations, including source, reasoning and
  resulting impacts
• Know all contract terms conditions prior to
  start, reconcile any provisions that are vague /
  use, where practical, hard rate terms especially
  for reimbursable items
• Maintain and keep accessible records and files
  throughout the project
• Conduct cash to cost to projection reconciliation
  regularly and anticipate audit issues preemptively

37
Contract Terms for Focus

• Audit scope and processes
• Recordkeeping requirements and data support
• Reporting requirements, timing and content
• Pre-established costs for specific project
• General conditions pricing
• Self-performed work rates or equipment usage
  rates
• Approved mark-up rates
• Change order minimum rates
• Acceptable cost support documentation especial
  for cost-plus or reimbursement
• Disclose related party transactions
• Address rebates and cost caps
• Specific measureables (e.g., efficacy) and
  deliverables
• Guarantees and warranties
• Cost sharing

38
The Federal Government and Insurance Costs

• So what
• Insurance costs are generally recoverable under
  government awards, but can be long tail
• Establishing well-defined processes and proper
  accounting are key practices to achieve recovery
  of insurance costs
• Certain practices EC contractors employ for
  commercial contracts (e.g. lump sum) may be
  questioned by government auditors
• Government regulations may require a different
  practice
• Government auditor may believe a different
  practice is necessary
• Typical existing practices
• Measuring cost of self-insurance based on losses
  incurred rather than a projected average loss
• Self-insurance charges not in accordance with
  accepted actuarial principles
• Insurance costs based on premiums charged from
  captive insurers or companies under common
  control of contractor
• Insurance programs have not been approved

39
Regulations

• Key regulation for accounting for insurance
  costs
• Cost Accounting Standard (CAS) 416, Accounting
  for Insurance Costs
• Cost Accounting Standard (CAS) 403, Accounting
  for Home Office Costs
• FAR 31.205-19, Insurance and Indemnification
• FAR 31.201-5, Credits
• FAR 28.3, Insurance
• When to evaluate your current accounting
  practices for insurance costs?
• Contracts will be CAS covered
• Contracts subject to Federal Acquisition
  Regulation 31.205-19, Insurance and
  Indemnification
• Full text of FAR clauses can be found at
  https//www.acquisition.gov/far/index.html
• Full text of Cost Accounting Standards can be
  found at http//www.access.gpo.gov/nara/cfr/waisid
  x_01/48cfr9904_01.html

40
Identifying CAS and FAR in contracts

• Typically, CAS and FAR requirements are disclosed
  in
• Contract and subcontract solicitation documents
• Draft contract terms and conditions
• Solicitation representations and certifications
• Draft contract clauses to be incorporated by
  reference in the awarded contract
• FAR cost principles may apply in other
  circumstances where the original contract did not
  require application of FAR cost principles
• Change order proposals
• Cost reimbursement or progress payment requests
• Equitable adjustment claims
• Termination clauses

41
CAS Coverage

• The CAS are governed by the CAS Board and
  currently consists of 19 separate standards.
• The CAS can be imposed on a contractor under the
  following circumstances
• By reference by the Federal Acquisition
  Regulation (FAR)
• Modified CAS coverage Single federal contract or
  subcontract greater than 7.5 million but less
  than 50 million
• Full CAS Coverage Federal contracts or
  subcontracts greater than 50 million or Net
  Federal CAS-covered contracts received by the
  contractor totaling 50 million or more during
  the preceding cost accounting period

42
FAR Cost Principles

• FAR Part 31 Applicability
• Cost reimbursable contracts
• Fixed price contracts priced based on submission
  of certified cost or pricing data
• Cost principles in effect when contract awarded
  applicable for life of contract, with certain
  exceptions
• Allowable costs limited by FAR Part 31 and CAS
  requirements
• Includes FAR 31.205-19, Insurance and
  Indemnification

43
Basic CAS Insurance Accounting Concepts

• CAS includes an express requirement that the
  amount of insurance cost assigned to a period is
  the projected average loss for that period plus
  insurance administration expense
• Because CAS requires a projected average loss,
  measuring insurance costs based on actual losses
  is limited to circumstances where actual losses
  will not vary significantly from a projected
  average loss
• Under the CAS 416 concept, a risk of loss is
  covered by either purchased insurance, payments
  to a trusteed fund or self-insurance
• Applied
• Projected average loss means the estimated
  long-term average loss per period for periods of
  comparable exposure to risk of loss.
• Self-insurance means the assumption or retention
  of the risk of loss by the contractor, whether
  voluntarily or involuntarily. This includes the
  deductible portion of purchased insurance.
• Self-insurance charge means a cost which
  represents the projected average loss under a
  self-insurance plan. Because CAS requires a
  projected average loss, measuring insurance costs
  based on actual losses is limited to
  circumstances where actual losses will not vary
  significantly from a projected average loss .

44
FAR Part 31, Cost Principles Allowability

• Factors for determining allowability A cost is
  allowable only when the cost complies with all of
  the following requirements
• Reasonableness Allocability
• Cost accounting standards, or otherwise generally
  accepted accounting principles and practices
  appropriate to the circumstances
• Terms of the contract
• FAR subpart 31.2 limitations
• Costs of insurance required by contract are
  allowable
• Costs of general insurance are allowable if
  reasonable and measured, assigned and allocated
  in accordance with the requirements of CAS 416
• Costs of business interruption insurance must
  exclude coverage for lost profits
• Self-insurance program approval is required when
• 50 or gt of the self-insurance costs allocable to
  negotiated government contracts
• Self-insurance costs for the fiscal year are
  anticipated gt200k

45
Purchased Insurance Premiums

• The projected average loss (PAL) starts with the
  premium cost
• If covers more than one cost accounting period,
  pro rate costs over the period covered (prepaid
  insurance account)
• If insurance is purchased specifically for and
  directly allocated to a single cost objective
  (e.g. job), do not need to pro rate
• The applicable portion of any income, rebate,
  allowance, or other credit relating to any
  allowable cost and received by or accruing to the
  contractor shall be credited to the Government
  either as a cost reduction or by cash refund.
• Includes refunds, dividends or additional
  assessments
• Must be recognized as an adjustment to the pro
  rata premium costs in the earliest period in
  which it is actually or constructively received

46
Insurance Reserves

• IBNR (Incurred But Not Reported)
• Reasonable reserves for IBNR should not be
  considered deposits and related premiums reflect
  insurance costs
• While generally understood by Government
  reviewers to be a common feature, may be concern
  that reserves are too large
• If Government reviewer considers reserve
  unreasonably large, may question a portion of the
  reserve and the related insurance cost
• To lessen risk of issues with purchased insurance
  reserves, contractors and insurance carriers
  should be prepared to demonstrate that reserves
  are reasonable based on
• Exposure to loss
• Actual loss experience
• Loss Trending and / or Inflation
• Loss development experience or lag studies
• Discounting reserves not expressly required by
  CAS 416, but DCAA guidance suggests reserves may
  be subject to present value discounting

47
FAR 31.205-19(b) Captive Insurance
Self-Insurance

• Mistake to account for payments to a captive as
  purchased insurance
• Exception when able to demonstrate that captive
  sells insurance to general public in substantial
  quantities and insurance charges reflect market
  forces
• Contractor should plan to measure captive
  insurance as self-insurance, unless Captive
  sells the coverage commercially and premiums paid
  by the contractor can be demonstrated to be based
  on market prices
• Must treat Government as a Favored Insured
• Group Captives will generally be treated as
  purchased insurance with limitations for
  deductible or A-Layer accounts.

48
Measurement of Self-insurance Charges

• With significant self-insurance, typical
  practices for recovering insurance costs are
  establishing methods for
• 1.Estimating annual projected average losses
• 2.Allocating self-insurance charges to segments
  and cost objectives (jobs)
• Under CAS 416, three ways to measure projected
  average loss (PAL)
• 1.Actual Losses actual amount of losses (where
  actual losses not expected to differ
  significantly from PAL)
• 2.Comparable Purchased Insurance Estimate of the
  PAL based on the cost of insurance that could be
  purchased for the self-insured risk
• 3.Actuarial Measurement self-insurance charge
  based on the contractors or industry experience
  and anticipated conditions in accordance with
  generally accepted actuarial principles
• The total of self-insured charges plus insurance
  charges must not exceed guaranteed cost insurance
  for the same exposures

49
Measurement of Self-insurance Charges

• However, when the self-insurance charge is not
  based on actual losses or the cost of comparable
  purchased insurance, CAS 416 indicates
• Insurance charge must take relevant experience
  and expected conditions into account
• Must be in accordance with accepted actuarial
  principles
• Outside quotes / broker indications are allowable
• May lessen risk of Government challenge if
  estimate is performed by an actuary and true
  ups are made (though not expressly required by
  CAS, the DCAA
• CAS Board and DCAAs position appear inconsistent
• Contractors should be aware of DCAAs
  interpretation and recognize risk that DCAA may
  challenge self-insurance accounting practice that
  does not include true up adjustments
• Contractors may use DCAAs favored practice to
  lessen potential disagreement
• Should clearly document practice in CAS
  Disclosure Statement or other document
• Consider agreements with the Contracting Officer
  on cost measurement, e.g. through a Memorandum of
  Understanding

50
Allocation of insurance costs under CAS 416
Home Office

• Commonly allocated home office costs
• Purchased insurance
• Self-insurance
• Administrative costs
• Main allocation concepts
• 1.Insurance costs and losses allocated directly
  to segments (to maximum extent possible)
• 2.If not allocated directly to segments,
  allocation base should reflect factors used to
  determine premium or self-insurance charge
• 3.Material administrative costs are to be
  allocated same as related premium or
  self-insurance charge

51
DCAA Audit Guidance Allocation of Insurance Costs

• 1st and most important in determining if
  insurance costs reasonable and/or allocable is to
  review policy coverage
• If policy provides coverage for general practice,
  allocation of costs to all contracts through GA
  generally acceptable
• If policy provides unique coverage (e.g. for a
  particular segment), costs should be allocated
  directly to the benefiting cost object
• Auditors may challenge allocations
• Auditor may review loss and claims experience to
  challenge a broad-based allocation (GA) if can
  determine policy provides unique coverage (e.g.
  punitive affirmative wrap)

52
Summary Government Contracts Insurance Costs

• Insurance accounting under government regulations
  is complex and interpreting regulations can be
  difficult
• Insurance costs are generally recoverable under
  government awards
• Establishing well-defined processes and proper
  accounting are key practices to achieve recovery
  of insurance costs
• Can be applied directly or conceptually to
  non-Federal work.
• Grants
• Cooperative Agreement
• State and Local Contracting Regulations
• The Contract itself

53
Other Construction Issues During the Recession

• Prequalification of contract owners
• Verification of project financing
• Credit verification
• What entity is signing the contract?
• Prequalification of subcontractors
• Bonded subcontractors
• Credit report and review of financial statement
• Verification of payment of materials

54
Other Construction Issues During the Recession

• Monthly meetings between project management and
  accounting
• Bid spread jobs
• Underbillings
• Claims or change orders
• Receivable and retainage collection - cash flow
  report
• Jobsite and office theft
• Cost control
• Labor reporting - daily time sheets
• Phase code comparisons
• Re-think every cost and expense

55
IRS Audits Issues Strategies for Contractors

• IRS being directed to "greet" many more taxpayers
• A. Wall Street Journal column states that IRS
  looks to audit 300,000 to 400,000 small to
  mid-size businesses (5 million to 50 million
  revenue)
• B. Audits can consist of office review of tax
  return (most returns) or full field audit
• C. Appearance of return, large rounded numbers,
  and confusing terminology can add to odds of full
  field audit
• D. Don't let the threat of an IRS audit change
  the way you do business but be prepared if one
  comes

56
IRS Audits Issues Strategies for Contractors

• Intercompany and related party transactions
  attract immediate attention
• A. Document all related party transactions with
  minutes, invoices, contracts and calculations
• B. Be specific about intercompany payments. Use
  Office Expense, Accounting Services or Shop
  Costs vs. "Management Fees" or "Consulting
  Fees.
• C. Calculate exact amounts vs. round numbers
• D. Make payments monthly, quarterly, etc. vs.
  during year end audit (adjustments at year end
  appear to be manipulating profits)
• E. Document related party business purpose (rent,
  bond indemnity, loan guarantee, equity, or
  working capital requirements)

57
IRS Audits Issues Strategies for Contractors

• Audit technique is to review revenue and "cost of
  goods sold" (direct costs)
• A. Most auditors do not understand construction
• B. Make it easy for them. Prepare schedules and
  statements that agree to tax returns. Give them a
  file of documents that they can keep.
• C. Auditors will review financial statements and
  footnotes for relationships, claims filed and
  disclosures
• D. IRS will select a sample of contract activity.
  They have been told that contractors use company
  funds to build personal assets!
• E. Accrued expenses (claims, workers comp.,
  etc.) not paid by March 15 are not deductible.
  Adjust costs to complete contracts instead.
• F. Prepare look-back tax returns. Form 8697 for
  company (or individual if company is an S
  Corporation or LLC).

58
IRS Audits Issues Strategies for Contractors
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IRS Audits Issues Strategies for Contractors
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IRS Audits Issues Strategies for Contractors
61

• James C. Lundy, CPA
• Partner
• Davidson, Golden Lundy
• Charlie Woodman, CPA
• Risk Finance Advisory
• Willis National Construction
• 2011 Willis Construction Risk Management
  Conference
• April 21, 2011

• Questions Thank You