Three Ways Every Contractor Can Think Like An Auditor

For this weeks Guest Post Friday here at Construction Law Musings, we welcome Shane Brown. Shane leads the construction services group at EKS&H CPA’s, serving private and public companies with a specialization in construction and auditing. Shane has extensive experience partnering with his contractor clients to understand their goals and provide financial expertise. Shane is a member of the AICPA, CFMA, AGC and ABC. EKS&H has been providing solutions for construction companies since 1978, with locations in Denver, Fort Collins and Boulder, Colorado.  Shane can be reached at 970-282-5405 or at sbrown@eksh.com. Follow Shane on Twitter at @constructorcpa and on LinkedIn at linkedin.com/in/shanebrowneksh.

Contractors go to great lengths to manage risks inherent in their business. Contractors are arguably among the best risk managers in the business world.

Service providers such as banks, bonding agents, sureties, attorneys and CPAs manage risks in providing services to contractors as well. One of the key risk management tools that service providers use is a financial statement audit conducted by an independent CPA.

Part of the auditor’s work includes an evaluation of a contractor’s financial strength. The bank and bonding companies use the auditor’s report to assess whether the company has the ability to operate through the next year or business cycle. An auditor’s ability to identify those risks is valuable insight that every contractor can benefit from.

Auditors know from experience what causes contractors to fail. Although an auditor is required to follow a long process, here are three key controls auditors look for that every contractor should be aware of as well.

1. Accurate Cost Estimates

Service providers typically have concerns about a contractor’s ability to estimate the costs to complete a project. In many cases, a contractor’s ability to do so is only as good as the project manager on the job. All too often, the only internal control over cost estimation is to terminate project managers after a significant job loss.

In today’s economy, contractors are being forced to accept projects outside their normal job scope, making it more difficult than ever to estimate cost. New clients, new contracts, new geographies and new disciplines will all affect cost estimation.

This leaves a risk gap for the contractor and the service providers to bridge.  In turn, auditors are left to analyze margin fade, confirmation of contract terms and status to determine if any cost issues exist.

To help mitigate these issues, a contractor should have strong controls to identify estimation problems and to assist the project manager. Controls to dial in costs are essential, especially when in unfamiliar territory.

A number of controls are available to contractors, including consistent monitoring by experienced senior project managers and oversight by senior operations and finance executives where risk is increased.  Whatever controls a contractor chooses to implement, cost estimation has become even more critical in our current economic situation. Missing the target could be catastrophic for some companies.

2. Contractual Risk Management

Contractor bankruptcies are often attributed to an unfortunate series of incidents. However, it is frequently a single, identifiable incident that led to the crash – the signing of a contract.

The current economic climate, besides leading contractors into new territories, has led to a willingness to sign contracts without properly addressing, mitigating or avoiding certain inherent risks. In today’s competitive environment, it is common for contractors to accept the terms as a requirement for being awarded the project.

If a contractor can estimate the cost, they will often sign a contract without hesitation. This worked well several years ago when contractors were working with the same clients and doing the same types of projects. Since contractors are finding work in new areas and working with much leaner margins, contract review should be a top priority.

In order to audit a contractor, the auditor must address the risk management controls surrounding the review and acceptance of the contract. All too often, these controls are lacking. Ideally, the contractor should implement controls that encourage a devil’s advocate approach to contract acceptance.

When it comes to contracts, contractors can take a lesson from the poker table. Doyle Brunson, the 10-time World Series of Poker champion, instructs his students to look for a reason to fold in order to avoid unnecessary risk. He notes that winning at the game of poker is not about the hands you win but about avoiding catastrophes. Contractors can benefit by having an independent review to ensure risks are identified and openly addressed.

Strong contract review programs require a review of the contract terms, contract type and estimator’s takeoffs. Independent reviews should also include a “What if?” or “Why not?” perspective. These programs often include an independent external review by a bonding agent or surety as well.

Auditors understand that many estimates and contracts must be prepared and accepted under fire drill conditions.  Auditors simply look at a contractor’s resources to identify when acceptance of a contract is not appropriate and perhaps reckless under the conditions.

Contracts in a new industry, with a new owner, in a new location, requiring new expertise or a new delivery method are examples of situations where more stringent contract reviews are critical. When a contractor is in a situation with a great deal of experience, the same skeptical approach may not be required.

3. Budgeting and Forecasting

When it comes to budgeting and forecasting, contractors have a significant advantage over many other types of businesses. Contractors have the ability to forecast income based on contract terms. Subsequently, contractors can ensure that budgeted expenses and overhead are adjusted to achieve appropriate income.

Unfortunately, many contractors do not take full advantage of this benefit. Some contractors operate like companies that have revenues tied to historical results.  Historical results produce expenses that are included in future budgets by default. Once an expense is there, it never seems to go away.

The problem is, when known contracted revenues are less than expense structures, contractors are literally driving toward a brick wall that could be avoided. A mechanism should be in place that allows for the adjustment of variable costs with changes in volume.

The recent economic downturn has made the gap between contract revenues and historic expense structures widen. Many construction companies have experienced a 20 percent to 50 percent decrease in volume. This downturn comes after 10 to 15 years of steady growth, leaving many companies without a highly flexible expense structure. It’s no wonder many contractors feel entrenched in their budgets and struggle with cutting costs.

This year we had a client facing a 25 percent decrease in revenue. They had not produced revenues that low since 2001 and were unsure how to react. We lined up their 2010 budget next to their budget from 2001. The easiest cost cuts quickly became evident. We were able to see where costs had significantly increased in the past several years and how to scale back to 2001 levels.

Take the current year’s estimated revenue and compare it with the most recent year with similar revenue. Review the overhead expenses side-by-side. In most situations, opportunities for cost cuts will stand out.

Next, maintain a schedule of contracts that includes revenue, expense and cash forecasts on a monthly basis.  These forecasts will identify obvious shortfalls in income and cash flow in advance, allowing you to make adjustments before critical damage is done.

Take a close look at what’s coming in, what’s going out and ask yourself, “Am I okay with that?”

Other Concerns

While cost estimation, contracts and forecasting represent three major risk areas for auditors, it is by no means an exhaustive list. Auditors are required to cover a long list of items. However, these areas are high-level risk factors for auditors because of their ability to capsize companies. Contractors will find a great benefit in examining their own businesses with the perspective of an auditor in these areas.

Finally, some of the best risk managers in construction actively seek out the best industry experts to be their advisers. Advisers who ask good questions, even difficult questions are critical. Be wary of no-questions-asked or low-cost providers. Risk rarely goes away, it is simply distributed.  The key is to distribute it to those who are most able to manage it.

Shane and I welcome your comments below.  Also, please subscribe to keep up with this and other Guest Post Friday Musings.