Many contractors labor under the false impression that financial statements are what their accounting software lists under “standard reports.” Others believe their in-house accountant 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 line of credit for working capital growth.

The moment a surety or commercial lender sees that a contractor is trying to submit in-house standard software reports for financial statements that are not in accordance with generally accepted accounting principles (GAAP), 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 often prepared by a certified public accountant (CPA), which are compliant with GAAP and supported by schedules of open and closed job activity, 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 its financial statements hid the fact that no real assets existed and no real revenues were being earned. GAAP helps to prevent 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.

Important Insights

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 the contractor values cash and understands its necessity.

Most banks also want to see positive cash flows from operations. 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

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.

Key Role

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.

Doeren Mayhew’s Construction Group works closely with contractors to help them better understand their financials and make more informed decisions related to their business. To obtain assistance, contact our dedicated construction CPAs today.