Can increasing expenses also increase your net income? Can profitable jobs bankrupt a company? Today, we are exploring more unconventional wisdom in construction that you may not have ever considered.
Topics we cover in this episode include:
- How adding expenses helps your bottom line
- How a profitable job could bankrupt your company
- Why an LLC is not always the right choice for setting up a construction company
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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com
[00:00:00] Wade Carpenter: Can increasing expenses also increase your net income? Can profitable jobs bankrupt a company? Today, we are exploring more unconventional wisdom in construction that you may not have ever considered. Come on in. Let’s talk about it.
This is the Contractor Success Forum. If you’re new here, I’m Wade Carpenter with Carpenter & Company CPAs. With me is my co host Stephen Brown with McDaniel Whitley Bonding and Insurance.
Stephen, I enjoyed doing this topic a few episodes ago and thought about some bigger questions that defy logic. I felt it was thought provoking and, any additional thoughts on it?
[00:00:38] Stephen Brown: It is, Wade. I mean, I’m excited about this topic. All right, you say to yourself, how do adding expenses increase my net income? That makes no sense, and yet it does make so much sense. Here’s the thing, and your topic is just right dead on, Wade, is construction accounting is different from regular accounting. And if you don’t understand it, you need a good construction oriented CPA.
Of course, I preach that all the time and it kind of embarrasses you because you think it’s shameless plugs for you, but it’s true. And in this situation, you had some topics that really seem unconventional to normal logic, but are very logical for contractors. So what’s the first topic you were going to tell us about?
Adding expenses helps your bottom line
[00:01:24] Wade Carpenter: Well, if it’s okay, I’d like to address what I just said. Adding expenses helps your bottom line. How does that increase your–
[00:01:31] Stephen Brown: Okay, so are we talking about something you do at the end of the year or all year long?
[00:01:37] Wade Carpenter: Well, just to give you a scenario, say we’re at the end of the year and we’re trying to look at our income and, I used to do a lot of construction audits, and they would try to hide payables because they think, well, hey, that’s going to make my financial statement look worse. Think about it, if you take an accounts payable, yes, you’re going to increase your expenses, but if those expenses are on a profitable job, that is going to bump up your percent complete, if you’re on a percent complete financial statement. Which is what you should be giving GAAP financial statements to Stephen for bonding, to your banker, even though a lot of times they only pay attention to your tax basis. But If you are looking to dress up your financial statements, don’t try to hide those accounts payable.
And we may need to walk through the mechanics of that for that to make sense, but does that make sense to you, Stephen?
[00:02:28] Stephen Brown: Makes sense. So tell us a little bit about more what you need to do there.
[00:02:32] Wade Carpenter: So let’s just explain the mechanics of it. So if you’ve got a job and we are doing percentage of completion accounting, and let’s just say, I don’t know, easy math, you’re going to do a half a million dollars in costs. And you’ve got $100,000 at the end of the year
in costs on it. So you would be 20 percent complete. Well, just again for easy math, let’s just say you had $100,000 of accounts payable. You ‘ve got invoices from your subcontractors or suppliers for another hundred, but you don’t want to put those in because that’s going to make your bottom line look worse, right?
But, say you add that $100,000 to your accounts payable on the one side, it’s going to bump up that percentage completion from 100,000 divided by 500,000 of total cost to 200,000 divided by 500, 000.
So that’s going from 20 percent complete to 40 percent complete. And again, I like my easy math here, so let’s just say it’s a million dollar contract. So whether you’ve billed anything or not, what the percentage completion calculation It says that how much have you actually completed this job?
So let’s just say we’re 20 percent complete on that job. That’s a million dollars. In the first scenario, you would only recognize 200,000 of revenue. If you had those payables in there, if they were properly dated before December 31st, and you bump it up to 400,000, you’re 40 percent complete. You’re going to recognize another 200,000 or 400,000 in total of revenue. And we can walk through the mechanics of the over and under billings.
Am I losing anybody so far?
[00:04:11] Stephen Brown: I think what you’re saying makes sense. Basically what you’re doing, and from my perspective, just look how that affects the Work in Progress report at that year end, that you’re adding those extra costs and you have less costs to complete. So you worked your program down even more from bonding purposes.
But I’ve always been fascinated with percentage of completion accounting and how construction CPAs decide to post this or not post this at different. Like, let’s not close this job out. It’s 99 percent complete. Let’s take it into next year. These sort of questions.
[00:04:48] Wade Carpenter: Well, that’s definitely a different–
[00:04:49] Stephen Brown: It’s a different topic, but.
[00:04:51] Wade Carpenter: That’s a very different topic too, but we can probably go along on that. And I’d like to continue with the example in just a minute, but this truly is one of those things that, as I was thinking about the previous episode we did, this is truly unique to construction.
Like a manufacturer, you add costs to a manufacturer, that’s just usually going to go in inventory. It’s not put in place. I can’t think of another industry where this even possibly makes sense.
So, continuing the example we had, so let’s just say instead of 100,000, let’s say we had billed 150,000 on that job, and we hadn’t put those payables in there, so we’re only 20 percent complete. So we would have $100,000 of revenue earned. So we would actually be overbilled by $50,000 on that. So we’re going to make an adjustment On the balance sheet, as well as the P& L is going to go down, the profit is going to go down by $50,000.
In the case of we add that $100,000 of extra payables that were billed, but we didn’t put in our books, now we’re 40 percent complete or $400,000 earned. Now for that $150,000 we’ve billed, we’ve actually got $250,000 of revenue that’s been earned. So we’re going to book a underbilling of $250,000 and we’ve still got the receivable, but the bottom line for your profit will jump $250,000.
[00:06:24] Stephen Brown: Because an underbilling is an asset and overbilling is a liability. I got you, Wade.
[00:06:29] Wade Carpenter: So, again, I don’t know of any other industry that, that is true for. And as I used to do these audits, or a review and you find some invoices that weren’t in there and then you start talking to the contractor and it’s like, well, I didn’t want to hurt my bottom line, and we didn’t pay it by the end of the year. As long as it’s on a profitable job, then you’re going to increase your bottom line.
[00:06:52] Stephen Brown: Okay.
[00:06:53] Wade Carpenter: And usually that doesn’t hurt you unless you’re a larger contractor. And the rules with the Tax Cuts and Jobs Act, for tax purposes, is now pushing about 30 million a year for average gross receipts before you get forced to be put on percent complete for tax purposes.
You may be on cash or accrual basis for tax purposes, but most of the time, you’re going to be pumping up your financial statement, but not hurting your tax picture. So that is, in a nutshell, one thing that I’ve struggled to explain to people over the years, and that probably should have been the first one when we did the other episode with unconventional wisdom.
[00:07:33] Stephen Brown: Yeah. Well, I, I agree. It’s important. And just like my comment to you was, it’s fascinating to me the adjustments that contractors and CPAs make at the year end.
You’re right. That’s really not the main topic we’re addressing now. We’re addressing the logical part of the construction industry based on the accounting rules, Generally Accepted Accounting rules for contracting.
I wonder, Wade, why even those rules were written for contractors so differently way back when, and when they were written?
[00:08:07] Wade Carpenter: Just talking about the percentage of completion in particular, and not all of the topics are around accounting rules. It’s more of like, what doesn’t fit common logic in business? And the idea behind the percentage completion is just simply that, hey, you could bill more or less and adjust your profit. But is that really a true picture of how you’re doing on your job?
And anybody that’s running on cash basis, you can have a whole bunch of money come in one month and pay out a whole bunch of money go out the next month. So if you did that in December, you could drastically misstate where you are.
So, do you want to maybe try a couple more of these? Thoughts or any other thoughts on that?
[00:08:52] Stephen Brown: No, I think I understand that. I hope our listeners do. And again, you can always reach out to Wade for questions on this topic if you like.
[00:09:01] Wade Carpenter: The next one I’d like your input too, because you may probably have a different perspective.
How can a profitable job bankrupt a company?
[00:09:06] Wade Carpenter: But the second question that I’ve got is how can a profitable job bankrupt a company? So when I say that, what does that mean to you? Do you have any thoughts on that?
[00:09:16] Stephen Brown: Well, I mean, my first reaction is, is you estimate the job and you build profit in it, and then there’s things that you didn’t see that come up to take that profit away. That’s my initial reaction. So what do you mean by that?
[00:09:30] Wade Carpenter: I’ve probably used this on the podcast somewhere over the last two and a half years, but one of the most vivid examples I remember was right at 2008, 9, 10. I had a whole lot of heavy equipment guys, And 2008, took a lot of those out of the picture, but there was one contractor in particular that got a 20 million grading job, very close within about two miles of me right now, for a huge Walmart development.
So it was a 20 million grading job that he was going to be, doing, and it was going to take a full three years to complete it. And he’s like, okay, I got 8 percent in this job profit. I bid it at 8%. Okay. And so that’s 20 million. What is that? 1. 6 million profit. When everybody else in the industry was struggling to find work.
He made a lot of other mistakes because of his misconception here. What he did was, hey, I’ve got this great job. And he forgot the fact that he’s got a 10 percent retainage clause. So he’s got 10 percent retainage and this 20 million job was way bigger than any of them he had done before, even though, in aggregate, he’d done a lot more, but he’s put all his eggs in this one basket.
All the cashflow comes in normally, 90 percent of the money, but he’s only making 8 percent on that. So he’s negative–
[00:10:59] Stephen Brown: 2%?
[00:11:00] Wade Carpenter: 2%.
[00:11:00] Stephen Brown: Even if he bid it perfectly, yeah.
[00:11:03] Wade Carpenter: And again, he didn’t realize that having this very profitable job, he was going to need to cashflow it somehow. And so he was actually in the negative on the cashflow, just on the job.
He wasn’t even covering his overhead. And this guy, at the time he was doing 50 to 60 million a year, and he had all this heavy yellow iron, he had notes on, $100,000 is easy on an excavator or a bulldozer.
And within like six to eight months, he was out of cash and scraping the bottom of the barrel. And unfortunately, he lost everything. And again, that’s one of the most vivid examples I can tell you about how a very profitable job bankrupted one company.
So with that explanation, I’m sure you’ve got some stories along those kind of lines.
[00:11:51] Stephen Brown: Absolutely, Wade, one after another. And the retainage and your understanding of how that affects not only your cash flow, but the profit that you need to take out of the company is huge.
You hear so many contractors, Wade, say, well, that retainage is just like a bonus for me at the end of the project. That’s what they say. But from an accounting standpoint, it’s a different animal, especially like you said, this contractor of yours, had a lot of equipment debt and everything just snowballed as the job got started. And, that’s a great point, Wade.
[00:12:26] Wade Carpenter: Well, again, he forgot, the job cost is 92%. And then he’s not getting 10 percent of it. But he’s also forgetting, he had probably about two and a half million dollars of overhead to cover every year. He wasn’t covering any of the overhead with it.
[00:12:41] Stephen Brown: Ooh, he did not include the overhead in his estimate.
[00:12:45] Wade Carpenter: Right. He did, but he’s like, Hey, I’m getting 1. 6 million in profit. Well, if you got the cash flow to do it, that makes sense, and that would have covered his overhead had the cash come in like it normally would, but retainage took that out.
[00:13:00] Stephen Brown: I gotcha.
[00:13:01] Wade Carpenter: That’s something that I see all the time right now is the difference between markup and margin. Thinking, hey how much should I mark this up? And how much should my overhead factor be?
And I don’t think we need to dive into the details of that today, but I have had a lot of conversations in the last two months doing tax planning, and this is something that typically contractors need to be doing here at the end of the year or start of a new year.
That overhead rate is not the same from year to year. There’s no such thing as an industry standard because–
[00:13:34] Stephen Brown: You can throw that out the window.
[00:13:35] Wade Carpenter: –you have. Yeah, exactly.
[00:13:37] Stephen Brown: I really liked your point about this dirt project for this super Walmart. It’s just the whole logic of saying, okay, if I’m a concrete contractor, my costs are directly tied to the price of concrete. What I can get that concrete for. And it’s a long term project, I don’t know if that’s going to change.
But as a grading contractor, my ability to get all that dirt moved depends on all the equipment that I have. The fuel cost, the cost of the equipment, the cost to have qualified operators involved, and you think to yourself, I’m going to make even more profit because I own X amount of equipment outright.
But, just like you said, you know, you depreciate something in order to account for the ability to replace it. And I bet your contractor really hadn’t given that any thought either when things started spiraling out of control for him.
[00:14:29] Wade Carpenter: Well, that as well as, another common topic we talk about all the time is his job costing. Even though he had one of the really expensive packages, he had a full accounting department, it was a mess and he never set it up right.
And unfortunately he had a bunch of land and everything. The bank foreclosed on all of it. The bonding company had to come in. it was not a great situation.
And, sometimes from these vivid examples, there’s a lot of other examples that they happen every day and contractors are not realizing we are not marking our stuff up enough. We can’t afford to do this job sometimes.
[00:15:07] Stephen Brown: Hmm.
[00:15:07] Wade Carpenter: We are using a factor. I think I used this last time we did this, but, say, a standard foot price for a pipe when you got conditions that are, if it’s super easy to get to that pipe versus, really tough. And you gotta go jump through hoops or like a pipeline contractor going through rock.
[00:15:28] Stephen Brown: Oh, yeah.
[00:15:28] Wade Carpenter: There’s all kinds of examples.
[00:15:30] Stephen Brown: Whose fault is that? Then you go back and look at the contract and it said that you’re responsible for being comfortable with the conditions of where you’re working. So it’s your fault that you ran into rock, not ours. I’ve seen that in contracts before.
And then my first reaction when you said they did the job for Walmart, was that they signed a egregiously unilateral based contract written by Walmart attorneys.
[00:15:55] Wade Carpenter: Yeah. And that’s, that is–
[00:15:57] Stephen Brown: And even if it was–
[00:15:58] Wade Carpenter: There was a lot of issues.
[00:15:59] Stephen Brown: –construction managers, so much of their language is tied into what their agreement with Walmart says, and you don’t even know what that is. You agree to liquidated damages, you don’t even know what you’re agreeing to because it’s in the Walmart contract. And then you say, I want to copy that Walmart contract. Ah no, we don’t do that.
[00:16:16] Wade Carpenter: Well, again, there was so–
[00:16:18] Stephen Brown: Well, that is a wonderful topic. All right. Do we have time for one more or do we need to move this on to another…
[00:16:23] Wade Carpenter: Let’s see if we can do one more. And this is sort of changing gears a little bit, but.
An LLC is not always the right choice for setting up a construction company
[00:16:28] Wade Carpenter: One of the questions I see: why is an LLC not always the right choice for setting up a construction company?
[00:16:38] Stephen Brown: I want to ask you that exact question.
When you set up your company, you usually get advice from your CPA, or your lawyer, but what do the different entities mean? Am I going to be incorporated? Am I going to be an LLC? Am I going to be Subchapter S? Am I going to be a Partnership? Am I going to be a Sole Proprietorship?
So, again, Wade, I’m going to ask you the question that you just asked.
[00:17:04] Wade Carpenter: Okay, well, the reason I bring that up is because everybody assumes that they should be an LLC. And here in Georgia, I can say in particular, they’ve made it super simple for anybody to go to the Secretary of State and form one.
[00:17:20] Stephen Brown: Mm hmm.
[00:17:21] Wade Carpenter: And now it’s just assumed that’s what you’re going to do. But as these things were coming into play, I go back as far as before these things, I know you do too, but before there was even such thing as LLCs. But, there is a difference from a tax standpoint, as well as sometimes a liability standpoint, and the common answer– and not to knock attorneys, we just had Alex Barthet, good friend, attorney, and I’m not saying that this is not really his practice area.
But any attorney generally would say an LLC, you can pretty much do what you need to do. You can change it into anything you want to. But a lot of people do not understand, number one, the implications of that. If you’re a one person shop and you form an LLC, then you are going to report that on your personal return as a Schedule C and be fully liable for self employment taxes. And I don’t want to go too deep into an example, but, you could be incurring about another 15 percent in self employment taxes, some of which you could have avoided with an S Corporation.
If you’ve got a partner, you’re going to have to file a partnership return. Again, I probably should have led with this. An LLC may be the right thing for you. But don’t assume it is. And don’t go doing anything based on what I’m telling you here, because I’m giving you really high level stuff, and it depends on facts and circumstances.
It can depend on the state you’re in. It can depend on the type of construction you’re doing. But there’s a lot of implications, and attorneys, a lot of times, they do not discuss this tax issue with them. They don’t understand the tax issue. And assume that the CPA is going to be filing the S Election. And a lot of times it’s too late to do an S Election.
But there are also times where a straight C Corporation can make sense. Again, if you got two partners, a lot of people don’t realize you got to do another return for that, but you’re also subject to self employment taxes on that.
So this is a loaded question I probably shouldn’t have tried to do in five minutes, but is there any particular aspect of that you want to–
[00:19:39] Stephen Brown: Well, the first thing that pops into my head is just the stress of not having understood that. Like you said, the attorneys aren’t really concerned about it. The bonding companies don’t really give it any thought, but it is a huge implication.
And understanding the protection that you get by the different entity that you choose to form, it’s huge to me as a risk manager handling insurance. You can lose all the assets of your company if you’re not insured properly. So that’s my perspective.
But in your perspective, my first reaction was well, okay. What if you did file the wrong corporation? Can you become another corporation? And then, of course, that gets into all the fact that, you know, you have to change all your contracts and licenses as well. So, those are just the things that were going through my head when you mentioned that.
[00:20:27] Wade Carpenter: Yeah, again, some states treat them different. One other thing that I was going to say, too, on the liability side, is an LLC that’s a sole proprietorship, if you treat it like it’s your extension of your personal self and any money in there is your money, then number one, you probably pierce that corporate veil, but you also, it doesn’t matter whether that LLC is in place, they can come after you personally in some cases.
[00:20:54] Stephen Brown: I think we should talk about that some more in another episode because there’s a lot of meat to that.
A funny story that I wanted to tell you real quick is when you mentioned you go back before LLCs, I do too. I guess it’s embarrassing. I don’t know, but it just tells you we’ve got a lot of years under our belt.
And so, Mike McDaniel, my partner here at McDaniel Whitley, we worked for my uncle in a construction agency. And they called us into the conference room to announce that they were making us assistant vice presidents. And my uncle’s partner had a really cheap bottle of champagne to celebrate and poured it in some Dixie Cups and then my uncle told us to get our asses back to work.
Well, Mike and I were walking away together and he goes, there’s no Executive Vice President position in an LLC. And I said, what? He goes, what he just promoted us to does not exist. So anyway, I knew you’d get a kick out of that. We laugh about it.
[00:21:48] Wade Carpenter: A good point.
Well, you can make up a title, but anyway, you’re good.
[00:21:52] Stephen Brown: was a hundred years ago. Anyway, Wade, great topic. Thank you.
[00:21:56] Wade Carpenter: Okay, again, these things, unconventional wisdom. There’s just a lot of things in construction that I’ve sort of enjoyed thinking about some of these questions, because it’s things that I explain all the time, but people just do not get, and they’re just not the same thing that you would tell a normal business sometimes.
[00:22:13] Stephen Brown: That makes a lot of sense, Wade. Thanks so much.
[00:22:16] Wade Carpenter: Okay. Let’s go ahead and wrap this one up. Again, don’t do anything based on what I said on the LLCs . Go get some advice. That’s the point. Please do that first.
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