The New Accountability Part 1: Contractor’s Accounting and Tax Update

1. James C. Lundy, CPA Partner Davidson, Golden & Lundy Charlie Woodman, CPA Risk Finance Advisory Willis National Construction 2011 Willis Construction Risk Management Conference April 21, 2011 The New Accountability Part 1: Contractor’s Accounting and Tax Update

2. Construction Industry - Current Trends and Observations • The recession is not over • Certain sectors hit harder than others: residential, retail, commercial building, hotel/motel, churches • Certain sectors have held steady: healthcare, infrastructure, education, utility • “It’s not just a recession, it’s a correction.” • Concern about construction materials price volatility and inflation: fuel, asphalt, PVC, steel, cement, aggregates, copper, etc. • Escalator clauses are becoming more common • How strong is the guarantee behind your price quote? • Supply bonds • Lower profit margins • 30% to 100% reductions • Increase in bidders and bid spreads

3. Construction Industry - Current Trends and Observations • Increase in mergers and acquisitions • Strategic acquisitions • Buyers market - “Steals” - not “Deals” • Increase in self performed work • Too many contractors • Construction period or “Gap” financing • Extended period warranties • Overbilling vs. warranty reserve • Reporting issues • Generally, survivors are winners - construction fortunes have been made by being aggressive during recessions • Bankers and sureties are concerned

4. Overview of Financial Reporting for Contractors • Financial reporting is the responsibility of Owners, CFOs, Management, Controllers and Independent CPAs - all share the risk • Economic crisis has resulted in more reliance on statements • More scrutiny and analysis on financial reporting than prior years • Management, CPAs and Controllers have personal liability if intentionally misleading • Reliance by various users on financial statements: • Sureties • Banks and finance companies • Regulatory boards - licensing • Owner and prime contractor prequalification • Suppliers • Stockholders (owners) • Joint venture partners • Unique methods and disclosures • Real world suggestions • Timeliness - delaying year end statements longer than 75 days is unacceptable; monthly and quarterly reporting - 30 days • Honest communication is key • Surprises damage credibility: job fade, claims, losses • The surety and bank are your Partners

5. Revenue Recognition • Commandments of Construction Reporting • Underbillings are bad • Unrecognized loss (fade) of poor cash flow management? • Historical support for underbilling recognition • Dumb or dishonest? • Professional skepticism • Overbillings are good, but should be in the bank • Positive ratio of non-borrowed cash to overbillings • Current Accounting Under SOP 81-1: Percentage of completion method is required • Cost to cost unless another method is more conservative • No gross profit estimates in excess of historical without tangible documentation • Soft fade/gain analysis: type of work, location, customer • Use caution when segregating and combining contracts • Accurate phase coding is required

6. FASB / IASB Preliminary Document on Revenue Recognition • Exposure Draft issued June 24, 2010 (Topic 605-35); final statement due in 2011 (replaces SOP 81-1 after 30 years) • Revenue recognition FASB proposes major changes to the way contractors account for revenue recognition. Under the proposal, contractors would be required to adopt new financial reporting techniques that may be more subjective compared to the current method, percentage of completion (POC). • Purpose: “Recognize revenue to depict the transfer of goods and services in an amount that reflects the consideration expected to be received for those goods and services.” • A balance sheet approach that emphasizes: • Unconditional obligation to pay • Legal title • Physical possession

7. Comparisons

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10. Issues • Why – convergence with IFRS / US GAAP “better information for users” • A new focus on control and separation during the earnings process • But: • Is the contract a “continuous transfer of assets”? Confusion over what satisfies performance obligations • Has the customer “gained control of the work in process”? If yes, percentage of completion method will be required • Interpretation that title of control does not transfer until contract completion, will require revenue recognition on the completed contract method • Possible split of the revenue recognition model between goods (transfer upon sale of product), and services (continuous transfer through performance of tasks or series of tasks). • Leading to a new definition of construction contracts as a continuous delivery or process?

11. Other Issues • Specialized assets – completed contracts progress billing – percentage of completion (and Work In Process) • Warranty costs result in revenue deferral vs. cost accrual • Warranties are an emerging issues • Change from cost to cost to units / labor hours • Uninstalled materials and timing • Unpriced change orders recognize profits? • Performance bonuses estimated at reporting date • Acceptance by sureties?: A sometimes skittish lot. • Tax?

12. Updates • New proposals to retain the current accounting principle SOP 81-1 for measuring revenue during the progress of a contract • Continue to pursue a carve out provision for revenue recognition with FASB for the construction industry • FASB wants to understand how the proposal will impact contractors’ income tax reporting • At this point FASB still plans to issue the new revenue recognition accounting standard in the second or third quarter of 2011, but admits significant issues on the proposal still exist.

13. Changes to Lease Accounting Could Impact Contractors’ Finances • On August 17, 2010 FASB and IASB (Topic 840) draft accounting standard on lease accounting which attempts to ensure assets and liabilities arising from lease transactions are recognized in the statement of financial position (Balance Sheet). • Currently (FASB 13)leases accounted under one of two ways: operating lease or capital lease. • Capital (or financing) leases transfer substantially all of the risks and benefits of ownership to the lessee as if the lessee borrowed the money to purchase the property. Capital leases are treated similarly to a purchase of the underlying asset. On Balance Sheet Recognition • Operating leases are all other leases that are not classified as capital leases and are generally treated as rental of property, and the effects are recorded as rent expense over a straight-line basis over the term of the lease. Off Balance Sheet, with disclosure • A lease is deemed to be financing if: • Ownership transfer • Bargain purchase options • Lease term > than 75% of asset’s useful life • NPV of future lease payments is > 90% of FMV of asset

14. New Lease: FASB Discussion Paper (Topic 840) • FASB is going to “fix” SFAS 13, and make it more like IAS 17. Once again a balance sheet emphasis. • The preliminary conclusions of the board are: • A lessee obtains the right-to-use an asset • The lessee creates a corresponding liability • Lease options do not require separate accounting. These include: •  Renewal options •  Contingent rental arrangements •  Guaranteed residual value requirements • The results of these preliminary conclusions will result in leases: • - All being treated uniformly • - Not being capital versus operating leases • - Being treated as a single transaction • - Being treated as purchases of the asset • 

15. New Lease: FASB Discussion Paper (Topic 840): Con’t • The Accounting • A liability is recorded • − Based on the present value of the lease payments • − Payments reduce liability to zero • A corresponding asset is recorded • At cost (present value of lease payments) • Identified separately from owned assets • Amortized over the shorter of: • − The lease term • − The economic life of the asset

16. New Lease: FASB Discussion Paper (Topic 840) • Changes can affect liability and asset (impairment) • Option to buy: • Option price is included in liability • Exclusion of asset from owned assets not required • Topics not addressed in this opinion paper are: • Impact on exploration and use of natural resources agreements • Treatment for non-core assets (such as airplanes for non-airlines) • Short-term lease contracts • In summary, the discussion paper indicates FASB is working to treat virtually all leases • under the existing capital lease rules, and significantly reduce off-balance sheet financing by operating leases.

17. Changes to Lease Accounting Impact • These changes could have a significant impact on construction entities that do a lot of financing through operating leases. • Due to the impact of the lease accounting changes, we will likely see lessees desire shorter term leases to reduce both the increased leverage and the impact of the increase in first-year lease costs. Lessors may be inclined to charge a higher price on leases to offset the additional risk they would be subjected to with shorter term leases. • These changes likely will not become effective until 2012. There are some actions that can be taken now to quantify and possibly reduce the impact: • Determine if this is going to have a major impact on your business. If you lease a significant amount of assets, this accounting change is likely to have a larger impact on your financials. • Quantify the impact of the proposed changes by considering all existing and potential future operating leases. • Review and analyze how your corporate agreements (e.g. loan documents, compensation agreements, etc.) are affected and if the agreements can and should be amended to take into consideration the changes solely due to the changes in lease accounting.

18. Updates • The AGC issued a formal comment letter to FASB detailing its concerns. These issues may be hard to resolve in this short time frame. • “Accounting for lease transactions Under FASB’s proposed model, all operating leases would be classified as capital, which could redefine the underwriting processes and covenants in the banking and surety industry. This will have a significant impact on contractors’ balance sheets, working capital, and leverage”: • No real effect to cash flow or existing tax law • May change job costing due to depreciation and capital cost charges • Operating ratios: EBITDA • Proposing differentiation between equipment leases and real estate leases • How this impacts accounting for services such as cranes, scaffolding, and other sub-contractor arrangements • The need to separately address short-term rental arrangements or leases with terms less than a year or an operating cycle • Other ramifications: • FAR: Rents are allowed but interest and financing charges are disallowed • Sales tax–capital lease vs. rent classification creates sales tax consequences

19. FASB Interpretation No. 48 (FIN 48) • FIN 48- FASB’s latest pronouncement in accounting for income taxes. • Released July 13, 2006 / Effective Date for Years Beginning on or After December 15, 2006 • FIN 48 interprets FAS 109 • Intent is to decrease the diversity in accounting for uncertainty in income tax financial statement positions. • Prior to recognizing the benefit of a tax position for financial reporting purposes, the tax position must be more-likely-than-not (MLTN) of being sustained solely on its technical merits (excluding detection risk) • Tax positions recognized are reported at the largest amount that is MLTN to be sustained 19

20. Evaluate each position for recognition. In order to recognize any amount of the benefit, the position must be MLTN of being sustained assuming: The position will be examined The examiner will have full knowledge of all relevant info Evaluation based solely on technical merits No offset or aggregation of positions Should assume resolution in the court of last resort May Not Take Into Account Audit Risk or The Likelihood of Being Audited Sage Input Overblown reaction by CPA profession? Is it a reasonable method with substantial authority or frivolous? Is it more likely than not (>50%) that the IRS will disallow? FIN 48: As Applied 20

21. Surety analyst email statement • “There has been some discussion about FIN 48 recently and I wanted to let everyone know how we see it affecting us as a Surety. First, keep in mind that a FIN is an interpretation and clarification of pre-existing GAAP – CPAs were already required to disclose these issues. Simply stated, FIN 48 states that if an entity takes a tax position that is “more likely than not” to fail a tax examination, they must book a liability and include a disclosure reflecting such. Second, I think it is a good rule for the Surety, as users of the financial statements. It forces entities with whom we do business to disclose and quantify unreasonable tax positions, which will assist in our underwriting. A far more important issue is the necessity to disclose off balance sheet tax liabilities of pass through S-Corporations and LLCs.”

22. Other Financial Reporting Items • Going Concern Opinion • Losses, significant debt and significant backlog reductions • SAS 59 - Exposure draft issued to enhance - FASB issued Project Update on 10/21/09 • Look forward 12 months or longer • FASB 165 – Subsequent Events • Establishes cutoff date for evaluation of subsequent events • Recognized and unrecognized events • Concerns and issues with “holding” financial statements – liability to CPAs if delay results in damages to user

23. Most Commonly Missed Disclosures and Format Errors • Will the disclosure affect the conclusions of the user?” • Formatting errors: • Balance sheet segregation and disclosure of: • Retainage receivable and payable • Claims receivable and payable • Unbilled receivables • POC adjustments • Loss contract accrual • FIN 46 consolidation • Joint venture partial consolidation results in correct working capital recognition • Would the consolidation affect the user’s conclusion?

24. Most Commonly Missed Disclosures and Format Errors • Accrual for self-insurance deductibles / liabilities • Accounts receivable • Aged receivable issue (over 90 days) • Claims and unapproved change orders (recognition of income = to cost incurred) • Detailed and comprehensive disclosure of claims and unapproved C/O’s • Facts and basis for the claim • Revenue recognized, if any • Detailed calculations, discounts and assumptions • Arbitration or court dates • Separate line item reporting on contract schedule to prevent POC cost to cost recognition

25. Most Commonly Missed Disclosures and Format Errors • Significant changes in contract estimates • SOP 94-6 disclosures for current and cumulative impact to revenue and gross profit • Loss contract accrual calculation • Backlog • Key consideration in going concern determination • Backlog gross profit calculation on contract schedule • Backlog subcontracted - bonded? • FIN 45 off balance sheet guarantees • Surety bonds issued and outstanding

26. Most Commonly Missed Disclosures and Format Errors • Equity with characteristics of liabilities (FAS 150) • Mandatory buy sell liability • Callable preferred stock • Subordination agreements • Tax liabilities of pass through entities (S-Corp & LLC) • Not in SOP 81-1, but… • Current and deferred liabilities • Management intention to distribute cash • Consideration of accrued distribution

27. POOLED RISK LAYER – not common Cell A Cell B Cell C Cell D Individual Cell Capital – If Applicable Core Capital of Captive “General Account” Tax Update on Rent-A-Captives / Segregated Cell Arrangements • Sponsored Facilities • Rent-A-Captives • Agency Captives • Carrier Captives • Key: Insureds and Captive Owners are usually unrelated entities.

28. IRS View of Cell Taxation • In 2005, the IRS asked the industry how cell captives should be taxed and the industry responded. • In 2008, the IRS stated how it would test the presence of “insurance” and the deductibility of the premium by the insured. It advised how it was considering treating the cell for tax purposes, but asked for comments before it made a final decision • Rev. Rul. 2008-8 – “insurance” is determined on a cell-by-cell basis; if there is “insurance, the insured can deduct it. • Notice 2008-19 – the IRS currently intends to treat each cell as its own insurance company and all elections will be made on a cell-by-cell basis; but, the IRS is seeking comments before it makes its final decision. The final rules will not go into effect until the first taxable year beginning more than 12 months after the date the final decision is published. • The Notice does not state how the cells will be taxed in the interim. Cell & Rent Session / 28

29. Proposed Treasury Regs (9/14/2010) A Domestic Cell (or series in a series LLC) will be taxed as a separate entity. The same applies to a Foreign Cell (or series), if the Cell (series) would be an insurance company. Each cell gets its own EIN and files its own return. Each cell makes its own elections. Effective when regulations are finalized. Cell & Rent Session / 29

30. Grandfather Rule in Proposed Treasury Regs (9/14/2010) if all below are met: • There is a grandfather rule if all tests are met: • The cell company was established before September 14, 2010 • The cell conducted business (if a foreign cell, more than half its business was insurance) before September 14, 2010 • If foreign, the cell classification is “relevant” [technical requirement] • No cell owner treats the cells as a separate entity for any taxable year • The cell and cell company had a reasonable basis for their historic treatment • Neither the cell, cell company, nor owner was under audit for the cell treatment on or before September 14, 2010 • Grandfathering ceases if 50% or more of the vote or value of the cell company or cell is owned by those other than those who owned them on September 14, 2010 Cell & Rent Session / 30

31. Other • Foreign Bank Account Reporting • New amnesty • Not as generous as last year’s • Signal for aggressive enforcement in the future • Tax treaty partners

32. James C. Lundy, CPA Partner Davidson, Golden & Lundy Charlie Woodman, CPA Risk Finance Advisory Willis National Construction 2011 Willis Construction Risk Management Conference April 21, 2011 The New Accountability Part 2: Compliance and Audit Discussion

33. Why Cost Accounting is So Important • It Helps In: • Bidding • Determining problem projects • Supporting change order pricing • Claims process • Reconciling job costs to financial reports • Making better decisions • Making “expansion” less frightening • Today’s focus: Supporting Audits • Commercial • Governmental • Tax

34. What is a Contract Compliance Audit • Compares costs billed to costs incurred • Compares costs billed to allowable costs • Compares fees (formula and rates) to contract provisions • Confirms contract procedures were followed • Confirms owner’s administrative procedures were followed • Assures that owner is not overpaying especially on reimbursable costs • Keeps contractor accounting staffs on edge • Keeps forensic accountants and the DCAA (and like kind agencies) employed

35. If You’re Not Prepared: What Can A Contract Compliance Audit Do • Create tension • Cause ill will and jeopardize relationships • Distract employees and incur significant cost • Highlight contract vagaries • Lead to penalties and fines • Cause future contract / bid disqualification or debarment • The biggest failures: • disorganization • poor contract negotiation or understanding of terms and conditions • inability to support or defend cost allowability, cost determination, and information / data processes

36. Success Strategies • Adhere to planned project procedures and document any deviations, including source, reasoning and resulting impacts • Know all contract terms & conditions prior to start, reconcile any provisions that are vague / use, where practical, hard rate terms especially for reimbursable items • Maintain and keep accessible records and files throughout the project • Conduct cash to cost to projection reconciliation regularly and anticipate audit issues preemptively

37. Contract Terms for Focus • Audit scope and processes • Recordkeeping requirements and data support • Reporting requirements, timing and content • Pre-established costs for specific project • General conditions pricing • Self-performed work rates or equipment usage rates • Approved mark-up rates • Change order minimum rates • Acceptable cost support documentation especial for cost-plus or reimbursement • Disclose related party transactions • Address rebates and cost caps • Specific measureables (e.g., efficacy) and deliverables • Guarantees and warranties • Cost sharing

38. The Federal Government and Insurance Costs • So what… • Insurance costs are generally recoverable under government awards, but can be long tail • Establishing well-defined processes and proper accounting are key practices to achieve recovery of insurance costs • Certain practices E&C contractors employ for commercial contracts (e.g. lump sum) may be questioned by government auditors • Government regulations may require a different practice • Government auditor may believe a different practice is necessary • Typical existing practices: • Measuring cost of self-insurance based on losses incurred rather than a projected average loss • Self-insurance charges not in accordance with accepted actuarial principles • Insurance costs based on premiums charged from captive insurers or companies under common control of contractor • Insurance programs have not been approved

39. Regulations • Key regulation* for accounting for insurance costs: • Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs • Cost Accounting Standard (CAS) 403, Accounting for Home Office Costs • FAR 31.205-19, Insurance and Indemnification • FAR 31.201-5, Credits • FAR 28.3, Insurance • When to evaluate your current accounting practices for insurance costs? • Contracts will be CAS covered • Contracts subject to Federal Acquisition Regulation 31.205-19, Insurance and Indemnification *Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html Full text of Cost Accounting Standards can be found at http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html

40. Identifying CAS and FAR in contracts • Typically, CAS and FAR requirements are disclosed in: • Contract and subcontract solicitation documents • Draft contract terms and conditions • Solicitation representations and certifications • Draft contract clauses to be incorporated by reference in the awarded contract • FAR cost principles may apply in other circumstances where the original contract did not require application of FAR cost principles: • Change order proposals • Cost reimbursement or progress payment requests • Equitable adjustment claims • Termination clauses

41. CAS Coverage • The CAS are governed by the CAS Board and currently consists of 19 separate standards. • The CAS can be imposed on a contractor under the following circumstances: • By reference by the Federal Acquisition Regulation (FAR) • Modified CAS coverage –Single federal contract or subcontract greater than $7.5 million but less than $50 million • Full CAS Coverage –Federal contracts or subcontracts greater than $50 million or Net Federal CAS-covered contracts received by the contractor totaling $50 million or more during the preceding cost accounting period

42. FAR Cost Principles • FAR Part 31 Applicability • Cost reimbursable contracts • Fixed price contracts priced based on submission of certified cost or pricing data • Cost principles in effect when contract awarded applicable for life of contract, with certain exceptions • Allowable costs limited by FAR Part 31 and CAS requirements • Includes FAR 31.205-19, Insurance and Indemnification

43. Basic CAS Insurance Accounting Concepts • CAS includes an express requirement that the amount of insurance cost assigned to a period is the projected average loss for that period plus insurance administration expense • Because CAS requires a projected average loss, measuring insurance costs based on actual losses is limited to circumstances where actual losses will not vary significantly from a projected average loss • Under the CAS 416 concept, a risk of loss is covered by either purchased insurance, payments to a trusteed fund or self-insurance • Applied • Projected average loss means the estimated long-term average loss per period for periods of comparable exposure to risk of loss. • Self-insurance means the assumption or retention of the risk of loss by the contractor, whether voluntarily or involuntarily. This includes the deductible portion of purchased insurance. • Self-insurance charge means a cost which represents the projected average loss under a self-insurance plan. Because CAS requires a projected average loss, measuring insurance costs based on actual losses is limited to circumstances where actual losses will not vary significantly from a projected average loss .

44. FAR Part 31, Cost Principles Allowability • Factors for determining allowability :“A cost is allowable only when the cost complies with all of the following requirements” • Reasonableness & Allocability • Cost accounting standards, or otherwise generally accepted accounting principles and practices appropriate to the circumstances • Terms of the contract • FAR subpart 31.2 limitations • Costs of insurance required by contract are allowable • Costs of general insurance are allowable if reasonable and measured, assigned and allocated in accordance with the requirements of CAS 416 • Costs of business interruption insurance must exclude coverage for lost profits • Self-insurance program approval is required when: • 50% or > of the self-insurance costs allocable to negotiated government contracts • Self-insurance costs for the fiscal year are anticipated >$200k

45. Purchased Insurance Premiums • The projected average loss (PAL) starts with the premium cost • If covers more than one cost accounting period, pro rate costs over the period covered (prepaid insurance account) • If insurance is purchased specifically for and directly allocated to a “single cost objective” (e.g. job), do not need to pro rate • The applicable portion of any income, rebate, allowance, or other credit relating to any allowable cost and received by or accruing to the contractor shall be credited to the Government either as a cost reduction or by cash refund. • Includes refunds, dividends or additional assessments • Must be recognized as an adjustment to the pro rata premium costs in the earliest period in which it is actually or constructively received

46. Insurance Reserves • IBNR (Incurred But Not Reported) • Reasonable reserves for IBNR should not be considered deposits and related premiums reflect insurance costs • While generally understood by Government reviewers to be a common feature, may be concern that reserves are too large • If Government reviewer considers reserve unreasonably large, may question a portion of the reserve and the related insurance cost • To lessen risk of issues with purchased insurance reserves, contractors and insurance carriers should be prepared to demonstrate that reserves are reasonable based on: • Exposure to loss • Actual loss experience • Loss Trending and / or Inflation • Loss development experience or “lag” studies • Discounting reserves not expressly required by CAS 416, but DCAA guidance suggests reserves may be subject to present value discounting

47. FAR 31.205-19(b): Captive Insurance = Self-Insurance • Mistake to account for payments to a captive as purchased insurance • Exception when able to demonstrate that captive sells insurance to general public in substantial quantities and insurance charges reflect market forces • Contractor should plan to measure captive insurance as self-insurance, unless: Captive sells the coverage commercially and premiums paid by the contractor can be demonstrated to be based on market prices • Must treat Government as a “Favored Insured” • Group Captives will generally be treated as purchased insurance with limitations for deductible or “A-Layer” accounts.

48. Measurement of Self-insurance Charges • With significant self-insurance, typical practices for recovering insurance costs are establishing methods for: • 1.Estimating annual projected average losses • 2.Allocating self-insurance charges to segments and cost objectives (jobs) • Under CAS 416, three ways to measure projected average loss (PAL) 1.Actual Losses: actual amount of losses (where actual losses not expected to differ significantly from PAL) 2.Comparable Purchased Insurance: Estimate of the PAL based on the cost of insurance that could be purchased for the self-insured risk 3.Actuarial Measurement: self-insurance charge based on the contractor’s or industry experience and anticipated conditions in accordance with generally accepted actuarial principles • The total of self-insured charges plus insurance charges must not exceed guaranteed cost insurance for the same exposures

49. Measurement of Self-insurance Charges • However, when the self-insurance charge is not based on actual losses or the cost of comparable purchased insurance, CAS 416 indicates: • Insurance charge must take relevant experience and expected conditions into account • Must be “in accordance with accepted actuarial principles” • Outside quotes / broker indications are allowable • May lessen risk of Government challenge if estimate is performed by an actuary and “true ups” are made (though not expressly required by CAS, the DCAA… • CAS Board and DCAA’s position appear inconsistent • Contractors should be aware of DCAA’s interpretation and recognize risk that DCAA may challenge self-insurance accounting practice that does not include “true up” adjustments • Contractors may use DCAA’s favored practice to lessen potential disagreement • Should clearly document practice in CAS Disclosure Statement or other document • Consider agreements with the Contracting Officer on cost measurement, e.g. through a Memorandum of Understanding

50. Allocation of insurance costs under CAS 416: “Home Office” • Commonly allocated home office costs: • Purchased insurance • Self-insurance • Administrative costs • Main allocation concepts: 1.Insurance costs and losses allocated directly to segments (to maximum extent possible) 2.If not allocated directly to segments, allocation base should reflect factors used to determine premium or self-insurance charge 3.Material administrative costs are to be allocated same as related premium or self-insurance charge