Their Potential Impact on Valuing a Construction Contractor
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 contractorâ€™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 contractorâ€™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:
- The contract or other evidence provides a legal basis for the claim; or a legal opinion has been obtained, stating that under the circumstances there is a reasonable basis to support the claim,
- Additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractorâ€™s performance,
- Costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed, and
- The evidence supporting the claim is objective and verifiable, not based on managementâ€™s feel for the situation or on unsupported representations.
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 contractorâ€™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 contractorâ€™s cash flows and working capital. As can be seen, financial ratios or metrics that incorporate the contractorâ€™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 contractorâ€™s level of cash and working capital among other financial ratios and metrics. If the contractorâ€™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 contractorâ€™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 contractorâ€™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 contractorâ€™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:
- Delayâ€”An important dimension of a construction project is the estimate of the amount of time it will take to complete the project. The contract will usually specify a completion date and if the contractor is late, then it may be subject to penalties specified in the contract. The project time factor is commonly determined through schedule analysis which is a critical path analysis of the tasks and activities required to complete the project. Once the project commences, the critical path is usually monitored to determine if the project time is on track. If the contractor alleges that, through actions of the owner or someone outside the control of the contractor, the critical path has been impacted resulting in a delay, then the project will take longer than planned. The types of additional costs incurred from a delay are time-related costs. Time-related costs are incurred as a function of the duration of the project and include field indirect costs and home office costs.
- Accelerationâ€”Acceleration usually results after a contractor has been impacted through a delay to the critical path. After the delay, and for the contractor to complete the project by the contract completion date, the contractor may be required to accelerate the remaining work to make up the time lost due to the delay. Additional costs incurred due to an acceleration of the work may include project additional supervision, additional construction workers, materials, equipment, and related costs.
- Disruptionâ€”A claim for disruption is a claim for the impact to one or more activities in completion of the project that was allegedly the cause of the owner or someone outside of the control of the contractor. Activities, by way of example, include: the placement of concrete, framing, electrical, plumbing, roofing, and others. Disruption to activities results in increased activity-related costs. Activity-related costs are costs that are incurred as a function of the activity and not the time on the project. These costs would include construction worker labor and burden, subcontractors, materials, equipment, and other related costs.
- Change in Scopeâ€”If the contractor is directed by the owner to complete a certain scope of work that the contractor believes is not within the scope of work specified in the original contract, then this will most likely result in a dispute and claim over whether or not this scope of work is within the original contract. A change in the scope of the work can result in time-related and activity-related costs. This would include additional labor, subcontractors, materials, equipment, as well as field indirect costs and home office costs.
- Differing Site Conditionsâ€”During the negotiation of the contract and estimating the construction costs, the owner will make certain representations about the construction site that the contractor can rely upon. For example, on a project requiring excavation, the owner may make a representation of the sub-surfaces. If the owner represents that there are no unusual sub-surface obstructions such as hard rock material or buried utilities or tanks, then the contractor will estimate the construction costs and plan the duration and means and methods accordingly. If, upon excavation, the contractor discovers a significant amount of hard rock material or perhaps buried utilities or tanks, then this will most likely result in a differing site conditions claim. A differing site condition can result in time-related and activity-related costs. This would include additional labor, subcontractors, materials, equipment, as well as field indirect costs and home office costs.
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.
- Actual Cost Method (also referred to as the direct cost or discrete cost method)â€”This methodology is the most preferred. As the name infers, it involves the accumulation, quantification, and summary of the relevant actual cost records, such as labor and burden, equipment, subcontractors, materials, field indirects, and home office costs, that were incurred as a result of the owner or defendants fault.
- Total Cost Methodâ€”This methodology is the least desirable and may only be used under certain circumstances, such as: (1) there is no other way to quantify the claim, (2) the original estimate is reasonable, (3) the construction costs are proven reasonable, and (4) the contractor is not responsible for any of the cost overruns. These conditions are rarely, if ever, satisfied and a total cost claim will most likely fail in litigation. A total cost claim is simply adding up the additional cost overrun incurred by the contractor over and above the original estimate and then adding a profit margin to the additional costs. This total cost overrun will most certainly include costs for which the contractor is responsible.
- Modified Total Cost Methodâ€”This methodology is more preferred than the total cost method but certainly not as desirable as the actual cost method. This methodology entails preparing the claim starting with the total cost method and then the contractor subtracts costs for issues that the contractor has identified as being incurred through its own fault. This methodology is less desirable than the actual cost method since it most likely still includes costs for issues that the contractor has not identified as being their own fault.
- AICPA Construction Contractors Audit and Accounting Guide
- My professional experience and training
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 email@example.com.