Is your construction company aware of these top five common errors?
With a forecast slow down in construction activity and notable issues at certain of the larger listed contractors, we thought it would be useful to compile a specific list of errors that we sometimes see being made. It is critical that the company’s management and their advisers who are responsible for the company’s management information (including the annual financial statements) know what errors might be hidden behind the numbers.
Following are five common accounting errors that can appear in construction companies’ financial statements prepared using UK Generally Accepted Accounting Practice (GAAP).
1. Misstatement of Estimated Job Costs
The UK GAAP requirement to use the percentage of completion method for the recognition of revenue arising from construction contracts means that the most important factor is estimated job costs. Errors can occur as a result of poor estimating or forecasting, inaccurate actual costs accumulation or improperly measuring variations. To prevent errors, compare actual costs to estimated costs on a regular basis, ensure estimated costs include the same elements as actual costs, consider increasing prices and wages in the future (if possible) and revise the estimates accordingly on a regular basis if required.
2. Incorrect Recognition of Joint Venture Activity
Joint ventures are common in the construction industry, and the proper accounting for these arrangements is often misunderstood. There are varying methods of recording a joint venture, which are dependent on the nature of the joint venture arrangement.
Where the arrangement is for the joint control of either assets or an operation, they will be accounted for on a proportional basis (i.e. the company’s share of costs, income, assets and liabilities). Where the arrangement is for the joint control of another entity, UK GAAP allows the choice of either the cost model, the equity model or the fair value model. All jointly controlled entities must follow the same accounting treatment. It is therefore important to ensure that the nature of the arrangement is fully understood before determining the accounting treatment.
3. Inaccurate Application of Overhead to Jobs
It is common practice to use an overhead rate to allocate indirect costs (e.g., rent, utilities, depreciation, etc.) to individual jobs using a percentage multiplied by either direct labour costs or materials costs (although there are variations). If this percentage is not monitored in order to assess whether it is an accurate representation of the company’s current overhead costs, an over or under allocation of costs may occur.
To prevent this error, revisit the rate regularly to assess that the correct costs are being included and the most appropriate method is being applied. Assessing which method is most appropriate for a contractor should be based on the most critical component of the construction activity, labour or materials.
4. Failure to Record Onerous (Loss Making) Contracts in the Correct Period
UK GAAP requires that revenue from construction contracts shall be recognized by reference to the percentage of completion method where the outcome can be measured reliably. However, an error can often occur as a result of applying the percentage of completion rate to the total contract amount without considering whether the job is likely to be loss making. Generally accepted accounting practice requires that the expected loss must be fully recognised immediately.
This error can be avoided by monitoring the detailed job schedules consisting of estimated total job revenue, estimated costs and the related estimated gross profit (or loss). When a loss is expected, then an accrual for that loss must be recorded.
5. Improper Job Costs Cutoff
UK GAAP requires financial statements to be prepared using the accruals basis of accounting. When using this basis, the theory is that revenues and costs are recorded in the period earned or incurred. A cutoff error can arise regardless of the company’s industry and is the result of omitting costs incurred in the period being reported on. It generally occurs as a result of invoices received after the period end that are not picked up as part of the closing process in accounts payable. To avoid this error, a process such as cost value reconciliations should be performed by senior management on a regular basis. This should help to ensure that these liabilities are recorded in the correct period.
Preparing accurate financial statements for construction companies is never easy. Construction company owners should regularly seek the advice of their accounting advisers to help ensure that their management and statutory accounts remain error free.