Managing trading profiles in the construction industry
22 July 2019
For construction firms undertaking long-term, high-budget projects, accounting for long-term contracts (project accounting) is a requirement under IFRS. However, many construction businesses struggle to meet some key requirements. These include capturing and allocating all costs to projects/jobs, accurately assessing appropriate stages of project completion and allocating profits on projects to the correct accounting period. As a result, they may fail to accurately calculate profitability by project, resulting in poor decision-making.
To bring in additional complexities, IAS 11: Construction Contracts has now been replaced by a new standard called IFRS 15 Revenue from Contracts with Customers in order to provide a more robust framework for addressing revenue issues and to improve comparability of revenue recognition practices across industries.
The core principle in the new standard is to recognise revenue in a way that reflects how the goods or services are provided to the customer, whether that be at a point in time or over a period of time through project accounting. This new standard may lead to significant changes in the pattern in which revenue and profit recognition is applied.
The need to spend money on materials and labour before receiving payment from customers can leave businesses behind the cash-flow curve, potentially leading to serious financial difficulties. Maintaining strong visibility of the cash-flow impact of all new tenders and work taken on is key to ensuring the business takes on financially viable projects, which are not going to put it at risk. Keeping projects on budget, monitoring profit margins and understanding what and when to bill is key. But how should construction companies go about this and what can they do to avoid falling into the overtrading trap?
Long-term contract accounting is widely used by businesses in the construction industry and offers several benefits over traditional accounting methods. The complexities of large-scale projects mean that they are often treated differently to business-as-usual activities and their distinct timelines mean that standard accounting practices are often insufficient for tracking project profitability, cash-flow and working capital. However, a lack of understanding about how to effectively monitor project profitability and cash-flow means that some businesses may be underperforming as a result and could be at risk of 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.
Another possible pitfall is where businesses use a traditional accounting method and just insert a figure for ‘work in progress’ on the balance sheet. This often includes a degree of estimation and may not be an accurate representation of the business’ financial situation. If this approach continues, the business may make flawed decisions based on inaccurate assessment of profitability. Alongside poor cash-flow management and visibility of cash-flow on new tenders, this could place the business at serious financial risk, potentially leading to business failure and/or penalties for wrongful trading.
Cash-flow modelling is one way in which construction firms can help to minimise the 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 to inform decision-making and ensure the cash-flow impact of new projects is carefully considered and they are financially viable for the business. Other relevant data can also be fed into financial forecasts, such as if 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 transparent approach to project planning 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. Some businesses fail to capture these additional costs when raising invoices, or feel nervous asking for more money, but this should not be the case. If costs are going up and additional work is being done, seeking further payment from the client can be the difference between delivering profits and maintaining a healthy cash position, and making a loss.
If a business does experience cash-flow difficulties, it may be tempting to slow down payments to suppliers. However, this can be sensitive in terms of maintaining a strong supplier relationship and the business’ reputation in the industry. If a business is perceived to be a credit risk, its market reputation can quickly become damaged and it could become more difficult to secure contracts or finance in the future.
Professional advisors can help businesses to implement three-way forecasting effectively, as well as helping them to identify the most profitable jobs and stress-testing their cash flow cycle. If all of this is achieved, then project accounting businesses can stay one step 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 will minimise the risk of falling into the overtrading trap and owners will have more cash for future investment or extract value to meet their personal objectives.