The key components of a good construction financial statement

Your financial statements not only communicate the health of your company to your bonding agent, but they also give you a clear understanding of where you stand. This week, find out the basics of what should be included in those financial statements.

Topics we cover in this episode include:

• The key components of a good construction financial statement
• Levels of financial statements
• What your bonding agent looks for in your financial statements
• Supplementary Reports
• Cash flow statement
• Five minute bond underwriting
• Notes in the financial statement

LINKS

Watch the video version of this episode on YouTube.

Join the conversation on our LinkedIn page: https://www.linkedin.com/company/carpentercpas/

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | McWins.com

TRANSCRIPT

[00:00:00] Wade Carpenter: Welcome to the Contractor Success Forum. Today we are talking about the key components of a good construction financial statement that you should have before you send it to your bond agent.

Here on the Contractor Success Forum, our mission is to provide game-changing financial education for contractors to help you be more profitable, grow, and succeed in your business.

And who is here to help us? As usual, we have Stephen Brown with McDaniel Whitley Bonding and Insurance Agency. And I’m Wade Carpenter with Carpenter and Company CPAs. So Stephen, this is a topic you suggested. What did you wanna discuss on financial statements today?

[00:00:42] Stephen Brown: The key components of one.

[00:00:45] Wade Carpenter: Okay.

[00:00:45] Stephen Brown: Here’s the thing, a lot of contractors are good at building stuff, but they’re not good accountants. I mean, a lot of bond agents too are not good accountants. We’re not supposed to be accountants. You’re supposed to be the expert. And as I was telling you, I’ve learned most everything I know about accounting from construction CPAs who’ve been patient enough to explain things to me. And also, I used to be a bond underwriter and we were trained in analyzing financial statements. But it’s your job to put those key components in for us to study, to make a decision on whether to bond you or not.

The key components of a good construction financial statement

[00:01:19] Stephen Brown: So the very first thing that we were taught is you look at the financial statement that you receive, and these are usually year end financial statements. It’s the cornerstone of the whole next year’s worth of your work is your year end financial statement and your ability to get fairly accurate in-house interim statements every quarter, that you need your CPA to help you do almost always.

So here’s the thing. We were taught get your financial statement. It’s a neat stack of papers, stack it up. There’s a cover letter with the name of the CPA firm on. You flip it over, and there’s a letter that tells you whether it’s a compilation, a review, or an audit. And I wanted to ask you to explain those components in a little bit.

And then the next item that we would look for is a table of contents, just to make sure there weren’t pages missing. And believe it or not, there are, some contractors have certain pages in their financial statement that they don’t want you to know about, and they’ll just leave that page out. Well, that’s what they taught us to do. Look for the table of contents.

Then we start off with balance sheet, income statement, cash flow statement, then some other type of statements and some notes, and then work in progress showing completed projects done in the prior year and jobs in progress. Work on hand, WIP. Jobs in progress. And that’s a beautiful construction, financial statement to me, Wade.

[00:02:56] Wade Carpenter: Okay. Well, I mean, you just kinda went down the whole thing. But there, there are definitely some key components. I think we should probably talk about.

[00:03:04] Stephen Brown: Of those key components, why are they important? What do they tell you as an accountant to help educate your contractor about running their business? And also, we should take just a second, explain the difference between a compilation, a review, and an audit.

Levels of financial statements

[00:03:20] Wade Carpenter: Okay. Well, I know we did another episode. I don’t know what episode number it was, but we explained the differences in the levels. But essentially there is actually a fourth level now that a lot of people don’t even know about, the preparation level.

But let’s start at the top. The audit level is what everybody thinks about. And essentially that’s a lot of work to basically tie down the numbers and basically ensure that they’re not materially misstated, that’s all. We’re not guaranteeing there’s no errors in there or there’s, But what we’re trying to do is making sure that there’s no major errors in the whole thing.

[00:03:59] Stephen Brown: So what do you do with contractor inventory? I know that’s a big deal for audits.

[00:04:05] Wade Carpenter: Well, if they have inventory, yes. There’s a lot of things with. Contractors, if you’re on percentage and completion, you’ve got a lot of estimates. And, inevitably, wherever you estimated a job in the middle of the year or at the end of the year, things are gonna change. And so, it’s it’s, again we’re trying to establish that things are not materially different– and there are obviously things that are gonna go wrong sometimes on a job.

But that’s the goal is to say, for the most part, nothing’s out of place. A CPA is the only one that can issue an audit. A CPA is the only one that can issue any of these reports: the review, the compilation or the preparation. I have seen some bookkeeping firms or non CPAs put these reports on there, but they don’t mean anything. And unfortunately, according to our rules, they ethically can’t put that stuff on there. They can’t state that they’re a CPA and essentially we’re giving our opinion on whether these statements are materially correct.

[00:05:08] Stephen Brown: Well, that’s what the bonding company’s relying on. Someone beside them to verify some things. We were always taught that, you know, a review just basically verified cash and a few things. And I know it, it does more, and that we always thought the audit meant every item that was on that statement was verified to some degree of compliance. Which no one understood the rules of the AICPA on, on what those were.

And then the compilation was just nothing more than just taking the information off the contractor’s computer and printing it up, but not verifying anything. So, compilations were not considered worthy to getting bonds.

[00:05:53] Wade Carpenter: The review, there are some procedures on there and then a lot of what we’re doing is, yes, we should be looking at every one of them and every account and making sure that they’re not materially misstated. It’s still the goal, but we’re gonna do some analytical procedures and say, you know, hey, does this look out our line? We look at ratios and things like that to, to give a little more assurance that things are not outta line.

The compilation report, as you stated, there are some CPAs that will just slap a compilation and essentially the report really does say we’re essentially, we’re not aware of anything that would make it differ from GAAP, but there are some people that just say, yes, we’re gonna take it and put it on the on there and just stick this report on there.

[00:06:40] Stephen Brown: With a full disclaimer that, that they’re not verifying anything.

[00:06:45] Wade Carpenter: Well, I guess there are different approaches to that. We don’t take that approach in here.

[00:06:51] Stephen Brown: Of course not, but I mean, there are a lot of those out there.

[00:06:55] Wade Carpenter: Yeah. But the fourth level that came in, I think around 2016 or so was basically, one of the problems that CPAs had is we could not put out a financial statement without putting a report on it.

So, for a bookkeeping firm or somebody else, they didn’t have all these extra costs and all these extra rules to stick financial statements out there. So they kinda made this preparation level to where we can go out there and say, we can either write a report or there’s actually headers and footers we can put on the statements itself and not put a report.

But essentially it’s saying we’re, again, we’re not doing any procedures at all to say it’s in accordance with GAAP or. It could be in accordance with your income tax basis or whatever, but I mean, in a nutshell, that’s the major report differences. And I think we could probably refer some people to that other episode if you want to get in more detail on some of those.

[00:07:55] Stephen Brown: Sure. It’s important because, okay, key components of a financial statement. For a bonding agent, the key component is that it’s a review caliber or better audit, financial statement. That’s the most important thing to us. It’s the main piece of equipment, the tool that we need to do our job for you.

But also more importantly, just from what your bond agent thinks or your banker might think or someone else. What do you think, as the owner of the construction company? What kind of information is that statement telling you and how do you use that as a basis for the upcoming year?

What your bonding agent looks for in your financial statements

[00:08:32] Wade Carpenter: Right. Well, I mean, I guess I, I want to talk about some of the things that I would look for.

Uh, And I do, I do hate to say it, but I, I know Bond agents have told me the same thing, that you can pick up a financial statement and say, does this guy know what he’s doing or not? or.

[00:08:48] Stephen Brown: All right.

[00:08:49] Wade Carpenter: And so, if you’re number one, if you’re a contractor and you’re doing longer term contracts, you should be on percentage of completion basis. That’s GAAP. And so if you look on your balance sheet and you don’t see over or under billings or costs in excess of estimated earnings on uncompleted contracts if you want the– or the billings in excess, you know, that’s for your–

[00:09:14] Stephen Brown: On a cash or com– you know, complete contract. I mean that, that doesn’t do you any good for bonds, Wade.

[00:09:21] Wade Carpenter: Right. So that’s one of the things I would look for on a balance sheet. Yeah, I’m just gonna hit some high notes, but I, I kind of wanted to spend some time talking about some of the contract schedules and that kind of stuff.

[00:09:32] Stephen Brown: Okay.

[00:09:32] Wade Carpenter: The way we do an income statement is we do a summary financial statement in the front, and then we do some detail schedules. We’re breaking down the job costs and the SG&A or the overhead expenses in the back. And, what I believe is your cost of revenues on your P&L should be reflecting what’s in the that statement in the back, as well as should tie to your completed and incomplete contract.

Supplementary Reports

[00:10:03] Wade Carpenter: So, the way we work it is, we do the main components of the financial statements, the balance sheet, income statement cash flow statement, and then the notes. And then we will actually do a supplementary report. And I’ve had conversations with my peer reviewer about this, but it is, I mean, and we, if we get into it, I can explain why we do it because sometimes, say a contractor needs to turn in like their financial statements to a supplier or an owner or something like that, but they don’t want them to see the contracts and how they’re coming out on those kind of things.

So, we have it where we can do a short form and long form. But I guess I’m getting off the topic here, but.

[00:10:44] Stephen Brown: No, I mean, I, I wanna know, when you said my peer reviewer, what did you mean by that? Who is it?

[00:10:50] Wade Carpenter: So. As a CPA, if you’re issuing any kind of financial statements above the preparation level, we have to get peer review. People come in and look at our work to be sure that we are following our rules. So that can give you and a banker and anybody else using those financial statements assurance that we’re doing the job we’re supposed to be doing.

So that’s essentially the reason we do it.

[00:11:17] Stephen Brown: Okay.

[00:11:17] Wade Carpenter: But again we probably do a little different from a lot of CPA firms and that we put that additional report on there and all the stuff that is behind that with the contract schedules and the, we do things like a retainage receivable schedule that bonding companies wanna see. They really are not required parts of the financial statement.

And I believe that, if you’re getting bonded, you need to get some of these things in there.

[00:11:45] Stephen Brown: That’s right.

[00:11:46] Wade Carpenter: But you know, behind this supplemental report is, a reconciliation of number one the income statement, the contracts, a summary of the contracts from the completed contract schedule and the completed contracts in progress schedule. Right behind that is a completed contract schedule and a contracts in progress schedule.

You know, the completed contract should be reporting the costs and the revenues that were earned on those jobs, as well as, I believe something that’s not disclosed a lot is the type of job.

I mean, you may have some that are fixed priced. You may have some that are. Cost plus or time of materials or whatever, but, depending on who’s reading that statement– and a bond underwriter, I mean, they may look at a job a little differently if it were a fixed price type job versus and materials, I mean.

[00:12:41] Stephen Brown: Well, a good bond agent’s gonna go back to that CPA and have a relationship with that CPA to clarify some things before the questions start coming up from the underwriter. And as always, just us talking today, I’ve learned things I didn’t know before, so you know, thank you for that.

Current assets and liabilities

[00:12:58] Stephen Brown: But when we were talking about the components, Balance sheet, which shows your assets and your liabilities. A bonding company’s looking at current assets and subtracting it from current liabilities and getting working capital. That’s a key underwriting component to a bonding company. And then they have their own things that they move above or be below the line is the term that they take out of your current assets and they don’t give you credit for but current assets or anything liquid, and current liabilities are anything that you owe within the next 12 months.

Is that right?

[00:13:36] Wade Carpenter: Well, current assets are assets that could be turned into cash within 12 months, essentially.

That’s, that’s really The–

definition.

[00:13:44] Stephen Brown: receivable, cash value life insurance.

[00:13:47] Wade Carpenter: But yeah, I mean, exactly what you’re talking about goes into the next statement, the contract statement is the contracts in progress, and that’s where we’re reporting an over or under billing on a percentage of completion basis. And that number should be tying right back to that balance sheet.

[00:14:04] Stephen Brown: So if you’re underbilled. Does that show up as a current asset or a current liability?

[00:14:09] Wade Carpenter: That’s a current asset. Essentially it says that, hey, we’ve only billed so much, but we’ve actually earned so much based on, say we’re actually 50% complete and we’ve only billed 45% of the job, then we’re gonna recognize revenue up to that point.

And Sometimes it can be the other way around. That’s where, bonding company wants to be sure that it’s not overbilled. We could be front-loading all the bills, not paying our costs, and, be, completely overbilled and it, you know that’s what we’re trying to avoid.

[00:14:44] Stephen Brown: You’re right. Too much overbilling, too much under billing are gonna throw up some red flags. Some of it may be healthy under certain circumstances, some of them may not be healthy. But their perception of what that is gonna depend on whether you get working capital credit for it. So that’s one thing.

And then,

[00:15:02] Wade Carpenter: reasonable?

Cash flow statements

[00:15:03] Stephen Brown: Yes. And then, we talked, we were talking about the income statement a while ago, and cash flow statements that are in there. What does that tell a contractor, Wade?

[00:15:13] Wade Carpenter: Well, essentially there’s two different types. There’s direct and indirect, and I won’t get into the differences, but there’s two ways we’re getting at, like what happened to the cash. We started the year with X amount of cash. We ended the year with X amount of cash.

So did some of it come from operations or did some of it come from financing? Loans or I mean, were we paying down debt, those kind of things. So essentially that’s what it does. The way we do a contractor financial statement, we do the direct and the indirect with facing pages. And essentially the direct and indirect differences are on the operating side of the business.

So, for one side it’s cash received from contracts and cash paid out to suppliers and employees, versus the other way is more like a balance sheet approach. Hey, we started with cash, but receivables went up. Cash retainage went up, so our cash went down. Payables went up, or so, so it’s just a two different ways of reconciling what happened to cash.

[00:16:15] Stephen Brown: Okay. Okay.

[00:16:16] Wade Carpenter: And it tells you, number one, are if you’re bleeding cash, or are you fumbling cash back in? Or where did the money go? Where did it come from? So.

[00:16:26] Stephen Brown: And again, that’s considered a key component. They’re in every good construction CPA, yearend financial statement.

[00:16:36] Wade Carpenter: Yeah.

[00:16:36] Stephen Brown: Even though we talked about income statement briefly, I probably went a little bit too fast in saying, you look at sales, then it shows your gross profit, and then it shows your net income or net lost.

[00:16:48] Wade Carpenter: Right.

Five minute bond underwriting

[00:16:49] Stephen Brown: You’ve heard this before, Wade, but in, in my business, we’ve got this five minute underwriting. First of all, is this a CPA that’s good and that we trust them, that the bonding companies trust, they have a good reputation. Number two, what degree is the statement prepared? Number three, what’s the working capital? Number four, did they make money or lose money?

And if they made a little bit of profit or a little bit of break even, then you look to see if there’s any backlog gross profit in there. And you look at the billings. Over and under Billings. But that’s five minute underwriting that we do. It’s scary, isn’t it?

But I mean, it’s just, it’s the driving, it’s the driving force.

[00:17:31] Wade Carpenter: Well, you’re jumping into several things I wanted to dive into.

Incomplete contract schedule

[00:17:36] Wade Carpenter: We had gotten to the completed contract schedule and I wanted to spend a few minutes on the incomplete because that is again where we’re basically saying are we over or under billed?

And the other part, what you were talking about, we were talking about what’s applied to job cost. GAAP specifies what’s supposed to be going into job costs, but I don’t want to name any names because I worked at a very large Atlanta firm that still, you know, on several of their contractors, they would do just direct costs only. Direct labor materials.

And there are several things that can be affected in that. But again, sticking with that in progress schedule, it tells you a lot of different things. And it should be telling you some things. Like on a in progress schedule, it should tell you estimated completion dates. It should also be telling you things like, is there stored materials on this job?

Because it should be affecting your over and under billings calculation. And a lot of firms do that wrong. They adjust it in their over under billings when it’s actually a component of cost. And I won’t get into that right now.

Um, There’s also an issue with, GAAP says, If you got a job in progress and we think we’re going to have a loss, we need to recognize that immediately. So we need to make adjustments on that schedule to go ahead and recognize the estimated loss as of that date.

So if If we’ve lost, on a percentage of completion basis, $50,000 and we expect it to be $75,000 total loss, we’re gonna recognize another 25,000.

[00:19:15] Stephen Brown: Okay.

[00:19:16] Wade Carpenter: Again, on that contracts in progress schedule is also one of the components of we’re looking at backlog. And so we’re looking at, the way a GAAP statement looks at backlog is we’re total contracts in progress, minus the revenues. I know a lot of bonding companies look at it like total contracts minus billed today. Right? Because that’s what’s burned off. Right?

[00:19:43] Stephen Brown: That’s right.

Notes in the financial statement

[00:19:44] Wade Carpenter: But one of the other things that we glossed over in the notes is that’s something else that should also be reflected in the notes to the financial statement.

[00:19:53] Stephen Brown: Okay.

[00:19:53] Wade Carpenter: The notes should be reflecting, here’s where our backlog is, and a reconciliation of that. But they should also be noting that we should have, say the statement is done in March or something like that. Any contracts that are signed up to that date, they should also be footnoted in the notes to it.

So people like Stephen, you know when you go to analyze these financial statements, you’re looking for a lot of things for backlog too. I mean, tell us how you use some of that stuff.

[00:20:24] Stephen Brown: Well, you can’t, and I’ve told you this before, but you can’t have enough notes in your statement to make a bond underwriter happy. Because remember, everything you’re commenting on is verifying something that you’ve been told or that you’ve observed. So having an extra set of eyes observing the same thing with the reputable construction CPA carries a lot of weight.

And when we were talking about notes, that is a nice thing on your statement and how you analyze and represent the backlog. And the bonding companies look for your backlog of gross profit. So in other words, bonding companies can tell whether you historically make money.

Or if you lose money on a certain job, they want to know why. Usually there’s some good reasons for it. And the old running joke is such bond s would say, just tell them it’s the weather. They can’t argue about that unless they have a farmer’s almanac. I mean, seriously, there’s a reason you lost money and bonding companies need to know what it is.

And for one thing is they wanna know if you’re robbing Peter to pay Paul on projects.

too. So, so, an even amount of profit, consistent amount of profit gives bonding companies a great deal of comfort. I mean, wouldn’t you be if you were underwriting a contractor and you saw that track record? And so the notes that you put in Wade are so powerful because the notes first of all say, all right, this is how their accounting system is set up. This is how their taxes are paid. They are a Subchapter S corporation. All right. That’s one of the first notes that’s comforting. Okay. Got that. Got that. Cause we don’t always know.

And then the next thing that you get into is equipment notes payable. How much is current liability, how much is long term? You break that out and gives underwriters an idea. Okay, that’s normal for that type of construction company. That amount of overhead expense. And then the other notes that have to do with receivables and payables, credit exposure, what are some other notes?

[00:22:35] Wade Carpenter: Well in, like I said, we could spend a whole podcast talking about the notes. Talking about the receivables and payables, we typically will put a schedule in the back of the financial statements that details like the retainage as we said before.

But I wanted to come back to one thing you just said about we bonding companies and everybody wants to know, are you able to estimate your projects accurately. And again, things will come up and sometimes a job will go wrong. Hopefully, sometimes a job will come in a little better. But one of the notes that actually GAAP says should be in there, and I don’t see it a lot on other CPAs’ financial statement, but there should be a reconciliation or a footnote in there that says, hey, these jobs that were in progress at the end of last year, they actually came in this way. So it increased or decreased our profitability for this year because of the estimates that weren’t exactly right last year, if that made any sense.

[00:23:35] Stephen Brown: Yeah. Yeah. You gotta make adjustments for that. And also, I imagine when you take over doing a year end for an account that wasn’t posted correctly the year before, that can be a mess. But also the notes that, that talk about loans to or from shareholders.

[00:23:57] Wade Carpenter: Oh yeah. And there’s several of those.

[00:23:58] Stephen Brown: If you have that as account current asset, the loans from shareholder that’s thrown right off from the bonding company because it’s usually you. And they’re underwriting the company, not you, unfortunately, a lot of the times.

[00:24:11] Wade Carpenter: Yeah. There are several things like, if you got a lawsuit or something going on or contingencies on, those are the things that should be footnoted in there. One of the things that, a lot of times for a, say a heavy equipment contractor that a lot of their stuff is on, a lot of their equity is in the heavy yellow iron, whatever, you know, the fixed assets. We’ll do a lot more detailed, not a complete detail of it, but you know, like this is the major components or fixed assets and how depreciated those are. So, I mean, we think a lot of people appreciate that.

[00:24:47] Stephen Brown: Absolutely.

[00:24:49] Wade Carpenter: And I wanted to kinda address one thing that I know you asked me on a, one of our mutual clients recently about, or you commented on the way we did our financial statement or contract schedules.

We put like a contract number and we don’t put the name. And the very last one of these statements is the contract number codes and the description of the job. And the reason we do that is because a lot of times these contractors end up, if they’re heavy, water, sewer or whatever, they turn in these county bids.

And some of them become public record and they don’t want the competition or, you know, that they’re getting x amount on doing a certain type of work.

So they can choose to leave that off when they send it to the, say a city or county or those kind of things. That’s the reason we did that. And I know you mentioned it, but I wanted to address that.

[00:25:42] Stephen Brown: You did another one for the bonding company with the project names in there so we could match it up.

[00:25:47] Wade Carpenter: Yeah, we would definitely give that to the bonding company.

[00:25:50] Stephen Brown: We’d appreciate it. Or an index, we’re not that late. We’ll match them up but you’re right, there are a lot of projects going on and a lot of subcontractors, too, not just public record are working for larger GCs that have their own subguard insurance policies and other things enforced and they wanna see your financials.

[00:26:10] Wade Carpenter: Right.

[00:26:10] Stephen Brown: Yeah, sure. I have nothing to hide. You wanna see how consistently profitable I am on different size projects? There you go. You’re not gonna know which project it was, and you’re not gonna know how I made the money. But you’re gonna see that I got cash equity and I make money on my projects. So bring it. Bring it.

[00:26:29] Wade Carpenter: Well, nobody’s trying to hide anything, but there, there was a reason we did that.

[00:26:33] Stephen Brown: That’s right.

[00:26:34] Wade Carpenter: The, yeah. Yeah.

[00:26:36] Stephen Brown: Well, thanks for explaining that. Is there anything else you want the listeners to know about key components of a financial statement?

[00:26:44] Wade Carpenter: I think we hit the highlights. I mean, I, hopefully I answered the questions that you’ve got. Anything major that I didn’t answer?

[00:26:51] Stephen Brown: No, you answered everything. And I do love a lot of the things that you do as extra value added service to your contractors and us, bonding companies, because you talking we use this expression, greasing the wheels. You grease the wheels, they move smoothly. They don’t squeak. They go up and down the track. And a good financial statement greases the wheels.

And also, might I add, please get together with your construction oriented CPA before the year end is done. And with your bond agent to discuss the elements that are gonna be in place there. It just takes a little bit of time to please do that for us, your bonding agent. We, we really appreciate it because the worst thing we can do as your agent is have surprises.

And the last thing I’m gonna say, and I’ve said this before, it always embarrasses Wade, but you don’t learn construction accounting in college. You just don’t. It comes from experience and it is there’s so many moving elements, like you were saying, you got a huge amount of materials being stored and what are you gonna do when you ask the owner to prepay that?

How are you gonna account for that? So these are the sort of things, how do you post a job properly? How do you say, we gotta recognize a loss on this? Oh no, no, no, no, no. Yeah, we do. And it’s okay. Doing it right does not gut your program. It doesn’t hurt your bond program. Doing it right helps your bond program. Everybody feels better every step of the way. The wheels are greased. Everybody’s pulling with the same set of oars. I guess I could use those analogies all day and all night and I’ll stop now, but I guess you know what I’m talking about.

[00:28:33] Wade Carpenter: Yep.

[00:28:33] Stephen Brown: Okay.

[00:28:34] Wade Carpenter: Well, I appreciate you kicking that around. And I actually do agree with you that, from my experience that disclosing that you got a loss on a job is not the end of the world. Surprising a bonding company with the loss that can wreck your bonding program.

[00:28:49] Stephen Brown: Or take all the cash outta your company and then year end. And then ask for a bond.

[00:28:55] Wade Carpenter: Okay. And thank you all for listening to the Contractor’s Success Forum, wherever you might be tuning in from. Find us on our YouTube channel at Carpenter CPAs, or for more information, be sure to check the show notes for more free resources.

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As we said before, our mission is to provide game-changing financial education for contractors to help you be more profitable, grow and succeed in your business. And we sincerely appreciate your support and comments in this journey. We look forward to seeing you in the next episode. Thank you.