Begin Your Year-End Planning Now

Contractors who consider CPAs to be merely singularly focused, boring number crunchers probably have hired the wrong CPA. An engaged construction CPA is actually similar to a circus ringmaster who introduces important aspects of the show while directing the audience’s attention and focus. Expert construction CPAs understand how to simultaneously keep the focus on three key financial areas—working capital, net worth and income—throughout the year in order to be positioned for success at year’s end.

This kind of year-long planning enhances a company’s ability to take advantage of tax-savings opportunities and improves financial statement position before year-end. It is especially vital for construction companies whose financial statement “audience” includes the usual entities: banks and sureties. In many states, a contractor has to maintain working capital and net-worth requirements simply to keep a contractor’s license. And, most importantly, surety companies make decisions regarding allowable work programs based on these financial statements.

The sooner you start planning, the more you improve your range of options and, therefore, your potential for better outcomes. Here we examine the three primary factors that contractors and their CPAs should focus on as the year progresses. 

Working Capital
Working capital—defined as the sum of current assets (such as cash, receivables, inventories, marketable securities and under-billings) minus current liabilities (such as accounts payable, accrued expenses, taxes payable and over-billings)—is one of the most important metrics used by surety companies to determine a contractor’s bonding capacity. However, surety companies discount a contractor’s working capital to create a true picture of items that will become cash. Understanding this formula allows you to calculate working capital from the surety’s perspective (and perhaps develop a plan for improvement).

Generally, sureties exclude from the equations prepaid expenses, employee and related-party receivables, old accounts receivable and claims receivable. They also discount the value of assets like marketable securities, depending on the market conditions and type of investment. Investments in government bonds may not be discounted at all, while publicly traded equity securities may be discounted up to 40 percent. Other items, such as inventory, may be discounted depending on the nature of the contractor’s business. Some noncurrent assets are typically added back to working capital.

Monitoring “bonding working capital” allows enhancement opportunities prior to year-end. Suggested actions may include the following:
•    Refinance notes payable and lines of credit maturing in the next 12 months into a long-term position.
•    Refinance equipment purchases made with cash to long-term debt to free up cash and enhance working capital.
•    Have related parties and owners repay any money owed to the company.
•    Work older receivables for collection
•    Limit investments in marketable securities.

Of course, surety companies change their perspectives each year depending on the market. The point is to maximize planning opportunities to satisfy both the surety and the banker while minimizing taxes.

Net Worth
In addition to working capital, many state licensing boards, as well as sureties and bankers, have net worth or equity requirements. Net worth, also called equity or capital, is simply the company’s assets less liabilities. Most state licensing boards have minimal requirements for net worth—especially compared to sureties and banks, which also use net worth to test a company’s debt-to-equity ratio. Debt-to-equity (net worth) is usually calculated two ways: total debt (meaning every liability) divided by total equity, for a goal of three (or less) to one, and hard debt (bank and finance company loans) to equity, for a goal of one (or less) to one.

With the construction market downturn, the focus on net worth has become more intense. If this issue is noticed early, then improvement opportunities may exist and may be acted upon using the following steps:
•    Have owners invest more money into the company.
•    Add owners by selling new interest (often as part of a good succession plan).
•    Have owners loan the company money under a subordination agreement with a surety company or bank—as long as state licensing isn’t an issue.
•    Sell idle equipment to pay off debt (if debt levels are a problem).

These choices may have tax consequences and should be reviewed with a construction CPA.

Income
Many contractors assume that income is the most important factor to monitor because it is the driver of income tax liability when performing year-end planning, but income is the factor over which you have the least control. If financial statements are generally strong despite a loss, then it may also be the least important to your surety and banker. The key is to communicate openly with the banker and surety to avoid any surprises.

Depending on the company’s tax structure, contractors should evaluate ways to minimize taxes without hurting financial statements. It’s a feat that requires careful balance, but you shouldn’t feel as if you are walking a tightrope. Examples of this balancing process include the following scenarios:
•    Exploiting the difference in tax depreciation versus financial statement depreciation. Equipment purchases may help minimize taxes without negatively impacting financial statements. However, equipment should never be purchased solely as a tax decision.
•    Managing contract completion to minimize taxes without hurting financial position. For example, completed-contract taxpayers may be able to slow a job to delay completion into the next tax year with minimal negative impact on the financial statements.
•    Avoiding tax payments on profit that will note be earned. Percentage-of-completion taxpayers should ensure they are not being overly optimistic regarding profitability of jobs in progress.

By looking at these three key financial areas prior to year-end, contractors and their CPAs can capitalize on planning opportunities or, if there is no way to accomplish favorable options for both financial statements and tax, at least prioritize. Occasionally, due to timing, downturns in volume, or mandatory changes in tax method, contractors may choose tax strategies that hurt profitability or working capital. If faced with this choice, alert your bonding agent and surety about the available options and the choice that was made. Communication can help.

We have yet to meet a construction company owner who asked to pay the government an extra dime in taxes. However, contractors should always seek to avoid short-sighted decisions for tax savings that hurt working capital and curtail bonding capacity. It may seem like a three-ring circus, but when an experienced construction-specific CPA has time to evaluate all options prior to year-end, everyone wins.