95% of accountants in Australia do not understand how to prepare financial statements for a construction company…
However, it’s not entirely their fault…
It’s because of the jargon we use in the construction industry, and it’s been confusing the bean counters for far too long now.
The issue centre’s around the term ‘Work In Progress’ which means different things to different people.
Work In Progress
According to Investopedia, the term work-in-progress (WIP) is a production and supply-chain management term describing partially finished goods awaiting completion.
This is also how non-construction accountants typically calculate the value of work in progress for a building company.
This results in work in progress for a building company showing large amounts of ‘work in progress’ on their balance sheets as an asset.
However, the construction industry deals with work in progress in a very different way compared to the manufacturing industry...
In construction, work in progress is a formula that calculates the amount invoiced to the client in relation to the estimated related costs of the project.
Because new construction is generally cash flow positive that means the building company typically has claimed a larger percentage of the contract than they have been invoiced for by their suppliers.
This results in work in progress being a liability for those building companies rather than the asset that non-construction accountants are expecting.
The Australian Accounting Standards Board (AASB) is very clear on the process for calculating work in progress in their guidelines for accountants where they have issued a specific directive (AASB 15) that must be followed when producing financial statements for an Australian building company.
Additionally, the Australian licencing authorities even go so far as to spell out for accountants what is considered Work In Progress in the construction industry with the Queensland Building & Construction Commission stating:
"Work in Progress (WIP) requires estimating the assets or liabilities accumulated from construction contracts based on what is entitled to be invoiced for works performed under the contracts, less what has been invoiced at a particular point in time."
In order to spell this out for non-construction accountants they go a step further and clarify exactly what Work In Progress is not:
- Bringing to account the value of work remaining to be undertaken on a contract where the work has not been done.
- Doing 25% of the work on a contract but bringing to account more than 25% of the estimated profit.
- Projected or actual loss on a contract brought to account over time (losses must be brought to account immediately).
In simple terms, the construction industry acknowledges that work in progress can be an asset or a liability.
However, non-construction accountants that are not familiar with the specifics of preparing financial reports for a building company believe that work in progress can only ever be an asset because they believe the calculation is the same in construction as it is in manufacturing.
Where Things Get Messy
One thing in the accountant's defence is that they cannot calculate work in progress for a construction company without having all the required information as at financial year end including:
- The forecast cost to complete each job.
- The amount of supplier invoices recorded in the accounts at year end.
- The amount invoiced to the client at year end.
If they had requested this information from the builder, they would be able to perform the calculation.
However, because they believe work in progress relates to raw materials being used on site, they simply ask the builder ‘What is your work in progress figure?’.
This is where things get really messy because most builders are also not aware of the accounting standard AASB 15 either, so for them, work in progress is simply ‘how much work they have on the go’.
Which results in the builder providing their accountant with a large positive figure which duly gets inserted into the financial statements for the building company as an asset leading to artificially inflated profits which the company then pays tax on which compounds their cash flow issues.
So Who Is To Blame?
Is it the builder for not understanding what work in progress really means?
The non-construction accountant for not reading or understanding AASB 15?
Or the licensing authorities for accepting incorrect financial statements from builders who are blissfully unaware that their businesses are underwater and allow them to continue trading at a loss year on year?
Given the confusion over the jargon we use in the construction industry, it's hard to point the finger at any one person or body.
However, with around 50% of building companies either unable to pay their invoices on time or carrying negative equity on their balance sheets, the writing is on the wall for the Australian construction industry and unless immediate action is taken our sector will be completely decimated over the next 18 months.
With immediate effect we need:
- Compulsory financial education for builders.
- Accountants must be provided with the information they need to calculate or verify the work in progress figure submitted by their clients.
- Licensing Authorities must hold both accountants and builders accountable for the accuracy of the financial statements they are submitting.
The large building companies that signed 2, 3 and even 4 times more contracts than they would normally sign during the government stimulus are currently losing huge amounts of money on every one of those contracts that have still not been completed.
If they reflect those losses in their work in progress calculation then their assets will be reduced and they will either have their building license suspended or face restrictions on the number of new contracts they can sign.
If they don’t disclose their true work in progress figure they will be allowed to continue trading as normal.
It's those building companies that pose the greatest risk to consumers, subcontractors and suppliers while unfairly competing with professional building companies that have followed the rules and continue to trade profitably with healthy reserves in place.
To learn more about the work in progress calculation and how you can calculate it for a building company, watch this video…