Construction Claims Damages

The Proof is in the Accounting Principles

When presenting or rebutting construction claims, there is merit in the forensic accounting adage, “Follow the money trail you will find what happened” The reasonableness and reliability of the construction damages claimed on a project is in the accounting principles. The message in this article is how a forensic accountant can benefit the construction claims process on a construction project through the application of basic accounting principles.

When presenting or rebutting construction claims on a construction project, there is merit in the forensic accounting adage, “Follow the money trail and you will find out what happened”. The reasonableness and reliability of the construction damages claimed on a project is in the accounting principles. The message in this article is how a forensic accountant can benefit the construction claims process on a construction project through the application of basic accounting principles.

In my experience, entitlement proofs of construction claims are presented with a thorough review of the project and contract documents such as construction contracts and agreements, change orders, critical path schedules, daily activity reports, quality control reports, and other project records. Conversely, when addressing and presenting the construction damages proofs there is usually insufficient review of the underlying cost and accounting records, and accounting principles and practices applied that are intended to support the damages. These cost and accounting records derived from the accounting principles and practices are often superficially used as the foundation for the damages presentation. Forensic accountants are well-positioned to provide professional consulting services in adequately reviewing the cost and accounting records to provide assurance that the damages are presented with reasonable accounting certainty.

There is risk in using the cost and accounting records when presenting construction claims damages without a sufficient review and understanding of the underlying accounting principles and practices for which it was prepared. An otherwise well-prepared construction claim can be rendered unreasonable, unreliable, and overreaching if the cost and accounting data are used without a review and understanding of how, when, or why it was prepared.

Adjustments to the cost and accounting records that may be necessary to help assure reasonableness and reliability to the cost and accounting records used in the construction claims damages presentation can include the following, without limitation:

(a) Subsequent adjustments or edits to labor, subcontractor, and procurement transaction source documentation,

(b) Subcontractor invoices and other cost transactions recorded months after the work was performed,

(c) Accounting for change order work at a time different than the preparation and execution of the change order,

(d)Transactions paid for at a time different than contracted or at a time different than when the work was performed,

(e) Billings to the client include amounts for items of work in excess of the actual work performed.

Fundamental accounting principles of materiality, conservatism, matching, consistency, accrual, cost, and others if properly understood and applied are consistent with construction claims damages theory. They should be understood and addressed to help assure that damages quantification for construction claims are:

(a) Not overreaching,

(b) Reasonable and reliable, and

(c) Linked to the impacts and match the legal and entitlement arguments made.

A review and analysis of the cost and accounting records, and the accounting principles and practices applied should be considered in construction claims presentations to help assure that damages are presented to achieve the standard of a “reasonable degree of accounting certainty”.

To address the standard of reasonable degree of accounting certainty, consideration should be given to the following, without limitation:

(a) Appropriateness of the methodology employed,

(b) Reasonableness of the costs incurred,

(c) Reliability of the documents used,

(d) Linking of the damages to the alleged impacts.

The standard of reasonable degree of accounting certainty can be viewed from a legal as well as an accounting perspective. From the legal point of view, the outcome might suggest that the amount of the damages awarded has been tested by the trier of fact against the standard of reasonable certainty. An award of 50 percent of the damages amount claimed may mean that half of the legal arguments were supported by the evidence of the entitlements even though the damages met the standard. Conversely, in a well prepared and litigated case where a breach was proven, and no damages awarded might suggest that the trier of fact concluded that the damages presented did not meet the standard.

The accounting viewpoint may be answered by the principle of materiality, and others, in whole or in part. Materiality tolerance levels can be stated as the amount at which the claim can vary from the actual damages before it is deemed unreasonable. An unacceptable variance in a labor rate, for example, used in a construction claim over the actual labor rate may result in an overstatement in labor and related amounts claimed by an unacceptable amount.

Construction claims damages presentations can lose credibility and possibly be rejected if it is demonstrated that the amount of the damages claimed in whole or in part is aggressive and overreaching. The accounting principle of conservatism says that given two or more estimated outcomes where the probability of occurrence of each outcome is equal, it is appropriate to select the lesser outcome. When the principle of conservatism is not met, the construction claim may be viewed as overreaching and unreasonable.

The accounting principle of matching suggests that cost and expense items be recorded in the same period as the related construction activity. For example, if a construction activity occurs in the month of May, then the related labor and material costs should also be recognized in the month of May. The matching principle holds true for construction contracting and construction claims wherein the two important dimensions are time and cost. Costs should be recorded in the same period as the time incurred to perform the activity.

Similarly, the principle of consistency says that an accounting practice applied in one period should be consistent with the similar application in another period.

In summary, forensic accountants are well-positioned to provide professional consulting services of reviewing the underlying cost and accounting records, and accounting principles and practices applied to provide assurance that a construction claims damages presentation meets the standard of reasonable degree of accounting certainty. Apply a recognized damages methodology and, wherever possible, utilize contemporaneous and corroborated documents and evidence in support of a damages claim.

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Jack W. Harris, CPA, is a forensic accounting and valuation expert with a focus on construction contract damages and cost audits, commercial damages, lost profits, accounting, and related areas. He has 41 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 and has served as a panelist for the American Arbitration Association for construction and accounting matters. He has also been engaged as a mediator and special master. Please visit his website at www.jackwharris.com.

Mr. Harris can be contacted at (303) 324-5812 or by e-mail to jack@jackwharris.com.