© The College of Estate Management 2002

Paper 0414V1-1

Financial control for contractors

Contents

Aim

Learning outcomes

1. General financial control

1.1 Profit ratios
1.2 Liquidity ratios
1.3 Asset utilisation
1.4 Growth figures
1.5 Budgets
1.6 Long-term budgets
1.7 Short-term budgets
1.8 Cash flow forecasts
1.9 Invoices and payments

2. Improving cash flow

3. Cash flow forecasting

4. Cost–value reconciliation
4.1 Claims, variations and cost–value reconciliation
4.2 Cost–value reconciliation and final accounts
 Financial control for contractors Paper 0414 Page 2

Aim
z To introduce some key concepts in post-contract cost control for contractors.

Learning outcomes
After studying this module you should be able to:

z Discuss the main financial ratios used to ascertain the health of a construction
business.

z Explain how contractors set short- and long-term budgets.

z Explain the importance of accurate cash flow forecasting, discuss the common
forms of cash flow representation and comment upon the ways in which
contractors might improve their cash flow position.

z Explain cost–value reconciliation.

 Financial control for contractors Paper 0414 Page 3

1 General financial control

Like all management boards, the board of directors of a contracting firm must keep an
overall check on the firm’s financial position. The firm’s policy statements should
give an idea of what is expected. A regular check should be made that the usual
profitability and liquidity ratios are improving in accordance with the planned policy,
and are within acceptable limits.

The principal profitability ratios are:

z Return on capital employed

z Net profit on turnover.

The principal liquidity ratios are:

z Current assets to current liabilities

z Acid test ratio
z Ratio of turnover to debtors.

1.1 Profit ratios

1 Return on capital employed

Net profit before tax

× 100%
Capital employed

In the construction industry there are big differences between firms, some being
below 5% and others over 40%. The average would appear to be about 15–20%, with
the civil engineering firms being slightly higher than building firms; but these figures
depend upon the state of the various markets and of the economy generally. This
percentage is used to indicate how efficiently funds are used compared with other
firms or other years.

2 Profit on turnover

Net profit before tax

× 100%
Turnover

In the construction industry this figure is likely to vary between 1% and 8%,
depending upon the type of work and the efficiency of the firm. A UK average is
probably about 2–3%, with building firms generally slightly lower than civil
engineering.

1.2 Liquidity ratios

1 Current assets to current liabilities
This ratio is sometimes called the ‘current ratio’. A firm with a low liquidity tends to
be more vulnerable, in that it may have more difficulty in paying its debts. On the
other hand, an excessive liquidity generally results in low profitability. In most
industries 2:1 (current assets : current liabilities) is generally regarded as average.
Although in the construction industry some firms have ratios as high as or even
higher than this, it is generally regarded as too high, with a ratio of about 1.25:1 being
more acceptable. One reason for these high figures is the industry’s practice of
delaying payments to subcontractors, although in the UK and some other jurisdictions
prompt payment of subcontractors is now required by law.
 Financial control for contractors Paper 0414 Page 4

2 The Quick or acid test ratio

This ratio compares current assets, less stock and work in progress, with current
liabilities. Because of the nature of construction work and the progress payments
made during the work, this ratio will be similar to the one above. Firms involved with
the manufacture of systems buildings may be in a similar situation to the bulk of
manufacturing industries: an acid test ratio of 1:1 would be reasonable for most.

3 Ratio of turnover to debtors

This ratio indicates how quickly the contractor is getting paid. In general, the higher
the ratio, the more efficient the collection of amounts due.

1.3 Asset utilisation

1 Ratio of turnover to capital employed
This ratio varies widely. It may be as low as 1.5:1 or as high as 20:1. The average for
construction firms is probably about 7:1. A fairly high ratio is a good sign, as there
should be more opportunity for profit.

2 Ratio of turnover to fixed assets

If the previous ratio is low, this ratio, together with the next one, will indicate whether
the fixed assets of the working capital are underutilised.

3 Ratio of turnover to net assets

Often called ‘working capital’, the stability of this ratio is looked for rather than a
high or low figure.

4 Turnover per employee

This figure will vary, and of course is affected by inflation. Turnover per employee is
typically about 10% higher in civil engineering firms than in building firms. The
turnover of firms with fewer than 10 employees is generally lower than average
because of the type of work these firms tend to engage in.

1.4 Growth figures

Typical indicators would include:

z Growth in capital employed

z Growth in net profit
z Growth in turnover
z Growth in labour employed
z Labour turnover
z Ratio of direct to indirect workers.

In general, firms with a high proportion of indirect workers require a more

sophisticated management organisation, with closer supervision, but they tend to
achieve higher output.

If the actual ratios are widely different from what is to be expected in the industry, or
if they do not appear to be moving towards targets set in the company’s policy
statements, the board should investigate, where possible identify the reason for the
deviation, and issue the necessary instructions to rectify the situation.
 Financial control for contractors Paper 0414 Page 5

1.5 Budgets
Preparation of the firm’s annual and medium term budgets are an essential part of the
financial control system. For the budget to be an efficient control tool, this means
estimating:

z what expenditures and receipts are likely, which in turn means –

z what the firm is likely to require in the budget period – plant, cars, equipment,
furniture and fittings, staff, materials etc;
z when large expenditures are likely to be made.

In terms of expenditure, the budget will need to include not only the direct costs of
carrying out the works, but also indirect costs and an allowance for distribution to
shareholders.

1 Indirect costs
Indirect costs may be defined as those costs that the contractor faces whether or not it
actually carries out any work. In crude terms, the commercial value of construction
work will include the total of the direct costs – that is, the net estimate – with
appropriate additions for indirect costs, basically represented by overheads and profit.
On top of this the bid price may then include an adjustment to reflect the perceived
risk, the degree of utility the contractor places on getting the job, here termed the risk
margin, and the contractor’s assessment of the marketplace at the time the bid is
submitted.

The bid price will therefore be built up as follows:

Net estimate
+
Overheads (%)
+
Additional project financing costs
+
Required profit (%)
+
Risk margin
+
Market risk allowance (may be negative)
=
Bid price

Each component must be considered separately, and one must be especially careful
not to confuse overheads, profit, additional project financing costs, risk margin and
the market adjustment.

Companies must plan their financial activity for the year, and the annual plan will
therefore include a prediction of the cost of overheads and an assessment of the base
level of profit required to present a reasonable return to the company’s shareholders.
Note that the baseline profit figure will include provision for the cost of normal
finance needed to keep the company afloat, but some projects may require additional
financing.

Overheads, calculation of the base profit margin and some elementary aspects of
supplementary project financing are considered here. The issue of risk margin is
considered in more detail in other papers.
 Financial control for contractors Paper 0414 Page 6

2 Overheads
Overheads represent the fixed costs of running the company regardless of whether the
company does any work or not. Costs will therefore include factors such as head
office staff salaries and on-costs, the cost of providing and maintaining company cars,
head office rental or mortgage payments, and operating expenses such as telephones,
heating and lighting.

In a competitive market there is an obvious relationship between the level of

overheads that a company can support, the amount of economic activity in the
company (often measured by the company’s turnover), and the level of profit that can
be achieved, and this relationship will form the basis of the company’s business plan.

The plan will therefore include an anticipated overheads component based on the
projected level of activity planned for the year. Most companies will project their
anticipated overhead expenditure for the coming year based on past costs, with
allowances for any additional resources required and for inflation.

3 Baseline profit
Baseline profit is defined here as the amount of money the contractor must make in
order to be able to service its forthcoming projected financial commitments. This
requires an assessment of the basic finance the company will require during the year.

To assess the level of baseline profit required, the contractor must consider:

z the proposed level of activity for the year, usually denoted by projected
turnover;
z the finance necessary to support the proposed level of activity;
z the return that needs to be earned on turnover in order to service the debt.

As an example, assume a construction company plans a turnover of £10,000,000 for

the coming year. The contractor must make a prediction about the level of investment
required to provide a satisfactory level of liquidity. If we assume that required
investment is roughly 10% of anticipated turnover, then £1,000,000 of investment is
required, on which the contractor must return, say, 15%. The amount of money the
contractor must earn in order to satisfy the above criteria is therefore 15% of
£1,000,000 = £150,000. The required profit on turnover is therefore:

£150,000
× 100% = 1.5%
£10,000,000

Assume that overheads, based on last year’s costs with additions for inflation etc, are
£500,000. Then the required recovery of overheads, as a percentage of turnover, is:

Net profit before tax

× 100% = 5%
£10,000,000

The combined baseline percentage on turnover required to cover the overheads and
finance the necessary debt is thus 6.5%.

Financial planning also means monitoring the company’s performance and cash flow
and taking remedial action as the year progresses. The baseline percentage required
may therefore change as time goes by. As an example, consider what would happen if
the anticipated turnover were not achieved. Assume that turnover only reaches
£8,500,000. Basic required earnings are still as before, ie £650,000 for profit and
overheads. To earn this level of return on a reduced turnover of £8,500,000 will
therefore require a mark-up of 7.65%.
 Financial control for contractors Paper 0414 Page 7

1.6 Long-term budgets

The board of directors usually requires a long-term budget to be prepared, covering a
period of five to 10 years. This will only indicate the turnover of work in general
terms, not details of individual projects, which will be covered by separate project
budgets prepared when jobs are obtained.

The budgets must be realistic. They must indicate to the directors the amount of
money the firm is likely to require in the budget period, for:

z capital projects – new headquarters, regional offices, new staff cars, furniture
etc;
z working capital to pay wages and subcontractors, purchase building land and
materials etc.

1.7 Short-term budgets

The long-term budget should form the framework for short-term budgets, which may
be for the next one or two years. These should be more detailed. They usually
indicate who will be responsible for seeing that expenditures are made wisely and
within budget limits.

At this level, separate budgets are usually prepared for the different areas in which the
firm is involved – capital budget, maintenance budget, turnover or contracts budget
etc – as well as a general overall budget for the firm. The number and complexity of
the various budgets will depend upon the size and type of firm, but it is essential for
good control that they can be understood easily by those intending to use them. In
general, the simpler the better.

1.8 Cash flow forecasts

A cash flow forecast chart should be produced for the firm as a whole as well as for
individual projects. It shows office overhead expenditure, together with total direct
expenditure on projects, and should indicate the periods when there is likely to be a
higher outflow of cash than inflow of income.

From this information managers can decide whether it is advisable to tender for
certain projects. A high expected outflow of cash on a new project that is likely to
coincide with a high outflow on projects already under way may be disastrous for the
firm. Sufficient overdraft may be difficult or impossible to obtain, and it may be
better to turn down the invitation to tender on what may appear to be a profitable
contract because of the possibility of running into financial difficulties later.

The more reliable the cost information system of the firm, the better the chances of
efficient financial control.

1.9 Invoices and payments

Time means money to a contractor. His financial control of all projects should aim at
completing jobs quickly with minimum costs and making every effort to obtain
payment as soon as practicable.
 Financial control for contractors Paper 0414 Page 8

Efficient financial control may be affected by the following:

z Contractors’ receipts are received from clients. Small firms involved with
jobbing and maintenance work are often not paid until they have submitted an
invoice. The management of the firm should ensure that invoices are sent out
promptly – though sometimes a short delay between carrying out the work and
submitting the invoice may be felt to enhance public relations.
z Firms involved in jobbing and maintenance are likely to have a large number
of clients, some of whom may take a long time to pay up even after receiving
the invoice. Others may never pay. Management should take all necessary
precautions to avoid bad debts by regular checking and follow-up procedures,
even employing solicitors to take action on long overdue accounts.
z Contractors often make payments some time after work has been carried out.
In the case of the contractor’s own workforce, some will be paid weekly and
others monthly, so that the contractor receives on average half a week’s or half
a month’s credit from these employees.
z Most materials are paid for two to six weeks after delivery, as suppliers usually
only require payment at the end of the month after the delivery date.
z Subcontractors and suppliers are also usually paid about a month or six weeks
after their work has been carried out. These conditions may vary, depending
upon whether the suppliers or subcontractors are nominated or not.
z In the course of carrying out its business, the firm will incur tax liabilities, but
these may not be paid to the government until as much as two years after the
work has been carried out.
z Delays can be built into the process. Receipts for work done may be delayed
by the quantity surveyor if he is slow in sending his valuation to the architect.
z The architect may delay payment still further in communicating his certificate
to the client. The client may delay the payment still further, either intentionally
or because of his system (eg signing most of his cheques on the last day of the
month). Though the contract will lay down certain requirements with regard to
payments, it is unlikely, because of the public relations issues involved that
contractors will take legal action to ensure prompt payment unless the problem
becomes especially serious. The prudent contractor when estimating and
working out his cash flows, will therefore allow for these unfortunate but
common delays.
 Financial control for contractors Paper 0414 Page 9

2 Improving cash flow

There are a number of strategies that a contractor may adopt to improve his cash flow
position. These fall broadly into two areas: reducing or delaying expenditure, and
improving or advancing income.

Reducing/delaying expenditure

z Negotiate lower labour costs

z Change from weekly labour payment
z Delay plant hire
z Off-hire as soon as possible
z Negotiate special terms with suppliers
z Rationalise management.

Improving income: pre-contract

z Increase profit level

z Negotiate different payment provisions
z Agree reduced retention value.

Improving income: post-contract

z Early recovery of preliminaries

z Claim all variations, agreed rates etc
z Keep up to date on all measurements
z Unbalance the tender bid such that early trades are priced higher than their true
value and corresponding adjustments are made to later trades.

The basic requirements of the contractor’s cost control system are the same as for the
client. However, the contractor will be trying to juggle numerous projects
simultaneously and looking to maximise his profits. The type of project being
undertaken, its value and duration all influence the way in which the system will
operate. The contractor needs to establish principles and coding systems that are
flexible enough to suit all types of project.

The estimate and the post-contract plan (method statements, resource analysis etc)
should form the basic documents for the financial control of a project, and once the
job is won the estimate then becomes the project budget. The contractor’s rates in the
bill of quantities are normally broken down into labour, plant, materials and on-costs,
including profit. The first three factors are direct costs to the project. The on-costs
provide a contribution towards the general running and profitability of the firm.

By combining the information in the estimate with the post-contract plan, it should be
possible to prepare a week-by-week list of expected expenditures. This is likely to be
exclusive of the work of nominated subcontractors and that covered by provisional
sums.

By using the rates in the bill of quantities and the programme, it is possible to
estimate the amount to be expected in each monthly valuation. From these two
calculations can be calculated a net expected cash flow for the project. If it is found
that the net outflow figure is unacceptably high, it may be possible to adjust the work
so that a more acceptable one can be obtained.
 Financial control for contractors Paper 0414 Page 10

3 Cash flow forecasting

In addition to the problems outlined above, the contractor must consider a number of
other factors when estimating his cash flow.

z The problems of undervaluation and payment up to eight weeks in arrears are

further complicated by the fact that he is given varying periods for credit for
materials and labour.
z He also needs to balance his various projects to ensure that he has sufficient
working capital to fund operations.
z He may need to disclose his cash flow forecasts to the bank to facilitate short-
term overdrafts to fund the construction work.

Two methods are conventionally used to depict a contractor’s cash flow for a project:
the cumulative S-curve and the Ogee curve (sometimes termed a ‘sawtooth’ diagram).
These can be computer-generated using a formula or by pricing a programme of
work.

Example 1 shows the contractor receiving his payments in line with a JCT 05 type
contract. It is normal for the contractor to operate in a deficit for much of the contract
period, but by good financial management (or by manipulating the prices in his
tender) he may be able to achieve a positive cash flow earlier.

Example 2 shows the Ogee curve (or ‘saw-tooth’ diagram), which shows clearly
when the contractor is in a positive cash flow position and the amount of money that
will need to be financed each month. The vertical lines each month indicate the size
of the payment that has been received from the client.

In each case the deficit between expenditure and income represents the amount of
capital required to service the project, sometimes termed ‘capital lock-up’.

EXAMPLE 1 Cumulative S-curve

 Financial control for contractors Paper 0414 Page 11

EXAMPLE 2 Ogee curve or saw-tooth diagram

Many contracting companies use planning software to establish their programme of

works and allocate resources to a project – financial as well as labour, plant and
materials. The programme enables an accurate cash flow forecast to be produced, by
taking into account:

z various delays in paying labour, subcontractors, materials suppliers and plant

providers;
z data such as:
{ retention percentage
{ estimated value of operations as included in the contract
{ estimated cost of operations
{ contract period
{ defects liability period.

In Example 3 the project lasts six months with a six-months defects period. The
contractor’s capital outlay is repaid three months after it has been incurred. A 10%
profit is built into the project. The retention percentage is 5%.

The programme shows the cost of each activity, with the calculation of the cash
requirement shown below. The cost of each activity is shown per month in £’000s.
The income received takes into account the addition of 10% for profit and the
reduction of 5% for retention on the contractor’s monthly costs. This is then paid two
months in arrears. Half of the retention is released at practical completion and the
other half after the end of the defects liability period.

Payments are likely to be made throughout the defects period as elements of the final
account are agreed, but for simplicity this has not been taken into account here.
 Financial control for contractors Paper 0414 Page 12

EXAMPLE 3 Construction programme with resource allocation

Month
Activity 1 2 3 4 5 6 7 8 14
A 18
B 14 14
C 8 8 8
D 7 5 4
E 3 4 5 2 2 2

Monthly expenditure 35 26 13 17 7 6
Income received – – 36.6 27.2 13.6 17.8 7.3 9.2 2.7
Cumulative expenditure 35 61 74 91 98 104 104 104 104
Cumulative income – – 36.6 63.8 77.4 95.2 102.5 111.7 114.4
Cash required each
month
Cumulative deficit 35 61 37.4 27.2 20.6 8.8 1.5 – –
Cumulative profit 7.7 10.4

Example 3 explains the principle used for producing the cash flow. In the example,
the maximum cash required at any time will be £61,000 in Month 2. If this were
funded by a bank overdraft, the overdraft limit would need to be, say, £65,000 to
allow for any undervaluation or over-expenditure.
 Financial control for contractors Paper 0414 Page 13

4 Cost–value reconciliation
The contractor must compare his actual expenditure with his predicted cash flow
forecast to ensure that he will eventually make the estimated profit. He should be able
to identify where he has made a profit or a loss and how this compares to the
anticipated expenditure. The procedure carried out by many contractors’ surveyors is
termed cost–value reconciliation. Simple reconciliations will typically be made on a
monthly basis and more detailed analysis on a three-monthly basis.

Standard pro formas are completed to identify expenditure made and monies received
against elements of the project. With the increase of computer-based accounting
systems and sophisticated coding, the contractor can analyse his expenditure
relatively easily in order to compare it with the sums received in an interim valuation.

Cost centres should be established for the project and given a code, decided by the
degree of information required by the management and the available resources
(manpower) to operate the system. There should be enough cost centres to give
adequate and appropriate control, but the system needs to be cost-effective to operate.

There is little use in providing very detailed information, at great expense, too late for
a decision to be made to be effective for control. Variances between actual and
forecast costs need to be analysed and fed back to the estimating departments so that
errors are not repeated.

Example 4 shows a simple form for a contractor’s monthly cost report in which only
nine cost centres have been used. Costs are given in £000s. If there is a problem with
a particular cost centre, there may be enough time to collect further information and
analyse it in more detail.

However, managers often make judgments for corrective action from their experience
because there is not enough time or resources to resort to further analysis. Some
managers in fact prefer to use their judgment, as this is what makes their job
interesting and a challenge.

In Example 4 the contractor has estimated his final costs for the construction of a
series of boathouses as £5,519,000, but anticipates receiving £5,658,000 from the
client, giving him a £139,000 profit. If the losses on general items and in situ concrete
can be reduced, perhaps by more efficient working or cheaper suppliers, the profit
may be increased further.
Financial control for contractors Paper 0414 Page 14
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A more detailed form is shown in Example 5. A considerable amount of work is

required to produce this form, bearing in mind that it is a summary of more detailed
forms. For instance, adjustments for the subcontractors’ section require the contracts
surveyor to look at variations to subcontractors’ work, their claims and counterclaims,
any further liabilities and retentions. The contractor should ensure that there has been
a reconciliation between the value received and the subcontractors’ costs at each
accounting period, particularly as this is often the largest part of his work.

Example 5 is given merely as an illustration of a typical form. Individual contractors

will tend to have their own variation. You should make yourself familiar with your
own company’s procedures devised to suit its accounting system.

If the contractor has tendered for and been successful in several contracts, he should
combine the cash flow charts and, where possible, arrange the programmes so that
high excess of costs over receipts on each project do not coincide. The expected cash
flow information will provide the financial plan against which financial control can
be measured. Each month the actual costs for the contract and the certificates issued
must be compared with the financial plan. If there are any large discrepancies, a
reconciliation statement should be made to indicate where the differences are and
what adjustments are to be made to allow for them and correct them where necessary.

The financial plan may include extra columns of data.

z Estimated value of work less retention may be stated for each month.
z Estimated direct cost of the work before adjusting for payment delays may also
be listed for each month.
z Comparison of actual costs and receipts with the plan is unlikely to be
straightforward, for a variety of reasons, some of which are listed below.
{ The work may not be exactly according to programme.
{ Certificates may be paid faster or slower than anticipated.
{ Variations will affect the figures.
{ True value of fluctuation will be difficult to calculate.
{ Payments for fluctuations may not be based on true fluctuations (eg
formula price method). With other methods, some materials may not be
included in the basic list of materials used to calculate fluctuations.
{ Invoices from suppliers and or subcontractors may be late in arriving.
{ The QS valuation may include the full tender value, whereas there may
still be some further work to do (eg making good defects etc).
Financial control for contractors Paper 0414 Page 16
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If the discrepancies are due to changes in the cost of the work, compare the cost of
individual bill of quantities items or groups of items with the rates included in the
tender. This may bring to light poor estimating or it may indicate possible errors in
the Bill or client variations. In such cases appropriate corrective action should be
taken. Or it may lead to improvement in the method of working on site, if the high
costs are due to poor management, inefficient operatives, poor utilisation or lack of
plant.

To check this type of detail, it is necessary to receive adequate feedback from site on
the time spent by operatives on different tasks. One person, perhaps a trainee
manager, should be made responsible for compiling and returning this information to
head office. All head office departments must co-operate fully if proper financial
plans are to be prepared and the necessary control data provided. However, the
system used must be relatively simple, otherwise the cost of operating it may exceed
the increased profit that should result from the control.

At the end of a project, a report should be prepared on how accurate the financial
forecasting has appeared to be, with reasons for any discrepancies between forecast
and actual. The report may be broken down into sections, covering:

z own labour;
z subcontract labour;
z materials;
z plant;
z PC sums;
z project on-costs;
z head office expenses.

This document will provide feedback to enable better estimating, planning,

management and financial control to be carried out in the future. All members of the
firm must be clearly aware of their responsibilities for financial control of projects.
Where practicable, managers and supervisors at all levels should be given guidance
on how to rectify a situation which does not appear to be following the planned
financial pattern.

In some firms separate monthly forecasts are prepared for materials, own labour,
subcontract labour, plant etc on each project. These can then be compared with the
actual expenditure on each item. However, preparing very detailed information for
each month for each project is likely to be time-consuming and expensive. When
setting up any financial control system, bear in mind that the saving resulting from
using the system must be at least as great as the cost of administering and running it.
There is a break-even point at which additional expenditure on the system will result
in a smaller marginal saving than the additional expenditure.

These issues are illustrated in Example 6.

 Financial control for contractors Paper 0414 Page 18

EXAMPLE 6
It is estimated that, under its usual procedures, a firm would incur a direct cost of
£1,750,000 on a project.

Employing an additional materials checker at a cost of £6000 would reduce the direct cost
to £1,740,000 plus cost of checker.

If security guards were also employed, pilfering would be reduced and materials costs
would be £15,000 less. The cost of the proposed guards would be £12,000.

It is estimated that additional forecasting of costs and cost checking by the accounts
department would reduce the materials costs still further by £7000, but this would involve
extra head office staff costs of £5500.

By using a computer and extra feedback from site, more materials and labour savings of
approximately £9000 could be made. The cost of using the computer is estimated at £6000
and the additional labour necessary to provide feedback on site is £3500.

Is it worth setting up these additional safeguards and controls?

When expressed like this, it is obvious which measures are going to benefit the firm. In
practice, many elaborate schemes are brought into operation which cost more to run than
the benefits in savings which they achieve. In this example, the materials checker would
result in a net saving of £4000, the security guard £3000, and the accounts department
£1500, but the use of the computer system would result in a net extra expense of £500.
The first three therefore might be introduced, but the fourth would probably not be. As the
figures are only estimates, the likely prediction errors and the social effects of introducing
the procedures should also be considered by the management.

4.1 Claims, variations and cost–value reconciliation

Cost–value reconciliations may also provide a pointer for likely contractual claims.
The likely revenue from such claims, and from the value of variations which are still
to be agreed, should be included in the reconciliation in order to give as accurate a
picture as possible of the firm’s trading position.

This point raises a number of potential problem areas from an accounting point of
view, problems which have become more evident in the case of recent high profile
company failures. In essence, including optimistic values will result in the
contractor’s financial position appearing to be better than it may be, and pessimistic
projections will have the reverse effect.

It is important to recognise that the accuracy of the cost–value reconciliation will to

some extent reflect the professional judgment of the contractor’s quantity surveyor,
and this will inevitably be reflected in any company accounts based upon this data.
Whilst most contractors’ quantity surveyors probably have a natural tendency to
manipulate the figures to hold back monies on ‘good’ contracts in case something
goes wrong in the future, conversely, where a contract is performing poorly, the
surveyor may be minded to manipulate the figures to give the impression that the
contract results are in line with forecasts, in the hope that the contract turns around
later.

Issues such as these are closely bound up with the company’s management
philosophy. If the surveyor believes, for example, that he will be held accountable in
some way for unprofitable projects, then his behaviour will be influenced
accordingly. Both approaches however have the potential to cause serious problems
for the contractor’s consolidated accounts, and a consistent policy must be adopted
for the calculation of all cost–value reconciliations.
 Financial control for contractors Paper 0414 Page 19

The following measures may go some way to ensure that the figures are accurately
presented:

z making the quantity surveyor and project manager jointly responsible for the
cost–value reconciliation;
z disclosure by the quantity surveyor of supporting documents used;
z disclosure of a preliminary valuation of the work in progress prior to the
release of the cost information, which will prevent the quantity surveyor
manipulating the reported income to suit the reported costs for the accounting
period;
z meetings between the contractor’s quantity surveyor, accountants and middle
management to probe and examine the project cost variation reports.

Further problems arise with the reporting of likely profits and losses. Fluctuations in
profitability will inevitably arise from estimating errors, non-recoverable costs (eg for
remedial work) and other variable risks. A sensible approach might be to take profit
as work proceeds on the basis of a proportion of the anticipated final out-turn.

The projected costs of non-recoverable losses should also be accounted for.

Assessment of future losses is a critical area for the contractor, and one where the
quantity surveyor will have to use professional judgment to predict trends and final
costs. There are three options:

z the whole of the foreseeable loss is provided for as soon as it is recognised; or

z a proportion of the foreseeable loss is calculated, by reference to either
{ The proportion of the time elapsed up to the date for completion of the
contract, or
{ the proportion of expenditure incurred, or
{ the proportion of the loss-making item which has been completed; or
z the overall foreseeable loss and profit is projected to the date for completion of
the contract, thereby representing the final out-turn of the contract.

A similar problem arises with variations. Contractors have historically complained at

length about the time taken to agree a valuation with the employer’s quantity
surveyor. In addition, variations frequently involve delays and disruption to the
regular progress of the works, giving rise to contractual claims.

How then should the contractor deal with variations which have not been agreed?
Clearly, some form of conservative estimate of the amount likely to be received has
to be made. Once again, this is a matter of the contractor’s quantity surveyor applying
professional judgment.

Settlement of contractual claims for delay, disruption, acceleration and other causes
of loss and expense may take many years. Differences of opinion between the
contractor and the contract administrator as to entitlement, liability and/or quantum
with respect to a particular claim creates a high degree of uncertainty as to the final
out-turn, and this can cause severe problems for contractors when preparing the year-
end or other financial accounts that have to be independently audited.
 Financial control for contractors Paper 0414 Page 20

It has therefore been suggested that the cost–value reconciliation should separately
identify:

z the claim(s) notices that have been issued;

z the claim(s) particulars that have been submitted;
z the claim(s) that are being prepared;
z the contractual grounds for the claim(s);
z the amounts claimed and the ranges of anticipated recovery;
z the anticipated settlement date(s);
z the status of negotiations.

4.2 Cost–value reconciliation and final accounts

In the UK, the Statement of Standard Accounting Practice 9: Stocks and Works in
Progress (SSAP 9) sets out guidelines for accountants as to the valuation of work in
progress in a company’s annual accounts. It has this to say about this difficult area:

‘The settlement of claims arising from circumstances not envisaged in the contract
or arising as an indirect consequence of approved variations is subject to a high
level of uncertainty relating to the outcome of future negotiations. In view of this,
it is generally prudent to recognise receipts in respect of such claims only when
negotiations have reached an advanced stage and there is sufficient evidence of
the acceptability of the claim principle to the purchaser, with an indication of the
amount involved also being available.’

Similarly, the International Accounting Standard 11: Construction Contracts (IAS 11)
states:

‘A claim is an amount that the contractor seeks to collect from the customer or
another party as reimbursement for costs not included in the contract price. A
claim may arise from, for example, customer-caused delays, errors in
specifications or design, and disputed variations in contract work. The
measurement of the amounts of revenue arising from claims is subject to a high
level of uncertainty and often depends on the outcome of negotiations. Therefore,
claims are only included in contract revenue when:

a. negotiations have reached an advanced stage such that it is probable that

the customer will accept the claim; and
b. the amount that it is probable will be accepted by the customer can be
measured reliably.’