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Understanding a Contractor’s Accounting System
Contracting can be a complicated and risky business. If a contractor doesn’t know its true financial position, then trouble can’t be far away; and when trouble arrives (and it will), no owner wants to be impacted by the fallout caused by a financially-stripped contractor. For this reason, it’s important that owners not only thoroughly vet contractors before awarding a project but also understand which accounting and billing methods the contractor adheres to.
Prequalification Process
Before undertaking a major renovation project, it pays for owners to engage in a rigorous prequalification process to select a professional, licensed contractor to complete the work. Included in this process is ensuring that the chosen contractor maintains a robust, audited accounting system. The contractor should also retain an outside Certified Professional Accounting (CPA) firm to perform independent audits on the contractor’s finances at the conclusion of each fiscal year. Additionally, the contractor’s CFO, or bookkeeper, should issue weekly Job Costing reports. Job Costing is an accounting method that tracks and reports transactions on each of the contractor’s jobs.
Revenue Recognition
Another component to the contractor’s accounting system is Revenue Recognition. Revenue Recognition determines when the contractor has officially made money on a project. This comes into play because large renovation and construction projects are usually long-term and have delayed payments.
Typically, contractors use the “Percent of Contract Completion” method for Revenue Recognition. This means that as the work on the contract progresses, the contractor invoices the owner on the percentage of the work completed during the billing period. Usually, the contractor invoices the owner on a monthly, Net 30-Day basis. The invoice, unless structured otherwise, will include the contractor’s percentage of work completed plus stored materials, if any. Stored materials are those which have arrived on-site, but are yet to be installed in the building.
Retainage
Owners should always hold retainage on a contractor. Retainage is the predetermined amount of money an owner may hold back from payment until the contractor has fully satisfied its contractual requirements. Retainage is usually paid after all work is completed (including punchlists) and when the contractor has submitted all job close-out documents – warranties, operating manuals, lien releases and other specified documents. A common retainage amount is 5%-10% of the contract value or invoiced amount.
Billing Methods
Because construction production is project-based, decentralized and long-term, contractors may use a number of billing styles and methods, including:
- Fixed Price (hard bid or negotiated)
- Time and Material
- Unit Price
- AIA Progress Billing
Owners should be quite sure as to which billing method a contractor plans to employ before signing a contract. Additionally, owners should be sure a contractor does not over-bill on a job. Over-billing occurs when the contractor invoices the owner for work, or a percentage of the work, which the contractor has not fully earned. Example: the project is 40% complete, but the contractor has billed the owner more than 50% of the contract amount. An owner never wants to be in such a position.
Payroll System
A professional contractor maintains an accurate and professional Construction Payroll system. The larger and more complex a contractor’s projects are, the more important the Construction Payroll becomes.
Contractors must adhere to federal laws in payroll. Certain amounts of payroll taxes must be deducted from employees' wages, and the contractor must report and submit these taxes to the Internal Revenue Service, as well as applicable state payroll taxes, reported and submitted to the State. State payroll tax requirements vary from state to state. In some cases, municipalities have payroll tax laws. If the contractor fails to adhere to federal, state or municipal tax laws, it can spell big trouble for the contractor when the IRS comes calling. A contractor’s failure to pay payroll taxes can negatively impact an owner. This is one of the main reasons contractors should submit a Release of Lien to owners with each of the contractor’s invoices. Release of Lien helps protect the owner from a contractor’s creditors.
On large renovation or construction contracts, an owner is wise to retain an attorney to review the contract and a consultant or architect to monitor the work.