Construction Articles

Warning: Articles in this archive are not updated for post original publication date law changes. Articles are also not providing legal, accounting, or other professional advice or opinions on specific facts or matters and, accordingly, no liability is assumed in connection with their use whatsoever. Please consult your tax advisor.

ENHANCING DEPRECIATION DEDUCTIONS THROUGH COST SEGREGATION ANALYSIS

Recent rulings by the IRS along with the favorable result in a 1997 tax court case have created a tremendous opportunity for building owners. Under general circumstances, costs associated with the construction and improvement of real property fall within the 39-year depreciation class. However, the IRS has softened its position lately as a result of recent defeats in tax court, and has now provided formal guidance allowing for the reclassification of certain building components to asset classifications with shorter depreciable lives. Through the process of a "cost segregation study", building owners may realize sizeable tax benefits, depending on the particular make-up and use of their building.

The ideal candidate for a cost segregation study is a building with substantial leasehold improvements and which is utilized for retail or manufacturing purposes. The idea behind this analysis is to identify and recharacterize certain components of real property classes to another property class upon which depreciable lives are shorter. Because personal property is depreciated much more quickly under federal tax law, current depreciation expense deductions are greater after this reclassification. For example, sidewalks, signage, and other land improvements can be reclassified from a 39-year life real property category to the land improvement category where the depreciable life is 15 years. Localized equipment, movable partitions and other personal property can be reclassified from the 39-year life category to a 5 or 7-year depreciable life category. Primary and secondary electrical distribution systems, wiring and connections, and special electrical equipment may be reclassified to the extent that its use is related to particular equipment that falls under tangible personal property categories. Often a significant portion of the cost of a building can be reclassified to a faster depreciable life. The shorter depreciable lives of reclassified property result in higher depreciation deduction in current years, and lower depreciation in later years, as contrasted to depreciating the entire building over 39 years. The present value of the larger current depreciation deductions is the measure of a cost segregation study's value.

Cost segregation studies can be performed for existing buildings, resulting in potentially greater current deductions as well as the opportunity to make up for understated depreciation deductions from earlier years. For new construction, cost segregation is a must. Our approach in performing the cost segregation study includes a review of construction drawings, anticipated equipment/fixture layout, facility inspection, fixed asset schedule development, management review of findings, and Form 3115 filing in the case of adjustments for existing buildings.

Cost segregation studies are a popular value added service in the construction and real estate industry. Many building owners consider them to be a standard aspect of new construction. BP's real estate group is excited to offer this service and can be contacted for more information.

IMPROVING CONTRACTOR FINANCIAL STATEMENTS

POSITIVE EFFECTS

CRITICAL	Hard Working Capital	Equity	Debt: Equity
1. Plan to make a profit and follow plan	X	X	X
2. Always concentrate on cash flow	X	X	X
IMPORTANT
1. Run company as a construction company, not an investment company (i.e., no development or major security investments)	X	X	X
2. Agressively monitor and collect receivables and retention (customer acceptance)	X	X	X
3. Secure receivables (develop lien plan)	X	X	X
4. Monitor under/over billings	X	X	X
5. Avoid inventory	X
6. Take antidote for "yellow fever" (i.e., equipment desires)	X	X	X
7. Sell unnecessary equipment	X	X	X
8. Hold real estate outside of company and lease to company			X
9. Consider leasing other assets (off balance sheet financing)			X
10. Finance long-term assets with long-term debt	X
11. Write loans from shareholder to company long-term or consider subordination to bank or bonding company	X
12. Refinance debt over longer term, if necessary	X
13. Comply with state B&O and sales tax laws	X	X	X
14. Never borrow from the Feds	X	X	X
15. Monitor interest rates and fees being charged	X	X	X
16. Beware of sales concentrations	X	X	X
OTHER CONSIDERATIONS
1. Time renewal so that prepaids are minimal at year end	X
2. Avoid loans to shareholders (at least repay debt by year end)	X
3. Don't use tax depreciation methods on financial statements		X	X
4. Consider the use of salvage values on depreciable assets		X	X
5. Have line-of-credit available even if no immediate need
6. Pay down A/P or LOC at year-end with excess cash			X
7. Evaluate deferred federal and state income tax accounts	X	X	X
8. If S Corporation, disclose timing differences and cash needs for taxes
9. Evaluate repairs and maintenance for possible capitalization		X	X
10. NEVER have a negative cash balance at year end			X

CASH FLOW PLANNING FOR CONTRACTORS

Cash management is an important, yet often neglected area of financial management for many businesses. And while analyzing cash flow is critical to the success of any business, companies in the construction industry can be especially hampered by a lack of cash planning due to the nature of their business.

Contractors know that there can be a significant lapse in time from the point at which they are granted a project, incur labor, material and other costs, and are actually paid for completed work. Factors such as retentions, decisions on whether to subcontract the work or use the company's own crews, renting versus buying equipment , and timeliness of customer payments all have an impact on a contractor's cash flow. This makes cash management difficult but essential. Construction companies must ensure that enough cash will be available at the right time to allow the business to operate profitably and effectively. If the company's cash position is not monitored, there is little or no time to react to a cash shortage.

Current vs. Future Cash Needs An analysis of working capital and current cash needs does not provide an indication of the company's future cash flow needs. It also does not show a company's ability to handle a cash flow interruption due to a problem on a current contract, nor does it indicate future cash needs as a result of being awarded a new contract. This information can only be obtained through the preparation of a cash flow projection.

The purpose of a cash flow projection is to determine the amount of cash necessary to handle the anticipated level of company operations and to determine when the cash will be needed. Each contract has its own cash flow cycle. At times, a contract will be a user of cash, and at other times, particularly at the end of a profitable contract, it will be a provider of cash. The company's ability to supply cash is determined by the combined cash flow position of all of its projects at any point in time.

CASH FLOW PROCESS

The preparation of a cash flow projection for a contractor involves three phases. First, job operating schedules must be prepared for each contract. Following the job operating schedules, cash flow projections for all current and expected contracts should be prepared. And, finally, a company-wide cash flow projection, which summarizes the cash flows for all jobs, should be developed.

A job operating schedule is a month-by-month analysis of anticipated contract production, progress billings and revenue recognition for each contract. The schedule is developed from the estimating department's construction schedule which was created when the contract was originally estimated and bid. The job operating schedule highlights the timing of labor, subcontracts, materials and equipment which will be used on the contract.

Once the job operating schedule is prepared, the job cash flow projection can be completed. This projection indicates when the costs incurred are expected to be paid and when the progress billings are expected to be collected. Company payment policies, as well as past history with customers, will be a factor in developing these projections.

A job operating schedule and job cash flow projection must be prepared for every contact on which the company expects to expend resources or collect funds during the planning period. This includes current contracts, anticipated work and closed contracts with remaining receivable balances. In addition, these schedules should be updated monthly in order to reflect changes in contract pricing, costs or timing.

The company-wide, or summary, cash flow projection incorporates the net cash flows from all job cash flow projections, along with anticipated indirect, selling, general and administrative, and financing costs for the company. This projection, normally prepared for a period covering one year should be updated monthly and compared to actual cash receipts and disbursements.

PUTTING THE NFORMATION TO USE

The company's cash flow projection will indicate, on a month-by-month basis, whether it has a net cash inflow or outflow. In turn, management will be able to determine if the company has the financial resources and lines of credit available to properly handle the anticipated volume of work. If a shortage of cash is anticipated, the company can demonstrate to its creditors why and when an increased line of credit may be necessary, and how and when the company will be able to repay any draws on the line. By providing this information on a proactive basis, "surprise" last minute requests for an increased line of credit will be eliminated and creditors will be better able to understand and appreciate the cyclical nature of the company's projects and business cycle. Sureties, also, will be interested in receiving this type of information in order to establish the contractor's bonding capacity.

CONCLUSION

Cash flow projections can be very revealing to contractors. A company's most profitable period may also be the period of greatest cash flow needs from outside sources. If the company is unaware of this, and therefore, has not planned to obtain additional credit, trouble could lie ahead. It makes sense to forecast cash flow.

-by Timothy J. Tremel, CPA Affiliate Member IGAF

CLAIMS AND CHANGE ORDERS... PASSING THE GAAP TEST

Your company is having a profitable year with fifteen jobs in progress, four in backlog and you're bidding a potentially lucrative job. You will need additional financing to run this job. Your bank will undoubtedly want to see recent financial statements demonstrating the performance of your company. Additionally, they will most likely request the statements be reviewed or audited by an independent CPA.

Contract accounting is unique with regard to accounting for long term contracts where substantial estimation is used in recognizing and recording revenue. Additionally, contracts rarely are completed and billed pursuant to the original contract specifications. Common deviations from the original contract include claims and change orders.

How are these changes from the original contract accounted so that your financial statements pass the "GAAP" test?

Generally accepted accounting principles (GAAP) give guidance under the AICPA Statement of Position (SOP) 81-1 relating to these issues.

Claims
In the case of a claim (an amount in excess of the agreed contract price), the contractor seeks to collect from customers or others for customer-caused delays, errors in specifications or designs, unapproved change orders, or other causes of unanticipated costs.
Under SOP 81-1, a claim is only recognized if it is probable it will result in additional contract revenues, and the amount to be collected can be reliably estimated.

If your claim meets the following conditions, it passes the probable collection and reliably estimated tests-

1. The contract or other evidence provides a legal basis for the claim; or a legal opinion has been obtained, stating that under the circumstances there is reasonable basis to support the claim.

2. The additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractor's performance.

3. Costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed.

4. The evidence supporting the claim is objective and verifiable, not based on management's "feel" for the situation or on unsupported representations.

If the above conditions are met then claim revenue may be recognized, but only to extent of the contract costs incurred. Thus, no profit is recognized on ongoing claims.

Change orders
A change order is a modification of an original contract that effectively changes the provisions of the contract without adding new provisions. Change orders include changes in specifications or design, method or manner of performance, facilities, equipment, materials, site, and period for completion of work.

When both the contractor and owner agree on the contractor adjustment in scope and price, contract revenues and costs should be adjusted to reflect such approved change orders.
Costs relating to unpriced change orders should be treated as costs of contract performance in the period in which the costs are incurred if it is not probable that the costs will be recovered through a change in the contract price.

If cost recovery is probable, then the costs should either be 1) deferred (excluded from the cost of contract performance) until the parties have agreed on the change in contract price, or 2) treated as costs of contract performance in the period incurred AND revenue recognized to the extent of the costs incurred. However, to recognize revenue on unapproved change orders in EXCESS of costs incurred (i.e., recognize profit on the unapproved change order), the adjustment to the contract price needs to be probable and reliably estimated.
In the case that change orders are in dispute or are unapproved in both scope and price, then they should be evaluated as claims.

Contract accounting typically relies heavily on accurate estimates and becomes more complicated with any departure from the original contract. A solid understanding of the accounting for claims and change orders is essential when managing your earnings.

EXECUTIVE SUMMARY

Recognition of claims is rare due to the difficulty in evaluating collectibility.
Revenue and costs should reflect approved change orders.
If cost recovery on unpriced orders is probable, then costs are deferred until the contract price is adjusted OR expensed in the current period and revenue is recognized, but only to the extent of costs incurred.
Revenue may be recognized in excess of costs on unapproved change orders but ONLY when realization is assured beyond a reasonable doubt.