Clear, accurate and properly created financial statements can go a long way toward helping a construction company owner run a successful business. One way that contractors can help themselves and those who read their financial statements is by creating a classified balance sheet. Let’s take a closer look at what this is and why it’s important.
General criteria
The difference between a classified balance sheet and a conventional one is that a classified balance sheet distinguishes current assets and current liabilities from other (that is, noncurrent) assets and liabilities. This approach is particularly well-suited to construction businesses because of the project-by-project nature of their operations. The general criteria for separating current and noncurrent items are:
Operating cycle. This is traditionally defined as the time needed to convert cash into materials and services, and then into products, which are then sold to create receivables. Finally, these receivables are converted through collections back into cash. (A construction company’s operating cycle works a little differently at first but ends up in the same place as other businesses.)
Current assets. These are cash and other items that are reasonably expected to be realized in cash or sold or consumed during one year (or within the company’s normal operating cycle if it’s longer than a year).
Current liabilities. These are obligations whose liquidation is reasonably expected to require the use of current assets or the creation of other current liabilities.
Although construction companies often have contracts of varying duration, the normal operating cycle is measured by the average time between the inception of a contract and its completion. When determining a normal operating cycle, using estimated time remaining to complete contracts is incorrect.
For example, if you usually operate under contracts lasting 18 to 24 months, and most of the contracts have six to nine months remaining to completion at year end, your normal operating cycle would still be 18 to 24 months.
Different operating cycles
The contracts of most small construction businesses can generally be completed in one year or less. Although a company such as this may present an unclassified balance sheet, a classified one is preferable. If some assets and liabilities are classified as noncurrent because the related contracts have terms of greater than one year, information about their realization and maturity should be disclosed.
In most other industries, an unclassified balance sheet is preferable when the operating cycle exceeds one year. Certain construction companies may use this approach, but the preferable practice is to classify contract-related assets and liabilities as current based on the operating cycle concept and to classify other assets and liabilities as noncurrent. (Amounts expected to be realized or liquidated during the year would still be classified as current.)
Assets and liabilities
For construction companies, contracts represent a primary source of assets and liabilities. How these two elements are represented on a classified balance sheet underwent a major transformation under the Financial Accounting Standards Board’s Accounting Standards Codification Topic 606 (ASC 606), Revenue from Contracts with Customers.
According to ASC 606, a contract asset is defined as an entity’s right to consideration in exchange for goods or services transferred to a customer when that right is conditioned on something other than the passage of time. Meanwhile, a contract liability is defined as an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or the amount is due) from the customer.
Unbilled contract receivables, for instance, are now considered contract assets, as are costs and estimated earnings in excess of billings. Equipment and small tools specifically bought for, or expected to be used solely on, an individual contract are typically defined as contract assets as well.
Billings in excess of costs and estimated earnings are now generally considered contract liabilities. If billings exceed total estimated costs at completion of the contract plus contract profits earned to date, the excess can be classified as deferred income.
Retainage issues
ASC 606 has a profound effect on retainage as well. A contractor needs to assess how to properly classify retentions as either receivables or contract assets. For instance, if there are restrictive provisions in the contract related to retentions, such as fulfillment guarantees, then those retentions are contract assets rather than receivables. Retentions should be classified as receivables only when the contractor’s right to the retention is unconditional (that is, subject to only the passage of time).
Retainage is determined at the contract level; therefore, some retentions may be classified as contract assets while other retentions are classified as receivables because the net right is conditional on some contracts and not conditional on others. A retainage payable is still considered a current liability, just like before ASC 606, and should be reported as such on a classified balance sheet.
Keeping tabs
It’s important for construction business owners and executives to keep tabs on their assets and liabilities, including how these items are being defined for financial reporting purposes. Your CPA can answer any questions you may have about classified balance sheets or other accounting matters.
What your surety wants from your financial statements
One party that likely appreciates a classified balance sheet is your surety. Bonding providers use financial statements and supplementary schedules to assess the financial stability of a contractor and to evaluate the company’s earnings trend.
Sureties typically want financial statements that, first and foremost, conform to Generally Accepted Accounting Principles rather than an ad hoc or special purpose framework. They also usually require comparative statements, often covering a three- to five-year period.
Finally, sureties typically prefer audited financial statements. Some, however, may accept reviewed or compiled annual financial statements.
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