Eric P. Wallace, CPA, is a partner at Carbis Walker LLP in Pittsburgh, PA. He has worked with construction industry clients on financial, consulting and tax issues since 1979 and serves construction and homebuilding clients in multiple states. Eric is a noted and frequent construction industry speaker and author. Nationally, Eric was past co-chair of CFMA's Tax and Legislative Affairs Committee. He is also a member of the AGC, and serves on the AICPA's Alternative GAAP Task Force. He can be reached by phone at 412.635.6270, or visit www.carbis.com.
As a business owner, you are concerned about numerous issues not limited to maximization of profits, employees, succession planning, business risks, customers, partners and that large bid you and your estimator just submitted.
On top of this, you want to have a better personal life, and in the back of your mind, retirement thoughts haunt you from time to time.
With all of these concerns, you have the auditors coming in at year-end for the company's annual audit. The last thing you are thinking about now is what your auditors will look for in the future, but you should. The best-in-class contractors expect the audit process and their auditors to perfect their businesses and in the process, assist in addressing all of the other areas of their businesses.
The secret to maximizing the value of the auditors' experiences and the audit process is to use the auditors to assist your business in perfecting business systems. Auditors come back year-after-year to perform your audit. They are exposed to the innards of your business, the talents (or lack thereof) of your people and in general, obtain a clear understanding of your business. Why would a construction business owner hire an outside consultant to come in and analyze the business when he already has access to experts-his audit team?
This is not to assume that all auditors are able to handle this challenge or that audit firms assign the proper individuals with the proper talent to a company's audit. A contractor can have control over this process by interviewing and selecting an audit firm that best fits that contractor's needs. In addition, insist that the audit team has at least one experienced CPA with construction industry background.
Keep in mind, while the auditor can assist in identifying the problems or concerns related to the contractor's business systems, independence must still be maintained. If not, the auditor will no longer be able to do the company's audit. The auditor cannot assist in management of the business or make management decisions. If you as the business owner have the auditor take on management roles, independence will be impaired. This is often a fine line, but generally as long as management approves and follows through on the auditor's recommendations, independence will not be an issue.
What are business systems and why are these so important to the success of any contractor? One can argue that the most valuable asset that a contractor possesses is its business functions. An entity cannot profitably succeed or grow without properly designed and performed business functions. A contractor with revenues of $5 million, but with business functions appropriate for a $50 million organization will be able to grow rapidly and successfully, whereas a contractor doing $50 million in revenue, but with business functions appropriate for a $5 million organization faces a great risk of failure. Positive and constructive modifications to business functions must occur before growth occurs, or at least at the same time, in order to be assured that defined management objectives are achieved.
Business functions can be called by many names-internal controls, internal control, business processes, business culture and/or business systems. These names can often be used interchangeably and describe the same issue. The term "internal controls" usually implies or refers to the collection of the various categories of controls within the entity's total business processes. "Internal control" refers to the sum total of the entity's methods and processes.
Internal control within a business can be defined as the methods and processes which are designed, created, monitored, documented and periodically modified as necessary by the owners, management and employees to provide reasonable assurance that defined objectives are achieved including:
- The reliability of data, whether operational or financial
- The efficiency and effectiveness of operations
- The protection and safeguarding of the entity's assets
- Compliance with applicable laws and regulations
A control is a procedure or process that provides reasonable assurance that defined objectives are achieved. On the other hand, not all procedures or processes are controls.
Missing or Inadequate Processes or Controls
Beneficial or needed internal processes or controls can also be missing or not yet created or performed by the entity. Every entity, construction related or not, almost immediately sets up processes over cash collections and cash payments. Other needed processes are added as the company grows in size and complexity. During this evolution, controls (i.e., procedures that assure that the objectives of the company are achieved) are added. Not all businesses develop all of the processes or controls that can make the business successful, more profitable, less difficult to manage, deliver a safer work environment, assure employee or management training and transition, address succession planning and more..
Frequently, the types of processes or controls that are missing or partially present in construction-related entities are not limited to:
- Cash management
- Budgeting (either annual budgets or capital budgets)
- Strategic planning, implementation and monitoring
- Quality control
- Safety programs
- Human resource such as employee hiring, retention, satisfaction, training and evaluation
- Succession planning
The reasons that missing processes have not been created and initiated is usually due to the lack of knowledge or understanding on how the process should operate or the benefits that can be derived from the processes or controls. Initiating, creating or adding such missing functions to an organization takes commitment on the part of the organization, the knowledge of how such a process should be structured and integrated into the other systems and the documentation of the process.
Basic Goals of an Audit
Besides the biggest concern that the business systems and processes are in place and working properly, there are basics and certain business attributes that the business must present to the auditor for the auditor to begin his or her work including the following:
- Books and records of the company are in order, available for examination, and balanced and reconciled with subsidiary journals (that is, for example, that the details of accounts receivable and accounts payable agree to the general ledger)
- Sufficient audit evidence can be obtained
- Management makes several representations to the auditor concerning issues such as:
- The books and records are complete and properly valued
- That assets actually exist and are owned
- That assets, liabilities, revenues and costs are properly accounted for and disclosed
Typical Substantive Testing vs. Reliance on the Contractor's Business Systems
An auditor must obtain audit evidence and draw a conclusion on the results of his or her testing and findings as to whether the contractor's financial statements are materially correct and presented properly with adequate disclosures. One of the best types of independent audit evidence is a confirmation from an independent outside source. In the confirmation process, the auditor is asking for verification that the contractor's account balances (for assets, liabilities or equity accounts) or that transaction classes (revenues or expenses) recorded in the contractor's books are materially correct.
An auditor considers the attributes of the account balance or transaction class in his or her decision to send confirmations. Most of the time, if a returned confirmation provides sufficient and timely audit evidence, further audit testing or other procedures is not required. If a confirmation can't be sent, or if it would not provide meaningful or timely information, the auditor must be able to obtain sufficient audit evidence through the performance of other procedures.
For all types of businesses, the performance of other procedures costs the company being audited more auditing fees. When substantive testing does not supply sufficient audit evidence, the auditors seek to obtain evidence through testing and reliance on the contractor's business systems. In simpler terms, auditors are asking and testing whether the results of the contractor's systems supply accurate and reliable information.
Beyond confirmations, other substantive procedures that the auditors can perform include:
- Visual inspections (This is used for counting items, verifying purchase of equipment or asset additions, possibly for a contract status)
Re-performance (This procedure is best described as repeating the steps that the contractor's internal people performed in order to come away with the account balances or numbers that they calculated.
- This is often done for calculations for pre-paid items, or quantity estimates.
- Inquiry (The auditors will interview and ask questions of the contractor's internal personnel and possibly outside people such as vendors, inspectors and subcontractors.)
- Tests of details (An auditor might match-up invoices that the contractor has received to the detailed list of accounts payable, or trace new asset additions to the original purchase invoices and then to their recording on the depreciation schedule; additionally, tests of details are often used on job costing where the auditor verifies that the contract costs are properly charged to the proper contracts.)
For contractors, auditors prefer to use confirmations in order to obtain the best (less expensive to obtain) evidence on:
- Cash and/or investment balances
- Accounts receivable (This is on non-contract related receivables such as sales of material, service work or time and material performances.)
- Contracts (Auditors request verification of a specific date, which is usually the last day of the contractor's fiscal or calendar year, on the contract amount, change orders, disputes, billings and payments to date and the owner's, architect's or engineer's estimate of percent complete.)
- Accounts payable (The auditor seeks to verify the amounts that the contractor owes to vendors.)
- Subcontractor contract payables (Auditors ask the position of subcontractors related to attributes similar to those of contract above.)
- Notes or leases payable (These include term loans for borrowings such as term notes, lines of credit, mortgages and leases.)
The Focus of Auditors' Effort in a Contractor's Audit
The main answers that auditors are seeking in an audit of a contactor are related to the uncompleted contracts. There is no mystery in contracts that are completed and accepted by the owners. The uncertainty exists in the uncompleted contracts related to two issues-balance of revenue to be received or earned by the contractor and the costs that it will take for the contractor to complete the contract. Change orders related to the contract are also included in this effort.
Other items of the audit are less important as they present less risk of misstatement. This statement is important to the construction company owner-auditors should be focused on the important/risk issues of the audit-and not in any other area. This concept means that auditors should be spending the majority of their time on drawing an audit opinion on whether the contractor's business systems or functions have the ability to produce reliance accounting data. Independent audits that do not address this focus are failures and a waste of resources.
Why the Testing of Business Systems are Paramount in Construction Company Audits
For many industries, other than the construction industry, auditors are able to perform substantive procedures that verify all of the account balances as of the end of the fiscal or calendar year. For contractors with significant uncompleted contracts, an audit cannot be conducted in this manner because substantive procedures alone will not produce evidence about the estimates of percent complete on uncompleted contracts.
The auditor, instead, must test and verify that the contractor's business systems are able to provide the necessary accounting information and that this can be relied upon by the auditor in issuing his or her audit opinion. Confirmations cannot be issued to anyone that will be able to verify that the amount of contract costs to complete that the contractor has estimated on a particular contract will in fact be true. Outsiders can verify what has happened to date, but no one can predict or verify future events. The auditor has to draw an opinion about that.
There are many future factors that will control the ultimate outcome of an uncompleted contract including, but not limited to:
- The project manager's and estimator's abilities
- Material price increases
- Site conditions
All of these factors are encompassed in the contractor's business systems and ability to handle change. Previous accuracy (or lack of accuracy) of ability to estimate contract profits is evidence of a continual ability to be able to do the same, assuming that the contractor's business systems are sufficiently stable. This is why the auditor will test and focus on the contractor's prior contract history of contract fade, or gain (i.e., whether prior projected contract gross profits, year-by-year, held up).
As an example: ABC Contractors has a fixed price contract for $1 million that, according to pay requests, is 50 percent complete as of June 30, ABC's fiscal year-end. ABC's auditors can request a written confirmation from the owner that the contract is in fact 50 percent complete from a visual, installed owner's perspective. ABC, however, does have other outside efforts in a fabricator's shop 90 percent complete that once installed with minimal amount of labor from ABC, will immediately increase the contract amount installed by 20 percent. Additionally, ABC has significant other fabricated material, unique to the contract, onsite (such as fabricated duct work). ABC's books and records show the contract to be 70 percent complete from the cost-to-cost method.
Is this estimate of percent complete on ABC's books and records materially correct? ABC's auditors must be able to answer this question in order to render an audit opinion on ABC. Only through the testing and reliance on ABC's business systems can ABC's auditors perform the audit.
Contractors can get significant guidance and business benefits from their external auditors if they properly select and manage their auditors. If your auditors are not helping you to perfect your business systems and increase profitability, seek ones that have the ability to do just that.
Advantages of Business System Documentation
Not all internal controls are documented. In fact, the majority of smaller entities do not have documented control processes. The advantages of documenting controls are numerous including transitions from one employee to another. There is no argument that the completion of proper and complete systems documentation takes time and money. In the alternative, however, the cost will inevitably be greater, that is, in the event of employee transition, which is unavoidable. Proper system documentation reduces the costs of turnover. System documentation, however limited, is meant to enable a person or persons with similar talent, education, experience and training to duplicate the process and ensure that the business functions continue with the least amount of interruptions or mistakes.
Additional considerations favoring systems documentation include:
- A work force in place along with system documentation has greater value in the event of a sale.
- Documentation assists in the prevention of employee or vendor fraud, which can be perpetrated against the entity.
- Documentation provides assistance for employers against some employees who would like to hold managers or owners as "knowledge hostages." If an employee is the only one who knows how a particular process is performed, the employer is less likely to terminate or even reprimand the employee based upon fear.
- A written visual and narrative of the system's process enables businesses to view for efficiencies and possible conversion to more of a paperless office environment and/or provide for computer or software efficiencies or modifications. It can also enable an entity to embrace and adapt for technological betterments.
- System documentation assists in the monitoring and evaluation of employee and management performances.
- Well-defined and documented processes enable management to better and more clearly communicate their goals and objectives and assist in their implementation and performance.
Modification of controls, as the term is used in this definition, is limited to positive steps or changes to the controls to improve the process or to accomplish the goals of the entity. The definition is not meant to include fraudulent modifications or efforts by management or employees to subvert the controls for personal gain.
Is Your CPA/Auditing Firm Doing a Good Job? How Do You Know?
What criteria can you compare your auditing firm's performance to? I am not talking about price. All CPA firms charge similar rates (but not all present the same value to you or do the work that is truly needed). The issue is pro-activity and ideas. Do they possess these attributes and use them to bring value to you? There is a relatively simple way to tell. You do not have to spend your time interviewing half a dozen CPA firms. If your CPA is doing a good job and helping you succeed, the following checklist will tell you. Complete it yourself or ask your CPA to rate themselves. Consider the following survey:
Are you getting everything from your CPAs/auditors that you are paying for?
- Did you get a detailed management letter with your last audit with valid business points? If you do not have these items in great shape, did your auditor bring them to your attention:
- Results of business system testing for the current year
- Fraud concerns and prevention techniques
- Strategic and succession planning
- Buy-Sell agreement
- Confidentiality and non-compete agreements from your key management personnel
- Calculation of your breakeven threshold
- How to prepare and use annual budgets and capital budgets
- Documentation of your internal controls or business processes
- Human resource best practices
- How to prepare for and adjust in a declining economy
- Buy or lease analysis for equipment considerations
- IT concerns
- Did the management letter address other issues that you (the owner or management) are concerned about and present a follow-up plan? Did it bring to your attention issues and concerns that you were not aware of? Did it address the issues that the CPA firm presented in the prior year and the current status of those issues?
- Did your set of financial statements include all of the needed disclosures that your bank or bonding company need (not limited to the schedule of completed and uncompleted contracts)? Do you or your CPA know what adjustments the surety analyst makes to your financials to determine your bonding capacity?
- Do you get comparisons (benchmarking, statistical and financial) of your company's results and key indicators to other similar construction entities? Do you know how your company is doing compared to your competitors? Compared to the best in your industry?
- Did you get a tax management letter with your tax returns that addressed potential IRS exposure issues for either the company or for the owners personally?
- Did you participate in advance tax planning for both the company and for the owners individually, or were you surprised with the tax amount due at the last minute? Did you get a detailed, explained and printed tax projection?
- Has your CPA firm brought tax saving ideas to your attention?
Construction Business Owners, December 2006