Determining Work in Progress at Balance Date for the Construction Industry

 

 

Determining Work in Progress at Balance Date

By now, your year-end progress claims (upward and downward) should have all been received and payment certificates issued. Your accounts team or person will soon be providing the reports of revenues and costs for you to determine your work in progress.

But this year will be different; very different.  Covid-19 “struck” prior to balance date so its impact must be allowed for at balance date.

Not only is the calculation different but the consequences are different.

The 2020 financial year has been a strong and profitable year for most. 

2021 will be very different due to the ongoing impacts of Covid-19.

• We start with a month with no revenue, continuing overheads and wages/salaries for those who would normally be working on projects.  Even in good times, it would be challenging to recoup the April loss over the balance of the financial year.  2021 will be even tougher.
• The cash flow consequences of the April loss will be quickly felt and without exceptional profits in the short term will be a continual drag on management time and efforts.
• Those that have had to manage a business with insufficient cash will know first-hand how much additional time it takes just communicating with creditors and forecasting, reforecasting and juggling cash flows.
• There will be claims, counterclaims and arguments from those seeking costs for delays, disrupted work and increased costs during the lockdown.  These will be both upward and downward.
• Even when teams are back on site, the new procedures required may be significantly less efficient, more costly and will set back planned timeframes.
• This too will create a further round of claims, counterclaims and arguments for these additional costs.
• Some subcontractors, operating on already tight margins, will run out of funds to pay their staff and either collapse or seek financial support from head contractors.
• If those subcontractors do fail who is going to provide the necessary professional sign off for all the work for that sub-trade, that all required work was done and was at the necessary standard?  Is there a workable plan B?  Is there a financial consequence?
• Less profit will mean less tax or more likely no tax for 2021.
• The banks will be scrutinising your results and financial position very closely and making difficult decisions.

So, when you sit down to calculate your work in progress, there is a whole raft of new factors to take into account that we have never had to consider before. There is now massive uncertainty as to the additional costs required to complete the existing projects and therefore the expected margins on those projects.

These issues flow directly to the heart of the work in progress calculation.

Some companies have to prepare General Purpose Financial Statements in accordance with NZ IFRS accounting standards including NZ IFRS 15 relating to revenue recognition (generally those with revenue over $30M or assets over $60M for the 2 previous years), whereas others (mostly those under that threshold) will apply SPFR (Special Purpose Financial Reporting).  The principles and the maths are quite similar, and the differences are mostly at the edge, in less common contracts and in the journal entries, disclosure and descriptions used (although there are some significant “fish-hooks” contained in NZ IFRS 15 requirements).

Right now, you simply don’t know what the impacts will be.  Meanwhile the directors, bank and others are anxiously waiting to know the results and financial position.  The suggested solution for some interim results is:

 

Two bites of the cherry, or perhaps 1 of cherry and 1 of lemon

1. First bite - For the sole purposes of some interim management accounts, (which may not yet comply with the technical requirements of the accounting standards), apply the information you know now using the methodology used in your monthly reporting but be very conservative. Take into account all the things you know or anticipate may occur that will adversely impact on the incomplete projects. For some projects, particularly those at an early stage it may result in no margin being accounted for at this stage.  Any financial reports must clearly show that these are pre-Covid results.
   It is important that these accounts are not used for year-end reporting or tax returns.
    
2. Second bite - When there is better, or at least some clarity on all the unknown additional costs, disruption, adjustments to revenue you will have the benefit of hindsight to know how some of the significant issues which existed at balance date are unfolding for your annual reporting.  Whilst use of hindsight is discouraged in the accounting guidance for financial reporting purposes, you will benefit from this knowledge and be able to use it to guide your fresh estimates to prepare a much more realistic work in progress calculation. This will most likely be significantly less, reflect your true level of profitability for 2020, and form the starting point of your annual financial statements and tax calculation.
   Maintain a record, either within or outside your system of the basis of your calculations to support the judgements made and provide a guide for the next monthly or quarterly calculation.

 

We utilise a very helpful checklist to identify the components of the work in progress calculation where additional adjustments may be required and to guide decision making in areas of uncertainty.

The above calculations are only as good and as accurate as your housekeeping and management of the data used to calculate your anticipated margins, costs and revenues to complete. Please ensure your quantity surveyors and anyone else who manages your data utilise their time working from home to have a big tidy up.  This is also a good time to ensure that all those that use the system really know how to operate all features and follow the correct procedures.  If procedures were correctly followed, the housekeeping would be much easier and integrity of the work in progress much more accurate.

 

Tax Opportunities

There are some different tax interpretations in construction but for most, the measurement of work in progress has a direct impact on the taxable profit and thereby on cash flow.  The correct principles and reasonable care must be followed.    

The recent announcement of the ability to carry back tax losses will be a huge benefit to the industry where 2020 was a good year and 2021 is unlikely to be as good.  Unfortunately, the carry back is a rather blunt tool and it will take too long to get the desperately needed cash.  Getting the 2020 tax calculation correct and not inadvertently overstating profit will have a more immediate benefit.

There is a range of other cash flow planning opportunities for tax depending on each company’s particular tax profile and circumstances.

In these most unusual times, application of subsequently gained knowledge may have a profound impact on work in progress measurement, profit measurement, cash flow, banking covenants and solvency.

 

Future Impact

This won’t be just a balance date decision making process. It will need to be applied to management accounts each month or quarter.  Your bank will likely raise queries on this too.

The costs, uncertainties and revised margins will directly impact your forecasting and cash flow planning.

Directors will need to carefully consider these matters in assessing solvency; hopefully in the context of dividends but for some, in the context of continued trading.