Many contractors labor under the false impression that financial statements are what their accounting software lists under “standard reports.” Others believe that their in-house bookkeeper can draw up perfectly acceptable financial statements on demand. Typically, these notions are dispelled when those contractors apply for a performance and payment bond, or attempt to procure some significant financial leverage in the form of a construction loan or extended working capital for growth.
The moment a surety or commercial lender sees that a contractor is trying to submit in-house standard bookkeeping software printouts for financial statements, and that these reports aren’t prepared by a CPA, the submission will more than likely be rejected. In turn, the surety or lender will ask the contractor to provide fully accrued and annotated financial statements that are compliant with Generally Accepted Accounting Principles (GAAP) and supported by schedules of work in progress, accounts receivable and payable, and a statement of cash flows.
Reasoning behind GAAP
All of this may sound like quite a bit of hassle to go through. But there’s good reasoning behind the strict stipulations of these external parties.
In the past couple of decades alone, several large organizations have collapsed because their financial statements hid the fact that no real assets existed and no real revenues were being earned. GAAP prevents this by requiring disclosures. The thorough nature of properly and objectively generated financial statements gives bankers, sureties, investors and others a solid understanding of:
• What’s being earned
• When and how earnings are being used to operate the business
• Whether earnings are being retained to grow and sustain the business or distributed to owners as compensation or return on invested capital
Financial statements also contain a notes section. These notes aren’t like footnotes in a book or a random list of assumptions. Rather, they’re disclosures required by GAAP to inform the reader:
• What type of company the contractor is running
• The precise nature of the core business
• How much revenue is generated from each customer type
• What accounting principles are followed
• How assets and liabilities are calculated
Financial statements should be prepared in accordance with GAAP unless a departure is warranted and disclosed.
Indeed, financial statements are intended to be seen by outside parties. But knowing what readers are looking for can help you — the construction business owner — understand whether your company’s financial performance will be judged favorably or if you’ll need to undertake additional efforts to improve that performance to gain favorable attention.
For example, most banks want to see a solid liquid cash position on the balance sheet. Yet many contractors invest their cash in fixed assets and leverage their own companies’ cash against future earnings growth. Maintaining a substantial cash reserve in a bank account, on the other hand, will put lenders and sureties more at ease and may soften their requests for bonding lines or extending lines of credit because the account shows them that the contractor values cash and understands its necessity.
Most banks also want to see positive cash flows. A cash flow statement prepared by a CPA clearly shows beginning cash and ending cash for each period, and what happened from the beginning of the period to the end to cause an increase (or decrease). This is most important in construction, because revenues are so difficult to understand by financial statement readers who may be less experienced in revenue recognition models specific to this industry.
Other items of interest
Outside parties may look for other items of interest as well. Both bonding and insurance agents often want to see a schedule of cash receipts as part of the notes to financial statements. Such a schedule of cash receipts shows how much cash was received each period — be it a month or a year — by project or customer, and date.
Sureties tend to look closely at whether and how a contractor is developing and maintaining an adequate backlog. In simple terms, a backlog is a dollar amount of work under contract by the contractor for future performance. This is significant, as the backlog is the only work that can be truly relied on for future revenues because it’s work under contract. Backlog is, thus, distinguished from revenue projections and sales forecasts.
Many construction companies start out using simple paper invoices and relatively inexpensive bookkeeping software on their owners’ home computers. But times change and, one hopes, the business grows. If your construction company is looking to reach that next tier of success, GAAP-compliant financial statements will likely play a key role.
Sidebar: Using financial statements for strategic planning
Properly prepared financial statements can prove immensely helpful for strategic planning. For example, say a construction company wants to procure more work under contract further into the future — say a year in advance — so that its backlog will look better to sureties and lenders.
Knowing that strong cash balances will raise the business’s bonding capacity and make loans to finance future jobs easier to obtain, the contractor may want to invest liquid assets in an investment account so that his or her financial statements reflect a strong cash position.
If the contractor can keep $100,000 in the investment account for no other purpose than to ensure future lending capacity, that $100,000 is better not spent than spent. After all, if it’s spent, he or she will have to replace the amount with earnings. But, if unspent, it can serve as a wellspring from which positive bonding and lending relationships can flow.