Understanding and Analyzing Contractor Financial Statements Part I of II
Q: Are the costs in excess of billings always "billable" or are they subject to approval by the client?
A: Usually costs and profits are always billable in accordance with the underlying contract. Based on the underlying contract, the contractor estimates the amount of costs and profits at a specific point in time and measures that against the actual amount it has billed the client. But it is always possible that the client could object to a specific periodic billing if it felt the billing was in violation of contract specifications.
Unless we have information to the contrary, we assume all unbilled costs and profits are, indeed, billable.
There is also the issue of retention to keep in mind. The contract may allow for a certain amount, or percent of total billings, to be withheld from payment until the client has approved the work, assuming all work was properly billed.
Q: Do we generally prefer to see a net balance of over Billings or under Billings? In the first case they're getting working capital from the client, but on the other hand there appears to be less risk in execution or completion.
A: We generally like to see overbillings exceed under billings since such a situation favors contractor cash flow throughout the projects. You can argue that the risk of execution exists regardless of over-billing, which gets to the issue of assessing and understanding the contractor's general ability to perform work as agreed to on time and on budget.
Q: We’re currently underwriting the renewal of a LOC to a Contractor who, in 2019, adopted ASC Topic 606, Revenue from Contracts with Customers. Did this replace the percentage of completion method, do you know? The change resulted in a very modest negative adjustment to financials, so wondering if this is materially different?
A: From an analytical point of view, nothing changes. If a contractor chooses "over time", it uses percentage of completion. All the analysis we offer applies. The issue is really whether the contractor has implemented "over time" estimates properly, but that is not an issue the lender needs to address or can address.
If the contractor choses "point in time", that's the same as the completed contract method, i.e., recognize revenue only when the completed product is delivered to the client. In this instance the contractor's choice of a point in time may be an issue but, again, that's a matter outside the lender's area of concern and expertise.
Since the IRS requires use of the percentage of completion method for all contractors whose 3-year average equals or exceeds $10 million, the percentage of completion method seems entrenched. But it will be interesting to see if the application of the "over time" rules force larger contractors to move more jobs to completed contracts. Unless the IRS changes its requirements, we may see larger contractors keeping two sets of books - one based on percentage of completion and one based on completed contracts.
Course overview: Understanding and Analyzing Contractor Financial Statements Part I of II