For those construction firms undertaking long-term, high-budget projects, accounting for long-term contracts (project accounting) is a requirements under IFRS. However, a number of construction businesses struggle to meet some key requirements. These requirements incorporate capturing and allocating all costs to projects/jobs, while accurately assessing appropriate stages of project completion and allocating profits on projects to the correct accounting period. Due to this, they may fail to accurately calculate the projects profitability and thus result in poor decision making.
As if this wasn’t confusing enough:
To add further complexities, IAS 11: Construction Contracts has been replaced by a new standard called IFRS 15 Revenue from Contracts with Customers in order to provide a better framework for addressing revenue issues and to improve comparability revenue recognition practices across industries.
What is the true purpose?
The primary use of the new standard is to recognise revenue in a way that reflects how the goods or services are provided to the customer, be that a point in time or over a period of time using project accounting. IFRS 15 could lead to significant changes in the pattern in which revenue and profit recognition is applied.
Behind the cash-flow curve in the construction industry
Financial difficulties can occur as you need to spend money on materials and labour before receiving payment from customers. This leaves you behind the cash-flow curve. Maintaining a strong visibility of the cash-flow impact on all the new tenders and work taken on is key to ensuring the business takes on financially viable projects, which will not put the business at risk. This will aid with keeping project on budget, monitoring profit margins and understanding what and when to bill, which is key for your business. But how should construction companies go about this and what can they do to avoid falling into the overtrading trap?
Accounting for large-scale projects
Long-term contract accounting is widely used by businesses in the construction industry and offers several benefits over traditional accounting methods. Due to the increased complexities of large-scale projects they are often treated differently to business-as-usual activities and their distinct timelines mean that standard accounting practices are often insufficient for tracking projects profitability, cash-flow and working capital. Although, a lack of understanding of how to effectively monitor project profitability and cash-flow means some businesses may be underperforming and could result in those businesses overtrading.
Despite the requirement to do so, some businesses in the sector may not properly prepare their accounts accurately using the long-term contract accounting basis. For example, if on a project they predict will be profitable, they have expended 70 per cent of the costs, but only recognised 30 per cent of the income, the profitability in their accounts will be understated.
An additional pitfall is where businesses use a traditional accounting method and just insert a figure for ‘works in progress’ on the balance sheet. This normally has a degree of estimation and may not a clear or accurate representation of the business in financial terms. If this approach carry on, the business may make inaccurate decisions based on inaccurate reporting of profitability. As well as poor cash-flow management and visibility of cash-flow on new tenders, this may place the business is difficulties or serious financial risk leading to the business failing or incurring penalties for wrongful trading.
How to minimise the risk of overtrading
Construction firms can use cash-flow remodelling as one of the ways to minimise risk of overtrading. Three-way forecasting, which involves combining financial data for profit and loss, cash-flow and the company’s balance sheet, can help businesses to predict how they might perform based on a few different scenarios. This analysis can also help in the decision making process and ensure the cash-flow impact of new products is carefully weighed up and are financially viable for the business. Additional data can be fed into financial forecasts, such as the firm is planning a recruitment drive or intends to invest in new equipment in the next few months.
Assessing profit margins and cash-flow impact should be priorities when quoting for new work. Decision-makers should ensure that they have strong visibility of both these factors at the outset, as quoting for a job based on margins alone could easily lead to cash-flow issues and overtrading.
Visibility of all decision-making processes is crucial, and perfectly accessible given recent innovations in accounting system technologies. When quoting for any new job, organisations should have a clear and effective template for calculating predicted profit margins and the cash-flow impact of the project. This template should include a consideration of when they are going to raise invoices, how soon they will get paid and the timing and level of costs they must pay out for, such as wages, materials and subcontractors. Without this information in place, managers will effectively be running their business blind.
This new transparent approach to planning projects should not stop once quotes are made and contracts are signed. On the contrary, a variety of factors could end up derailing the business financially during the course of the project. For instance, variations (requested extras or changes to the contract) can start to erode profit margins and require careful consideration. In some cases businesses fail to capture these additional costs when raising invoices, or don’t like asking for more money, but this should not be the case. If costs are rising and additional work is being carried out, seeking further payments can be the difference between profits that maintain a healthy cash position and making a loss.
Where do suppliers fit into your cash-flow difficulties?
Should a business experience cash-flow difficulties, it may be tempting to slow down payments to suppliers. However this can be sensitive as you wish to keep a good supplier relationship and maintain your reputation within the industry. If a company is a perceived credit risk, their reputation will quickly become damaged and it could become more difficult for them to secure contracts or finance in the future.
How we can help?
It is always good to get a professional adviser to help implement three-way forecasting effectively, as well as help to define the most profitable jobs and stress-testing the cash flow cycle. If this is achieved, then project accounting businesses can stay ahead of the cash-flow curve and start building their way to a more successful and sustainable future. As well as having much better visibility of how their business is faring, they can also reduce the risk of falling into the overtrading trap and owners will have more cash for future investments or have the ability to extract value to meet their personal objectives.