Large overbillings or underbillings could be an indication of problems that could jeopardize the stability of a construction contractor's bond program. The most accurate method of revenue recognition for most contractors to report earnings is the Percentage of Completion (POC) method of accounting, typically with the completion percentage determined by the costs incurred to date as a percentage of total estimated costs on the contract (cost-to-cost). This method ties together what the contractor actually earned, with what they actually billed, reflecting differences as either an asset or a liability on the balance sheet.
For example, if a contractor is 50% complete with the costs on a contract, but they have billed only 40% of the total contract price, the result would be an underbilling (a current asset on the balance sheet) in the amount of 10% of the contract price. If instead of 40% having been billed, it was 60%, the result would be an overbilling (a current liability on the balance sheet) in the amount of 10% of the contract price. Accordingly, the amount billed to date on a contract does not affect the amount of revenue recognized. Revenue is determined based on the contract price and the percentage of completion. Almost never does the amount billed match the revenue amount, and such differences are reflected in underbillings and overbillings on the balance sheet.
Billing concerns in the eyes of an underwriter:
- Large underbillings. This may be a sign of slow billing practices, unapproved change orders being included in the contract price, and/or profit fade on the contract that has not yet been recognized in the estimated costs to complete.
- Large overbillings. An underwriter will look to see that any large overbilling amounts are offset on the asset side of the balance sheet by a like or greater amount of cash and receivables. A strong positive working capital position (Current Assets minus Current Liabilities) is important as well. A job that is billed heavily in the early stages (front end loaded) or on which advance payments are made by the owner can show significant overbillings.
Most contractors try to overbill at least a little when possible. Sometimes a job is overbilled to the extent that the estimated costs to complete the job exceeds the remaining unpaid contract balances. This excess amount is known as “job borrow”. It is important for the contractor to realize that the cash flow for the remainder of the job will be negative, by the amount of the job borrow, and he/she must plan accordingly so that funds are available to cover remaining job expenses.
Coming Soon: A blog article on the new revenue recognition standards - ASC 606.
At Old Republic Surety Company, we can coach contractors and their trusted CPA adviser to understand what ramifications their billing practices could have on the analysis of their financial statements. We also consult on ways a contractor can improve their balance sheet which will enable them to be more competitive and grow their bonding program and their business. Contact your independent insurance agent for more information about bond programs with Old Republic Surety Company.
Mike Sanders, Senior Vice President of Underwriting, oversees the underwriting and operations of all branch and regional offices. Since 1992, Mike held responsibilities in one of our large branch office, working with both contract surety and commercial bond business, until taking a position at the Brookfield Home Office in 1999. Prior to joining ORSC, Mike launched his surety career with Aetna Casualty and Surety Company where has was trained and handled the marketing and underwriting of all lines of bond business. Mike has a Bachelor's degree in Finance from Drake University. He also has a AFSB designation.