CONSTRUCTION Accounting ARTICLE - Managing the costs and risks of long-term contractsTarget Audience: Construction Industry Professionals, Business Owners, Project Managers, Contractors, Construction Accountants Long-term contracts (those exceeding a 12-month period) can be tempting for contractors, as they’re typically associated with lower levels of competition and higher revenue. But because these arrangements transfer the risks from owners to contractors, many sureties hesitate to bond long-term projects — particularly in the current economic climate. And even if bonding is obtainable, you still need to be concerned about escalating costs and unforeseen glitches in these types of jobs, the chances of which increase with the length of the contract. Do what you knowNow more than ever, you need to ensure that entering into long-term contracts is the right choice for your construction company. This means taking steps to ensure that your bonding capacity is adequate and you’re in a position to effectively manage the contract throughout its lifespan. The first question to ask yourself before entering into a long-term contract is, “Is this familiar territory?” If venturing into a new sector, market or project type is risky, doing so in a long-term contract could be crippling — especially if cash flow and credit are already strained. Long-term projects are at a higher risk for cost overruns and glitches simply because their increased life spans allow more time for problems to occur. Plus, they make it harder to accurately estimate prices, materials costs, timelines and other crucial contract terms before the project begins. For these reasons, you need to be especially confident in your knowledge of the political, legal and environmental landscape in which you’ll be working on any lengthy job. For example, if you’re an expert in commercial construction, a long-term project probably isn’t the appropriate venue to dabble in government or residential projects. If, after assessing the nature of a prospective project, you decide to forge ahead in the bidding process and you go on to win the job, carefully reviewing the contract should be your next step. Long-term contracts call for special attention to payment terms. Be prepared to negotiate for clauses that protect against risks, such as rising materials prices and unforeseen events beyond your control, such as weather and any other unforeseeable delays. Become more bondableFinding a surety that will provide bonding for projects longer than two years has traditionally been difficult. In recent years, sureties have enacted even stricter bonding criteria, so you need to take steps to demonstrate to sureties that you have mitigated risks of long-term contracts as much as possible. Favorable contract terms can save you money and stress and may even help improve bonding capacity in the long run. Sureties pay particular attention to:
Make sure conditions addressing these items are reasonable. And, as with any bonding scenario, bear in mind that a long-term contract will require adept organizational skills, strong available labor, sufficient credit, and adequate net worth and working capital. Keep prices, subs in checkCosts can quickly creep upward when deadlines aren’t met, changes to the project scope occur and materials costs escalate. But this is especially a concern with long-term contracts, in which there’s considerably more time for errors, deviation and inflation to occur. Supply hedging is one way you can protect yourself from price escalations. It typically involves buying materials up front or signing a contract with a supplier to lock in a price. This approach, however, can actually work against you if prices fall. Another option is to include a price-adjustment clause in the contract that allows you to recoup additional costs from the project owner if materials prices rise. But you must pay close attention to contract clauses and terms that deal with change orders and project scope adjustments. You also need to document any deviations to ensure proper compensation. Subcontractor performance is another area of potential risk in long-term contracts — particularly when many contractors are struggling to stay afloat. Work with subcontractors you know and trust, and perform thorough reviews of their financial backgrounds before signing them on. Structure payment terms and conditions in a way that allows both you and your subcontractors to maintain healthy cash flow so they won’t default on payments for project materials and equipment. Look before you leapAll in all, long-term contracts can be lucrative and may offer a good strategic direction for some contractors. And you may find them all the more tempting as the shaky economy continues to challenge contractors in many markets across the country. But you must look before you leap and plan for the risks, complications and variables that these projects involve. Long-term contracts don’t have to be taxingFor long-term projects, which the IRS defines as any project that isn’t completed within one taxable year, contractors must use the percentage-of-completion method of accounting. This means that you must pay taxes on the gross profit of the completed portion of a long-term contract project — even if your construction company hasn’t yet been compensated. Clearly, this can put a major strain on your business. Certain exceptions, however, will allow you to defer taxes until the taxable year in which the project is completed. To avoid having to use the percentage-of-completion accounting method in long-term contracts, you must consult with your CPA to determine whether you’re eligible for this exception. The rules are complex and involve a number of factors, including your average annual gross receipts. Find out how our expertise in construction accounting can add value to your business. Email us or call us at 1 (888) 875-9770. related linksConstruction Newsletters & Articles |
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