Construction claims may impact the value of a construction company. In this article, the author discusses the issues that arise and the methodologies that may impact the valuation.
A construction claim is a demand made by the contractor to the owner for additional revenue for construction work performed on a construction project which is beyond the terms of the contract. Simply stated, a construction claim is a change order that has not been settled or negotiated between the owner and contractor. If the construction claim cannot be settled or negotiated, then most likely it will turn into a long and protracted litigation. If the claim is material, then it can have an adverse impact on the contractor’s financial statements, financial ratios, operations, and valuation. When performing a valuation of a construction contractor, inquire if there are any construction claims pending or in litigation and, if so, determine the potential impact to the valuation.
Construction Claims Revenue and Cost Recognition
The recognition of revenue of a construction claim differs from that of the original contract work and an approved change order. Conversely, the recognition of construction costs of a construction claim and original contract work and an approved change order should be the same. The difference in the revenue recognition may be problematic when valuing a construction contractor.
A change order is a modification of the original contract that effectively changes the provisions of the contract. A change order approved by the contractor and owner which results in a change in the contract price, the revenue from the approved change is recorded as construction revenue upon approval of the change order. The related accounts receivable will also be recorded and the collection of the cash from accounts receivable should be collected in a month or two. Likewise, the related construction costs incurred in performing the change order work are recorded as construction costs. With this proper change order accounting and matching of the construction revenue and costs, certain financial ratios, and metrics of the contractor’s financial statements, such as gross profits and others, should be unaffected.
By contrast, revenue from a construction claim may be recorded only if, (1) it is probable that the claim will result in additional contract revenue, and (2) the amount can be reasonably estimated. In assessing the probability of additional contract revenue from a construction claim and the reasonableness of the estimate, the following conditions apply:
If the above conditions have been met, then revenue from the construction claim may be recorded only to the extent that construction costs relating to the claim have been incurred and recorded.
In practice, the above conditions are usually not met until there is a negotiated settlement of the claim or, in the event of lack of a negotiated settlement, a court or arbitration opinion of the claim because of litigation. Therefore, the probability of additional revenue from the claim and the reasonableness of the estimated claim amount will not be known until the litigation is final. In the case of a final opinion through litigation, the timeframe for the opinion could easily be a year or more. Adding the potential appeals process, the timeframe will most likely be extended further.
The contractor’s action of walking-off the project and not completing the contracted work to save construction costs until the claim is settled is usually not an option as the contractor will most likely be obligated to complete the project regardless of the claim. The contractor will be left in a position of recording the construction costs without the ability to record the related construction revenue and accounts receivable. The lack of the construction revenue and related accounts receivable will also have an impact on the contractor’s cash flows and working capital. As can be seen, financial ratios or metrics that incorporate the contractor’s revenue and related costs, accounts receivable, cash and working capital, and others may be skewed and may not represent what historical financial ratios the contractor has been experiencing. The value of the contractor may be affected by the above example of accounting for construction claims if the construction claim is material.
To make matters worse, if the contractor bids on and performs municipality or government work, then surety performance and payment bonds will most likely be required. Surety companies make decisions to issue bonds by using the contractor’s level of cash and working capital among other financial ratios and metrics. If the contractor’s cash and working capital has been adversely impacted because of the construction claim, then this could lead to the non-issuance of the bonds and the reduction of the contractor’s bonding capacity. In this case, the contractor will suffer additional lost revenue from lost project opportunities. Depending upon the circumstances of the claim and related litigation, the surety company may decide to not issue any further bonds until the claim and litigation has been resolved.
The claim and related litigation could have an adverse impact to the contractor’s operations. For example, with the potential of reduced revenue from the loss of project opportunities, home office staff such as estimators and others may either be laid off or sent out to other projects to keep them busy. By transferring employees from the home office to the field may skew home office cost percentages and ratios from historical levels. The profitability and gross profit ratios of the other projects may be adversely affected since there may not be adequate budget to absorb the unplanned staff.
Further, the legal and expert costs could be significant, and the full extent of the legal and expert costs may not be known until the litigation is finalized.
Types of Construction Claims
If the valuation analyst valuing a construction contractor discovers a construction claim and related litigation that may impact the valuation, the valuation analyst should consider analysis and assessment of the potential impact of the claim to the contractor’s financial statements, ratios, operations, and valuation.
This section provides a general discussion of the types of construction claims and the following section provides a discussion of the common damages methodologies. The body of knowledge in the construction claims space is vast and a detailed discussion of this body of knowledge is beyond the scope of this article. The valuation analyst should, at a minimum, be able to have a general understanding of the type of construction claim and the damages methodology employed.
There are many reasons or impacts to a construction project that can result in a construction claim. Following is a general discussion of some of the common types. Quite often a construction claim includes multiple impacts with varying complex facts and circumstances:
Damages Methodologies Commonly Used in a Construction Claim
When quantifying the amount in a construction claim, it is important to only include costs that are attributable to impacts that are not the fault of the contractor and costs that are solely the responsibility of the owner or defendant. This is much easier said than done as a construction project generates a significant amount of cost and other documents, and sorting out these costs becomes an arduous and time-consuming task. Many times, a construction claim fails in litigation if the contractor has included additional costs for which the contractor is at fault.
Following are types of damages methodologies used in construction claims.
Jack W. Harris, CPA, is a forensic accounting expert with a focus on construction contract damages, construction cost audits, commercial damages, cost analysis, lost profits, business interruption, accounting, and related areas. He has 40 years professional experience and has worked on numerous domestic and international projects. Mr. Harris serves as an independent expert and consultant, and has also been admitted as a panelist for the American Arbitration Association for construction and accounting matters. Please visit his website at www.jackwharris.com.
Mr. Harris can be contacted at (303) 324-5812 or by e-mail to firstname.lastname@example.org.