The New Accountability
James C. Lundy, CPA
Part 1: Contractor’s Accounting
and Tax Update
Partner
Davidson, Golden & Lundy
Charlie Woodman, CPA
Risk Finance Advisory
Willis National Construction
2011 Willis Construction Risk
Management Conference
April 21, 2011
Construction Industry - Current Trends and Observations
• The recession is not over
• Certain sectors hit harder than others: residential, retail, commercial building,
hotel/motel, churches
• Certain sectors have held steady: healthcare, infrastructure, education, utility
• “It’s not just a recession, it’s a correction.”
• Concern about construction materials price volatility and inflation: fuel,
asphalt, PVC, steel, cement, aggregates, copper, etc.
• Escalator clauses are becoming more common
• How strong is the guarantee behind your price quote?
• Supply bonds
• Lower profit margins
• 30% to 100% reductions
• Increase in bidders and bid spreads
2
Construction Industry - Current Trends and Observations
• Increase in mergers and acquisitions
• Strategic acquisitions
• Buyers market - “Steals” - not “Deals”
• Increase in self performed work
• Too many contractors
• Construction period or “Gap” financing
• Extended period warranties
• Overbilling vs. warranty reserve
• Reporting issues
• Generally, survivors are winners - construction fortunes have been made
by being aggressive during recessions
• Bankers and sureties are concerned
3
Overview of Financial Reporting for Contractors
• Financial reporting is the responsibility of Owners, CFOs, Management,
Controllers and Independent CPAs - all share the risk
• Economic crisis has resulted in more reliance on statements
• More scrutiny and analysis on financial reporting than prior years
• Management, CPAs and Controllers have personal liability if intentionally misleading
• Reliance by various users on financial statements:
• Sureties
• Banks and finance companies
• Regulatory boards - licensing
• Owner and prime contractor prequalification
• Suppliers
• Stockholders (owners)
• Joint venture partners
• Unique methods and disclosures
• Real world suggestions
• Timeliness - delaying year end statements longer than 75 days is unacceptable; monthly and
quarterly reporting - 30 days
• Honest communication is key
• Surprises damage credibility: job fade,
claims, losses
4
• The surety and bank are your Partners
Revenue Recognition
• Commandments of Construction Reporting
• Underbillings are bad
• Unrecognized loss (fade) of poor cash flow management?
• Historical support for underbilling recognition
• Dumb or dishonest?
• Professional skepticism
• Overbillings are good, but should be in the bank
• Positive ratio of non-borrowed cash to overbillings
• Current Accounting Under SOP 81-1: Percentage of completion method is
required
• Cost to cost unless another method is more conservative
• No gross profit estimates in excess of historical without tangible documentation
• Soft fade/gain analysis: type of work, location, customer
• Use caution when segregating and combining contracts
• Accurate phase coding is required
5
FASB / IASB Preliminary Document on Revenue Recognition
• Exposure Draft issued June 24, 2010 (Topic 605-35); final statement due
in 2011 (replaces SOP 81-1 after 30 years)
• Revenue recognition FASB proposes major changes to the way
contractors account for revenue recognition. Under the proposal,
contractors would be required to adopt new financial reporting
techniques that may be more subjective compared to the current
method, percentage of completion (POC).
• Purpose: “Recognize revenue to depict the transfer of goods and
services in an amount that reflects the consideration expected to be
received for those goods and services.”
• A balance sheet approach that emphasizes:
• Unconditional obligation to pay
• Legal title
• Physical possession
6
Comparisons
Comparison of Key Features of the
Proposed Standard vs. Current Standard
Current Standard
Proposed Standard
Revenue Recognition - Construction-Type and
Production-Type Contracts
ASC 605-35 (Formerly SOP 81-1)
Sub paragraph
Revenue Recognition from Contracts with
Customers
Topic 605
Sub paragraph
Profit Center
25-3
Basic presumption is that each
contract is the profit center for
revenue recognition, cost
accumulation, and income
measurement. Segmented is
allowed under certain strict
conditions.
12-16
Evaluate distinct performance
obligations within each
contract for separate
revenue, cost accumulation,
and income measurement.
Combined obligations are
allowed when activities are
interdependent.
Method of Recording
Revenue
25-51
Recognize income as work on a
contract progresses. Incurred
costs in relation to total estimated
costs or other such measure of
progress toward completion.
Presumes ability to estimate total
contract costs.
25
Recognize income when it
satisfies a performance
obligation by transferring a
promised good or service to
a customer. The transfer
occurs when the customer
obtains control of that good
or service.
Variable Contract
Prices
25-60
Use most conservative estimate of
revenue that is assured and likely
to occur. When in doubt, use
lowest probably level of profit
until results can be estimated
more precisely.
41
If the transaction price cannot be
reasonably estimated, do not
recognize revenue. If
transaction can be reasonably
estimated, recognize revenue
from satisfied performance
obligations when it can be
estimated. Recommended to use
weighted probability measures
to determine transaction if entity
has sufficient history of similar
transactions.
7
Comparisons
Comparison of Key Features of the
Proposed Standard vs. Current Standard
Current Standard
Proposed Standard
Revenue Recognition - Construction-Type and
Production-Type Contracts
ASC 605-35 (Formerly SOP 81-1)
Sub
paragraph
Contract Costs
Revenue Recognition from Contracts with
Customers
Topic 605
Sub
paragraph
25-34
Accumulated in same manner as
inventory and charged to
operations as related revenue
from contracts is recognized.
Includes direct and indirect
costs.
58
Same as current standard with
exceptions for procurement,
mobilization, and inefficiency
Procurement
Costs
25-39
Costs should be expensed unless
they are recoverable under an
active contract
59
Costs of obtaining a contract,
including bid and proposals,
and negotiations are expensed
when incurred.
Mobilization
Costs
25-41
Costs may be deferred and
included in contract costs
on receipt of anticipated
contract.
57
Recognize these costs as an
asset when they related
directly to a contract,
generate or enhance
resources used for
satisfying performance
obligations, and are
expected to be recovered.
Amortize this asset ratably
over the duration of the
project.
8
Comparisons
Comparison of Key Features of the
Proposed Standard vs. Current Standard
Current Standard
Proposed Standard
Revenue Recognition - Construction-Type and
Production-Type Contracts
ASC 605-35 (Formerly SOP 81-1)
Sub
paragraph
Revenue Recognition from Contracts with
Customers
Topic 605
Sub
paragraph
Change Orders
Approved
25-25
Contract Price Adjusted,
cumulative catch up of
revenue
17-19
Contract Price Adjusted,
cumulative catch up of
revenue
Unpriced
25-87
If recovery probable (events
necessary for recovery
likely to occur), recognize
revenue to extent of cost
until approved. If changes
are in dispute, evaluate as
a claim.
41
Evaluated as variable
consideration
Claims
25-31
Reorganization appropriate only
if probable that the claim will
be sustained and amount can
be reliably estimated. Record
only to the extent of contract
costs. In practice, not
typically recorded until
amounts have been received
or awarded. May record as
adjustment to contract if
9 a
realization is beyond
reasonable doubt.
41
Evaluated as variable
consideration
Issues
• Why – convergence with IFRS / US GAAP “better information for users”
• A new focus on control and separation during the earnings process
• But:
• Is the contract a “continuous transfer of assets”? Confusion over what satisfies
performance obligations
• Has the customer “gained control of the work in process”? If yes, percentage of
completion method will be required
• Interpretation that title of control does not transfer until contract completion, will
require revenue recognition on the completed contract method
• Possible split of the revenue recognition model between goods (transfer upon sale
of product), and services (continuous transfer through performance of tasks or
series of tasks).
• Leading to a new definition of construction contracts as a continuous delivery or
process?
10
Other Issues
• Specialized assets – completed contracts progress billing – percentage
of completion (and Work In Process)
• Warranty costs result in revenue deferral vs. cost accrual
• Warranties are an emerging issues
• Change from cost to cost to units / labor hours
• Uninstalled materials and timing
• Unpriced change orders recognize profits?
• Performance bonuses estimated at reporting date
• Acceptance by sureties?: A sometimes skittish lot.
• Tax?
11
Updates
• New proposals to retain the current accounting principle SOP 81-1 for
measuring revenue during the progress of a contract
• Continue to pursue a carve out provision for revenue recognition with
FASB for the construction industry
• FASB wants to understand how the proposal will impact contractors’
income tax reporting
• At this point FASB still plans to issue the new revenue recognition
accounting standard in the second or third quarter of 2011, but admits
significant issues on the proposal still exist.
12
Changes to Lease Accounting Could Impact Contractors’ Finances
• On August 17, 2010 FASB and IASB (Topic 840) draft accounting standard on
lease accounting which attempts to ensure assets and liabilities arising from
lease transactions are recognized in the statement of financial position (Balance
Sheet).
• Currently (FASB 13)leases accounted under one of two ways: operating lease or
capital lease.
• Capital (or financing) leases transfer substantially all of the risks and benefits of ownership to
the lessee as if the lessee borrowed the money to purchase the property. Capital leases are
treated similarly to a purchase of the underlying asset. On Balance Sheet Recognition
• Operating leases are all other leases that are not classified as capital leases and are
generally treated as rental of property, and the effects are recorded as rent expense over a
straight-line basis over the term of the lease. Off Balance Sheet, with disclosure
• A lease is deemed to be financing if:
• Ownership transfer
• Bargain purchase options
• Lease term > than 75% of asset’s useful life
• NPV of future lease payments is > 90% of FMV of asset
13
New Lease: FASB Discussion Paper (Topic 840)
• FASB is going to “fix” SFAS 13, and make it more like IAS 17. Once again a
balance sheet emphasis.
• The preliminary conclusions of the board are:
• A lessee obtains the right-to-use an asset
• The lessee creates a corresponding liability
• Lease options do not require separate accounting. These include:
•
Renewal options
•
Contingent rental arrangements
•
Guaranteed residual value requirements
• The results of these preliminary conclusions will result in leases:
• - All being treated uniformly
• - Not being capital versus operating leases
• - Being treated as a single transaction
• - Being treated as purchases of the asset
•
14
New Lease: FASB Discussion Paper (Topic 840): Con’t
• The Accounting
• A liability is recorded
• − Based on the present value of the lease payments
• − Payments reduce liability to zero
• A corresponding asset is recorded
• At cost (present value of lease payments)
• Identified separately from owned assets
• Amortized over the shorter of:
• − The lease term
• − The economic life of the asset
15
New Lease: FASB Discussion Paper (Topic 840)
• Changes can affect liability and asset (impairment)
• Option to buy:
• Option price is included in liability
• Exclusion of asset from owned assets not required
• Topics not addressed in this opinion paper are:
• Impact on exploration and use of natural resources agreements
• Treatment for non-core assets (such as airplanes for non-airlines)
• Short-term lease contracts
• In summary, the discussion paper indicates FASB is working to treat
virtually all leases
• under the existing capital lease rules, and significantly reduce offbalance sheet financing by operating leases.
16
Changes to Lease Accounting Impact
• These changes could have a significant impact on construction entities that do a
lot of financing through operating leases.
• Due to the impact of the lease accounting changes, we will likely see lessees
desire shorter term leases to reduce both the increased leverage and the impact
of the increase in first-year lease costs. Lessors may be inclined to charge a
higher price on leases to offset the additional risk they would be subjected to
with shorter term leases.
• These changes likely will not become effective until 2012. There are some
actions that can be taken now to quantify and possibly reduce the impact:
• Determine if this is going to have a major impact on your business. If you lease a significant
amount of assets, this accounting change is likely to have a larger impact on your financials.
• Quantify the impact of the proposed changes by considering all existing and potential future
operating leases.
• Review and analyze how your corporate agreements (e.g. loan documents, compensation
agreements, etc.) are affected and if the agreements can and should be amended to take
into consideration the changes solely due to the changes in lease accounting.
17
Updates
• The AGC issued a formal comment letter to FASB detailing its concerns. These
issues may be hard to resolve in this short time frame.
• “Accounting for lease transactions Under FASB’s proposed model, all operating
leases would be classified as capital, which could redefine the underwriting
processes and covenants in the banking and surety industry. This will have a
significant impact on contractors’ balance sheets, working capital, and leverage”:
• No real effect to cash flow or existing tax law
• May change job costing due to depreciation and capital cost charges
• Operating ratios: EBITDA
• Proposing differentiation between equipment leases and real estate leases
• How this impacts accounting for services such as cranes, scaffolding, and other subcontractor arrangements
• The need to separately address short-term rental arrangements or leases with terms less
than a year or an operating cycle
• Other ramifications:
• FAR: Rents are allowed but interest and financing charges are disallowed
• Sales tax–capital lease vs. rent classification creates sales tax consequences
18
FASB Interpretation No. 48 (FIN 48)
• FIN 48- FASB’s latest pronouncement in accounting for income taxes.
• Released July 13, 2006 / Effective Date for Years Beginning on or After
December 15, 2006
• FIN 48 interprets FAS 109
• Intent is to decrease the diversity in accounting for uncertainty in income tax
financial statement positions.
• Prior to recognizing the benefit of a tax position for financial reporting
purposes, the tax position must be more-likely-than-not (MLTN) of being
sustained solely on its technical merits (excluding detection risk)
• Tax positions recognized are reported at the largest amount that is
MLTN to be sustained
19
19
FIN 48: As Applied
Evaluate each position for recognition. In order to recognize any amount of the
benefit, the position must be MLTN of being sustained assuming:
•
The position will be examined
•
The examiner will have full knowledge of all relevant info
•
Evaluation based solely on technical merits
•
No offset or aggregation of positions
•
Should assume resolution in the court of last resort
•
May Not Take Into Account Audit Risk or The Likelihood of Being Audited
•
Sage Input
•
Overblown reaction by CPA profession?
•
Is it a reasonable method with substantial authority or frivolous?
•
Is it more likely than not (>50%) that the IRS will disallow?
20
20
Surety analyst email statement
• “There has been some discussion about FIN 48 recently and I wanted to let
everyone know how we see it affecting us as a Surety. First, keep in mind that a
FIN is an interpretation and clarification of pre-existing GAAP – CPAs were
already required to disclose these issues. Simply stated, FIN 48 states that if an
entity takes a tax position that is “more likely than not” to fail a tax examination,
they must book a liability and include a disclosure reflecting such. Second, I think
it is a good rule for the Surety, as users of the financial statements. It forces
entities with whom we do business to disclose and quantify unreasonable tax
positions, which will assist in our underwriting. A far more important issue is the
necessity to disclose off balance sheet tax liabilities of pass through SCorporations and LLCs.”
21
Other Financial Reporting Items
•
•
Going Concern Opinion
•
Losses, significant debt and significant backlog reductions
•
SAS 59 - Exposure draft issued to enhance - FASB issued Project Update
on 10/21/09
•
Look forward 12 months or longer
FASB 165 – Subsequent Events
•
Establishes cutoff date for evaluation of subsequent events
•
Recognized and unrecognized events
•
Concerns and issues with “holding” financial statements – liability to CPAs
if delay results in damages to user
22
Most Commonly Missed Disclosures and Format Errors
• Will the disclosure affect the conclusions of the user?”
• Formatting errors:
• Balance sheet segregation and disclosure of:
•
•
•
•
•
Retainage receivable and payable
Claims receivable and payable
Unbilled receivables
POC adjustments
Loss contract accrual
• FIN 46 consolidation
• Joint venture partial consolidation results in correct working
capital recognition
• Would the consolidation affect the user’s conclusion?
23
Most Commonly Missed Disclosures and Format Errors
• Accrual for self-insurance deductibles / liabilities
• Accounts receivable
• Aged receivable issue (over 90 days)
• Claims and unapproved change orders (recognition of income = to cost incurred)
• Detailed and comprehensive disclosure of claims and unapproved C/O’s
• Facts and basis for the claim
• Revenue recognized, if any
• Detailed calculations, discounts and assumptions
• Arbitration or court dates
• Separate line item reporting on contract schedule to prevent POC cost to cost
recognition
24
Most Commonly Missed Disclosures and Format Errors
• Significant changes in contract estimates
• SOP 94-6 disclosures for current and cumulative impact to revenue and gross
profit
• Loss contract accrual calculation
• Backlog
• Key consideration in going concern determination
• Backlog gross profit calculation on contract schedule
• Backlog subcontracted - bonded?
• FIN 45 off balance sheet guarantees
• Surety bonds issued and outstanding
25
Most Commonly Missed Disclosures and Format Errors
• Equity with characteristics of liabilities (FAS 150)
• Mandatory buy sell liability
• Callable preferred stock
• Subordination agreements
• Tax liabilities of pass through entities (S-Corp & LLC)
• Not in SOP 81-1, but…
• Current and deferred liabilities
• Management intention to distribute cash
• Consideration of accrued distribution
26
Tax Update on Rent-A-Captives / Segregated Cell Arrangements
• Sponsored Facilities
• Rent-A-Captives
• Agency Captives
• Carrier Captives
POOLED RISK LAYER – not common
• Key: Insureds and
Captive Owners are
usually unrelated
entities.
Cell A
Cell B
Cell C
Cell D
Individual Cell Capital – If Applicable
Core Capital of Captive
“General Account”
27
IRS View of Cell Taxation
• In 2005, the IRS asked the industry how cell captives should be taxed
and the industry responded.
• In 2008, the IRS stated how it would test the presence of “insurance”
and the deductibility of the premium by the insured. It advised how it
was considering treating the cell for tax purposes, but asked for
comments before it made a final decision
• Rev. Rul. 2008-8 – “insurance” is determined on a cell-by-cell basis; if
there is “insurance, the insured can deduct it.
• Notice 2008-19 – the IRS currently intends to treat each cell as its own
insurance company and all elections will be made on a cell-by-cell basis;
but, the IRS is seeking comments before it makes its final decision. The
final rules will not go into effect until the first taxable year beginning
more than 12 months after the date the final decision is published.
• The Notice does not state how the cells will be taxed in the interim.
28
Cell & Rent Session / 28
Proposed Treasury Regs (9/14/2010)
• A Domestic Cell (or series in a series LLC) will be taxed as a
separate entity.
• The same applies to a Foreign Cell (or series), if the Cell (series)
would be an insurance company.
• Each cell gets its own EIN and files its own return.
• Each cell makes its own elections.
• Effective when regulations are finalized.
29
Cell & Rent Session / 29
Grandfather Rule in Proposed Treasury Regs (9/14/2010) if all
below are met:
• There is a grandfather rule if all tests are met:
• The cell company was established before September 14, 2010
• The cell conducted business (if a foreign cell, more than half its business
was insurance) before September 14, 2010
• If foreign, the cell classification is “relevant” [technical requirement]
• No cell owner treats the cells as a separate entity for any taxable year
• The cell and cell company had a reasonable basis for their historic
treatment
• Neither the cell, cell company, nor owner was under audit for the cell
treatment on or before September 14, 2010
• Grandfathering ceases if 50% or more of the vote or value of the cell
company or cell is owned by those other than those who owned them on
September 14, 2010
30
Cell & Rent Session / 30
Other
• Foreign Bank Account Reporting
• New amnesty
• Not as generous as last year’s
• Signal for aggressive enforcement in the future
• Tax treaty partners
31
The New Accountability
James C. Lundy, CPA
Part 2: Compliance and Audit
Discussion
Partner
Davidson, Golden & Lundy
Charlie Woodman, CPA
Risk Finance Advisory
Willis National Construction
2011 Willis Construction Risk
Management Conference
April 21, 2011
Why Cost Accounting is So Important
• It Helps In:
• Bidding
• Determining problem projects
• Supporting change order pricing
• Claims process
• Reconciling job costs to financial reports
• Making better decisions
• Making “expansion” less frightening
• Today’s focus: Supporting Audits
• Commercial
• Governmental
• Tax
33
What is a Contract Compliance Audit
• Compares costs billed to costs incurred
• Compares costs billed to allowable costs
• Compares fees (formula and rates) to contract provisions
• Confirms contract procedures were followed
• Confirms owner’s administrative procedures were followed
• Assures that owner is not overpaying especially on reimbursable costs
• Keeps contractor accounting staffs on edge
• Keeps forensic accountants and the DCAA (and like kind agencies)
employed
34
If You’re Not Prepared: What Can A Contract Compliance Audit Do
• Create tension
• Cause ill will and jeopardize relationships
• Distract employees and incur significant cost
• Highlight contract vagaries
• Lead to penalties and fines
• Cause future contract / bid disqualification or debarment
• The biggest failures:
• disorganization
• poor contract negotiation or understanding of terms and conditions
• inability to support or defend cost allowability, cost determination, and information /
data processes
35
Success Strategies
• Adhere to planned project procedures and document any deviations,
including source, reasoning and resulting impacts
• Know all contract terms & conditions prior to start, reconcile any
provisions that are vague / use, where practical, hard rate terms
especially for reimbursable items
• Maintain and keep accessible records and files throughout the project
• Conduct cash to cost to projection reconciliation regularly and anticipate
audit issues preemptively
36
Contract Terms for Focus
• Audit scope and processes
• Recordkeeping requirements and data support
• Reporting requirements, timing and content
• Pre-established costs for specific project
• General conditions pricing
• Self-performed work rates or equipment usage rates
• Approved mark-up rates
• Change order minimum rates
• Acceptable cost support documentation especial for cost-plus or reimbursement
• Disclose related party transactions
• Address rebates and cost caps
• Specific measureables (e.g., efficacy) and deliverables
• Guarantees and warranties
• Cost sharing
37
The Federal Government and Insurance Costs
• So what…
• Insurance costs are generally recoverable under government awards, but can be
long tail
• Establishing well-defined processes and proper accounting are key practices to
achieve recovery of insurance costs
• Certain practices E&C contractors employ for commercial contracts (e.g. lump
sum) may be questioned by government auditors
• Government regulations may require a different practice
• Government auditor may believe a different practice is necessary
• Typical existing practices:
• Measuring cost of self-insurance based on losses incurred rather than a projected average
loss
• Self-insurance charges not in accordance with accepted actuarial principles
• Insurance costs based on premiums charged from captive insurers or companies under
common control of contractor
• Insurance programs have not been approved
38
Regulations
• Key regulation* for accounting for insurance costs:
• Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs
• Cost Accounting Standard (CAS) 403, Accounting for Home Office Costs
• FAR 31.205-19, Insurance and Indemnification
• FAR 31.201-5, Credits
• FAR 28.3, Insurance
• When to evaluate your current accounting practices for insurance costs?
• Contracts will be CAS covered
• Contracts subject to Federal Acquisition Regulation 31.205-19, Insurance and Indemnification
*Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html
Full text of Cost Accounting Standards can be found at http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html
39
Identifying CAS and FAR in contracts
• Typically, CAS and FAR requirements are disclosed in:
• Contract and subcontract solicitation documents
• Draft contract terms and conditions
• Solicitation representations and certifications
• Draft contract clauses to be incorporated by reference in the awarded contract
• FAR cost principles may apply in other circumstances where the original
contract did not require application of FAR cost principles:
• Change order proposals
• Cost reimbursement or progress payment requests
• Equitable adjustment claims
• Termination clauses
40
CAS Coverage
• The CAS are governed by the CAS Board and currently consists of 19
separate standards.
• The CAS can be imposed on a contractor under the following
circumstances:
• By reference by the Federal Acquisition Regulation (FAR)
• Modified CAS coverage –Single federal contract or subcontract greater than $7.5
million but less than $50 million
• Full CAS Coverage –Federal contracts or subcontracts greater than $50 million or
Net Federal CAS-covered contracts received by the contractor totaling $50 million or
more during the preceding cost accounting period
41
FAR Cost Principles
• FAR Part 31 Applicability
• Cost reimbursable contracts
• Fixed price contracts priced based on submission of certified cost or pricing data
• Cost principles in effect when contract awarded applicable for life of contract, with
certain exceptions
• Allowable costs limited by FAR Part 31 and CAS requirements
• Includes FAR 31.205-19, Insurance and Indemnification
42
Basic CAS Insurance Accounting Concepts
• CAS includes an express requirement that the amount of insurance cost
assigned to a period is the projected average loss for that period plus insurance
administration expense
• Because CAS requires a projected average loss, measuring insurance costs based on actual
losses is limited to circumstances where actual losses will not vary significantly from a
projected average loss
• Under the CAS 416 concept, a risk of loss is covered by either purchased insurance,
payments to a trusteed fund or self-insurance
• Applied
• Projected average loss means the estimated long-term average loss per period for periods of
comparable exposure to risk of loss.
• Self-insurance means the assumption or retention of the risk of loss by the contractor,
whether voluntarily or involuntarily. This includes the deductible portion of purchased
insurance.
• Self-insurance charge means a cost which represents the projected average loss under a
self-insurance plan. Because CAS requires a projected average loss, measuring insurance
costs based on actual losses is limited to circumstances where actual losses will not vary
significantly from a projected average loss .
43
FAR Part 31, Cost Principles Allowability
• Factors for determining allowability :“A cost is allowable only when the cost
complies with all of the following requirements”
• Reasonableness & Allocability
• Cost accounting standards, or otherwise generally accepted accounting principles and
practices appropriate to the circumstances
• Terms of the contract
• FAR subpart 31.2 limitations
• Costs of insurance required by contract are allowable
• Costs of general insurance are allowable if reasonable and measured, assigned and
allocated in accordance with the requirements of CAS 416
• Costs of business interruption insurance must exclude coverage for lost profits
• Self-insurance program approval is required when:
• 50% or > of the self-insurance costs allocable to negotiated government contracts
• Self-insurance costs for the fiscal year are anticipated >$200k
44
Purchased Insurance Premiums
• The projected average loss (PAL) starts with the premium cost
• If covers more than one cost accounting period, pro rate costs over the
period covered (prepaid insurance account)
• If insurance is purchased specifically for and directly allocated to a
“single cost objective” (e.g. job), do not need to pro rate
• The applicable portion of any income, rebate, allowance, or other credit
relating to any allowable cost and received by or accruing to the
contractor shall be credited to the Government either as a cost reduction
or by cash refund.
• Includes refunds, dividends or additional assessments
• Must be recognized as an adjustment to the pro rata premium costs in the earliest
period in which it is actually or constructively received
45
Insurance Reserves
• IBNR (Incurred But Not Reported)
• Reasonable reserves for IBNR should not be considered deposits and related
premiums reflect insurance costs
• While generally understood by Government reviewers to be a common feature,
may be concern that reserves are too large
• If Government reviewer considers reserve unreasonably large, may question a
portion of the reserve and the related insurance cost
• To lessen risk of issues with purchased insurance reserves, contractors and
insurance carriers should be prepared to demonstrate that reserves are
reasonable based on:
• Exposure to loss
• Actual loss experience
• Loss Trending and / or Inflation
• Loss development experience or “lag” studies
• Discounting reserves not expressly required by CAS 416, but DCAA guidance suggests
reserves may be subject to present value discounting
46
FAR 31.205-19(b): Captive Insurance = Self-Insurance
• Mistake to account for payments to a captive as purchased insurance
• Exception when able to demonstrate that captive sells insurance to
general public in substantial quantities and insurance charges reflect
market forces
• Contractor should plan to measure captive insurance as self-insurance,
unless: Captive sells the coverage commercially and premiums paid by
the contractor can be demonstrated to be based on market prices
• Must treat Government as a “Favored Insured”
• Group Captives will generally be treated as purchased insurance with
limitations for deductible or “A-Layer” accounts.
47
Measurement of Self-insurance Charges
• With significant self-insurance, typical practices for recovering insurance
costs are establishing methods for:
• 1.Estimating annual projected average losses
• 2.Allocating self-insurance charges to segments and cost objectives (jobs)
• Under CAS 416, three ways to measure projected average loss (PAL)
1.Actual Losses: actual amount of losses (where actual losses not expected to differ
significantly from PAL)
2.Comparable Purchased Insurance: Estimate of the PAL based on the cost of
insurance that could be purchased for the self-insured risk
3.Actuarial Measurement: self-insurance charge based on the contractor’s or industry
experience and anticipated conditions in accordance with generally accepted
actuarial principles
• The total of self-insured charges plus insurance charges must not
exceed guaranteed cost insurance for the same exposures
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Measurement of Self-insurance Charges
• However, when the self-insurance charge is not based on actual losses or the
cost of comparable purchased insurance, CAS 416 indicates:
• Insurance charge must take relevant experience and expected conditions into account
• Must be “in accordance with accepted actuarial principles”
• Outside quotes / broker indications are allowable
• May lessen risk of Government challenge if estimate is performed by an actuary
and “true ups” are made (though not expressly required by CAS, the DCAA…
• CAS Board and DCAA’s position appear inconsistent
• Contractors should be aware of DCAA’s interpretation and recognize risk that DCAA may
challenge self-insurance accounting practice that does not include “true up” adjustments
• Contractors may use DCAA’s favored practice to lessen potential disagreement
• Should clearly document practice in CAS Disclosure Statement or other document
• Consider agreements with the Contracting Officer on cost measurement, e.g. through a
Memorandum of Understanding
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Allocation of insurance costs under CAS 416: “Home Office”
• Commonly allocated home office costs:
• Purchased insurance
• Self-insurance
• Administrative costs
• Main allocation concepts:
1.Insurance costs and losses allocated directly to segments (to maximum extent
possible)
2.If not allocated directly to segments, allocation base should reflect factors used to
determine premium or self-insurance charge
3.Material administrative costs are to be allocated same as related premium or selfinsurance charge
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DCAA Audit Guidance Allocation of Insurance Costs
• 1st and most important in determining if insurance costs reasonable
and/or allocable is to review policy coverage
• If policy provides coverage for general practice, allocation of costs to all contracts
through G&A generally acceptable
• If policy provides unique coverage (e.g. for a particular segment), costs should be
allocated directly to the benefiting cost object
• Auditors may challenge allocations
• Auditor may review loss and claims experience to challenge a broad-based
allocation (G&A) if can determine policy provides unique coverage (e.g. punitive
affirmative wrap)
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Summary: Government Contracts & Insurance Costs
• Insurance accounting under government regulations is complex and
interpreting regulations can be difficult
• Insurance costs are generally recoverable under government awards
• Establishing well-defined processes and proper accounting are key
practices to achieve recovery of insurance costs
• Can be applied directly or conceptually to non-Federal work.
• Grants
• Cooperative Agreement
• State and Local Contracting Regulations
• The Contract itself
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Other Construction Issues During the Recession
• Prequalification of contract owners
• Verification of project financing
• Credit verification
• What entity is signing the contract?
• Prequalification of subcontractors
• Bonded subcontractors
• Credit report and review of financial statement
• Verification of payment of materials
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Other Construction Issues During the Recession
• Monthly meetings between project management and accounting
• Bid spread jobs
• Underbillings
• Claims or change orders
• Receivable and retainage collection - cash flow report
• Jobsite and office theft
• Cost control
• Labor reporting - daily time sheets
• Phase code comparisons
• Re-think every cost and expense
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IRS Audits Issues & Strategies for Contractors
IRS being directed to "greet" many more taxpayers
A. Wall Street Journal column states that IRS looks to audit 300,000 to 400,000 small
to mid-size businesses ($5 million to $50 million revenue)
B. Audits can consist of office review of tax return (most returns) or full field audit
C. Appearance of return, large rounded numbers, and confusing terminology can add
to odds of full field audit
D. Don't let the threat of an IRS audit change the way you do business but be
prepared if one comes
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IRS Audits Issues & Strategies for Contractors
Intercompany and related party transactions attract immediate
attention
A. Document all related party transactions with minutes, invoices, contracts and
calculations
B. Be specific about intercompany payments. Use “Office Expense,” “Accounting
Services” or “Shop Costs” vs. "Management Fees" or "Consulting Fees.”
C. Calculate exact amounts vs. round numbers
D. Make payments monthly, quarterly, etc. vs. during year end audit (adjustments at
year end appear to be manipulating profits)
E. Document related party business purpose (rent, bond indemnity, loan guarantee,
equity, or working capital requirements)
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IRS Audits Issues & Strategies for Contractors
Audit technique is to review revenue and "cost of goods sold" (direct
costs)
A. Most auditors do not understand construction
B. Make it easy for them. Prepare schedules and statements that agree to tax returns.
Give them a file of documents that they can keep.
C. Auditors will review financial statements and footnotes for relationships, claims filed
and disclosures
D. IRS will select a sample of contract activity. They have been told that contractors
use company funds to build personal assets!
E. Accrued expenses (claims, worker’s comp., etc.) not paid by March 15 are not
deductible. Adjust costs to complete contracts instead.
F. Prepare look-back tax returns. Form 8697 for company (or individual if company is
an S Corporation or LLC).
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IRS Audits Issues & Strategies for Contractors
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IRS Audits Issues & Strategies for Contractors
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IRS Audits Issues & Strategies for Contractors
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James C. Lundy, CPA
Partner
Davidson, Golden & Lundy
Charlie Woodman, CPA
Questions & Thank You
Risk Finance Advisory
Willis National Construction
2011 Willis Construction Risk
Management Conference
April 21, 2011