Virginia Tech and VSCPA Accounting and Auditing Conference

1. Virginia Tech and VSCPA Accounting and Auditing Conference Construction Accounting and Auditing Update 2006 By C. Michael Wade , CPA and Director of Contractors Financial Consulting Services Group Brown Edwards and Company,L.L.P.

2. Construction Accounting and Auditing Update for 2006 Introduction Name and firm Practice area and experience Format of the presentation Questions after the presentation please

3. Construction Accounting and Auditing Update for 2006 State of the Industry View point of Ken Simonson Economist for AGC Residential real estate markets are cooling due to higher costs Commercial activity is increasing including the Richmond district Construction starts are slow in residential up in commercial Steel increases continue for the future Other commodities on the rise Delivery delays continue also

4. Construction Accounting and Auditing Update for 2006 Update on the Virginia Department of Transportation Public wants better transportation but no tax increases Budget approved but no long term $$ for transportation VDOT�s 6 year program has significant $$ cuts from the original plan passed by Warner Virginia relies on Federal Gov. for funding 70% with other states average of 42% Senate and House cannot agree on common plan The general assembly is still trying to come up with something September 27,2006 special general assembly session and nine new transportation bills will be introduced

5. A few statistics from CFMA Legal form 64% S corps, 25% C Corps and 11% other form Source of work 67% private and 33% public Top 5 challenges of contractors ( percent listed, ranking) Health care costs 71% ranked 3rd Trained field personnel 66% ranked 1st Workers Compensation costs 48% ranked 5th Future work 47% ranked 2nd Insurance costs 44% not ranked Shortage of project managers ranked 4th Construction Accounting and Auditing Update for 2006

6. Construction Accounting and Auditing Update for 2006 Views from the IRS on the Industry IRS has release new industry guide March 2005 Criminal investigations involving contractors in 2005 �.256 IRS has web site with industry specialization including construction

7. Construction Accounting and Auditing Update for 2006 Surety update and the Bond Market Bond Market Industry only bonding 40% of their work on the average Heavy highway bonds more than 80% Sampled contractors indicate bond credit remained the same as in 2004 ( for 2005 year) General contractors are bonding less than 20% of subcontractors costs Most contractors only using 1 surety company. Approximately 6% of the industry is uses more than one surety company in their programs

8. Construction Accounting and Auditing Update for 2006 Surety Market For 2006 continued tough underwriting guidelines for questionable financial results Middle market contractors <100,000 no sign of changes Surety will be competitive for them No significant price pressure ..some increases Indemnity still negotiable Mega contractors are viewed as most risky due to losses in the pass Surety promises to sue CPA�s on misleading financial statements

9. Construction Accounting and Auditing Update for 2006 Accounting Principles New and Old Percentage of Completion vs. CCM PCM used when reasonable and dependable estimates exist with certain conditions Contractual and estimates can be obtained CCM use is narrow Cannot obtain reasonable estimates under certain circumstances and Financial position and operating results are not significantly different from PCM 1.16

10. Construction Accounting and Auditing Update for 2006 Accounting method vs. tax methods Accounting methods PCM CCM Tax methods PCM CCM Cash method Accrual method Tax methods used in financial statements are under OCBOA rules

11. Construction Accounting and Auditing Update for 2006 Provision for Losses on Uncompleted Contracts The most ignored rule in construction accounting This accounting principle carries the highest risk with surety companies 80% of suits by sureties deal with this principle in some form The calculation Total projected loss � loss to date= contingency loss accrual on the financial statement presented Accrual � current liability and cost included in contract revenues earned

12. Construction Accounting and Auditing Update for 2006 Indirect cost allocations Cost need to be allocated to Cost of Revenues earned and preferably by contract Classification of accounts between direct and indirect creat the most problems Allocations need to be systematic and rational Allocation methods are many Presentation of these cost outside of Cost of Revenues earned cause sureties the most problem in estimating true profitability of jobs

13. Construction Accounting and Auditing Update for 2006 Unbilled Receivable Issues Many accountants do not address IRS will address in audits along with cost capitalized with these costs ( not GAAP) The issue is cutoff and consistency with use Many times under billing are due to unbilled receivables It is best separate unbilled amounts for bonding Special disclosure needed in the financial statement and policy footnote

14. Construction Accounting and Auditing Update for 2006 Retainage issues Recording is sometimes overlooked Classification between short term and long term is an issue with bonding company Do not forget the retainages associated with subcontractors Need to disclose amounts in the financial statement as part of receivable disclosure

15. Construction Accounting and Auditing Update for 2006 Contingency accruals Contract price contingencies GAAP Accounting � basic contract plus contract options, change orders , claims, provisions for penalties and incentives. Requires judgment in assessing probable outcomes Tax- as a general rule everything is included even though the �all events test has not been met�. Look back will make up the difference in the year it is realized.

16. Construction Accounting and Auditing Update for 2006 Contract Costing Rules GAAP Accounting � need to consider warranties, project guarantees, maintenance and other service agreements as accruable under contract costs ( cost must be foreseen to be put in estimated costs to complete on contracts) Tax � cannot accrue as part of contract cost or others and will be disallowed until cost incurred. Contingency costs are not deductible for tax purposes

17. Construction Accounting and Auditing Update for 2006 Issues in Financial Reporting Observed By Peer Reviewers Lack of Contractor statement terminology still being found Backlog disclosure footnote ( recommended) 90 day receivables and composition of AR Retainage disclosures and subcontractors amounts Provision for losses on contracts not addressed Policy statement of costs and allocated costs Revenue policy footnote Related party disclosure and FIN 46 not addressed Statement of Income not reconciled to job schedules in work papers ( a real surety risk) Calculation for PCM not GAAP under SOP 81-1 1.40

18. Construction Accounting and Auditing Update for 2006 New FASB affecting the Industry FASB 157 Fair Value Measurements Guidance on measuring Fair Value Only �FMV is price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date� Differences between entry price and exit price under FAS 141 Assets measured �highest and best use� Liabilities measured with nonperformance considerations Directly effects FMV determination for Business combinations FAS 141 Valuation techniques 1. market 2. Income 3. Cost approach Input to valuation 1. observable and 2. unobservable inputs Must prioritize inputs and consider 3 different levels Effective for F/S issued after November 17, 2007 for fiscal years beginning after that date.

19. Construction Accounting and Auditing Update for 2006 FAS 154 Accounting Changes and Corrections of Errors Supercedes APB 20 and FAS 3 for accounting changes Old rules required cumulative effect of the change in year of change as separate line on the income statement New rules require retrospective restatement of prior years for all statements presented or from the earliest practical measurement date Change in depreciation, amortization or depletion method is now a change in accounting estimate effected by a change in accounting principle ( should only change in recognition of changes in estimated future benefits of the asset, patterns of consumption , or for information available about the future benefits) Old rules for correction of errors and changes in accounting estimates are the same as old APB 20 Effective for fiscal years beginning after 12/31/2005

20. Construction Accounting and Auditing Update for 2006 FAS 153 Exchanges or Non monetary Assets ( amends APB 29) APB 29 stated exchanges of non monetary assets should be measured based fair market value of the assets exchanged ( resulting in possible gain or loss) with a general exception for similar production assets The new rule eliminates the old exception and replaces it with a new exception pertaining only to assets that �do not� have commercial substance. New definition- �commercial substance� means future cash flows of the entity are expected to change as a result of the exchange This rule will effect and encompass PPE and other intangible assets( example under old rules �a truck for a tractor� was exempt now it is not if there is commercial substance) Effective for fiscal years beginning after 6/30/2005

21. Construction Accounting and Auditing Update for 2006 Example New asset FMV ( selling price) 10,000 Old asset FMV (appraisal or credit) 3,000 Cash or note pay for new 7,000 Cost basis of old 8,000 Acc depr of old 7,000 Basis 1,000 Entry:Cost of new asset 10,000 Acc deprec of old 7,000 Cost of old asset 8,000 Cash or note payable 7,000 Gain on disposition 2,000 ( 3,000-1000)

22. Construction Accounting and Auditing Update for 2006 FAS 151 Inventory Costs ( amends ARB 43 chapter 4) Applies consistent application of abnormal inventory as period expenses ( idle costs, spoilage, rehandling and double freight costs) Old rules were unclear and could be interpreted and used differently ( possible capital vs. period costs) This statement formalized consistently in the international and US community Better defines capital vs. period costs also Effect on contractors defines a little more the rules for inventory capitalization particularly in quarry operations or manufacturing operations) Effective for fiscal years beginning after 6/15/2005

23. Construction Accounting and Auditing Update for 2006 FAS 146 Accounting for Costs Associated with Exit or Disposal Activities ( nullifies EITF 94-3 related to employee termination benefits and certain costs for restructuring) Old rule states�. Liability was recognized at the date of an entity�s commitment to an exit plan. New rule says� liability recognized when the liability is incurred Conclusion� liability is not recognized at the date of commitment to a plan Effect on contractors if businesses are sold or liquidated regarding employee liabilities or restructure costs (FAS141) Effective for fiscal years ending after 12/30/2002

24. Construction Accounting and Auditing Update for 2006 FAS 144 Accounting for Impairment or Disposal of Long-Lived Assets (supersedes FAS 121 and APB 30) Two types of Long Lived assets to evaluate LL Assets held and used For LL assets to be held the rule is �.impairment loss is recognized if the carry amount is not recoverable from its undiscounted cash flows�. which is measured by the difference of carrying amount of the asset and the fair market value This rule eliminates goodwill for consideration Probability weighed cash flow estimated approach can be used to determine FMV Assets identified as not being used but not for sale ( out of date or business changed) You still must depreciate the assets

25. Construction Accounting and Auditing Update for 2006 LL Assets to be sold Value of LL assets held for disposal is the lower of the carry amount or FMV less cost of sale LL Assets disposed of other than by sale Requires depreciation to be abandoned Impairment loss be recognized at date of exchange of similar asset or distributed to owners or spin off (measured by carry valve vs. FMV) CPA�s need to inquire about the status of equipment to apply this standard Effective date for fiscal years ending on or after 12/15/2001

26. Construction Accounting and Auditing Update for 2006 FAS 143 Accounting for Asset Retirement Obligations Statement addresses the recording of obligations associated with the retirement of long lived assets and the associated retirement costs Statement applies to all entities It applies to the legal obligations associated with retirement of LL assets that result from acquisition, construction, development and the normal operations of LL assets A legal obligation is a obligation that a party is required to settle as a result of laws, statute, ordinance or written or oral contract. Obligations are to be recorded at FMV in the period it is incurred if a reasonable estimate can be made This can be tricky in determining � the period it is incurred� If you sold or retired at this moment � Would you have an obligation? For contractors it may include environmental clean up etc on sale of related assets Concrete and quarry operations�. Evaluate and book clean up for environmental and reclamation purposes??? Effective date �way back when fiscal years beginning after 6/15/2002

27. Construction Accounting and Auditing Update for 2006 FAS 142 Goodwill and Other Intangible Assets (Super cedes APB 17) Goodwill and other intangible assets no longer amortized Impairment is now tested annually for fair value A two step process (1) screen for impairment (2) measures the impairment Other intangible assets that have finite useful lives will continue to be amortized over their useful lives Unamortized intangible assets( have no finite life) must be tested annually by comparison of FMV to carry value Specialized disclosures require changes in carry value, segregation of amortized and non amortized assets and 5 year amortization disclosure Effective date way back when .. Fiscal years beginning after 6/30/2001

28. Construction Accounting and Auditing Update for 2006 FAS 141 Business Combinations (Super cedes APB 16 and FAS 38) All business combinations are accounted for by the purchase method . Three things to do: Determine acquiring entity Determine cost of acquired entity Determine allocation of cost and liabilities of acquired entity Three requirements Must now separate other intangible assets from Goodwill ( must identify) Much better guidance on identifying the intangible assets Disclosures require reasons for business combination and allocation of purchase price Allocation rules did not significantly change but there are changes ( study the examples) Effective fiscal years ending after 6/30/2001( way back when) 2.10

29. Construction Accounting and Auditing Update for 2006 Financial Interpretations ( FIN�s) FIN 48 Accounting for Uncertainty in Taxes Requires evaluations of uncertain tax positions if client is examined by the IRS Need to incorporate the tax effect into the tax provision Evaluation should be based on the merits of a technical tax position General rule -It is greater than 50% chance it would happen on examination CPA exposure- IRS examination results in additional tax not booked in previous financial reports for which you knew of the issue � misleading financial statements Effective date - NOW

30. Construction Accounting and Auditing Update for 2006 FIN 46R Consolidation of Variable Interest Entities ( A Simple View Point) Rules require three items: Identification of variable interest entity (VIE) Identification of variable interest ( form of support) Identification of primary beneficiary (PB) If all three are present and identifiable then VIE is consolidated with the PB FIN46R provides test and rules for identifying the three requirements above USE PPC Related Party Program as practice aid ( Appendix 2E) Effective Now and it effects most all contractors is some fashion

31. Construction Accounting and Auditing Update for 2006 Guidance Related to Natural Disasters ( Technical Practice Aid TPA section 5400.05) This TPA gives you guidance for the following issues- Classifications in the income statement for losses incurred in a natural disaster (ND) ie Hurricanes !!! Asset impairment evaluation for ND ( FMV vs carry value) Liability recognition for non impairment losses associated with ND such as additional expenses required due to ND ( environmental issues etc) Accounting for insurance recoveries ( income and reinvestment) Additional disclosure requirements

32. Construction Accounting and Auditing Update for 2006 Engagement Risk For Contractors Understanding the Entity and Its Environment Understand the construction industry Know your client and their financial objectives and motives objectives Identify the entities business risk Many contractors lack proper internal accounting controls ( A significant Fraud Risk Factor)

33. Construction Accounting and Auditing Update for 2006 Auditing Variable Interest Entities December 2003 Issuance of FIN 46R Issues are common to small and medium size businesses Note these related Staff Positions Para. 13 FIN 46 on reporting VIN�s Calculation of expected losses FIN 46 Evaluating holders of equity interest to determine if they have direct or indirect interests FIN 46R Implementation issues related to Leasing Transactions

34. Construction Accounting and Auditing Update for 2006 Provisions in Engagement letters to eliminate certain accountants liability with the client AICPA ethics committee issues new ruling interpretation ET sec. 101.01 Certain types of liability provisions in engagement letters violate independence issues( i.e. elimination of actual damages from negligence or the client�s negligence) Other liability provisions would not impair independence ( i.e. client�s knowing misrepresentations or willful misconduct or fraudulent behavior Be sure you research unique changes you are making to your engagement letters to assure you are not jeopardizing your independence 2.20

35. Construction Accounting and Auditing Update for 2006 Internal Control Deficiencies Most common deficiencies noted Considerations of job site visits as it relates to controls on the job site Internal control considerations related to bidding and estimating Lack of sufficient evidence to support estimated cost to complete and controls designed to arrive at those estimates Other Issues Lack of competent personnel Documentation related to income recognition

36. Construction Accounting and Auditing Update for 2006 Companies are changing auditors at record rates Be advised to conform to the requirements of AU Section 315 Get permission from the client to make inquiry Make inquiries with the predecessor Allow review of work papers if needed Association with press releases in today�s business environment Just a word of caution �Don�t be associated if misleading

37. Construction Accounting and Auditing Update for 2006 Risk of Fraudulent Reporting and Improper Accounting Estimates Review all significant of Contracts ( encouraged during review engagements) Job Site visits to determine the status and completion percentage of a contract in progress ( not required by highly recommended) Auditing contract costs Components of contract cost related to original bid Proper classification of costs between contracts Sufficient audit procedure on contract costs Estimated cost to complete Need to consider types of contracts Fixed price ( high risk) Cost plus ( lower risk) Construction management ( can be high risk based on contract) Design build ( more like cost plus) (lower risk but depends on contract)

38. Construction Accounting and Auditing Update for 2006 Compilation and Review Engagements Fraud and illegal acts SSARS 12 requires understanding with client in the form of an engagement letter �Need to include separate paragraph in the engagement letter addressing your responsibility for detecting fraud� Rise in litigation risk in Compilation Engagements related to fraud Perform procedures in STRICK CONFORMAMCE with SSARS with appropriate documentation Re assess client acceptance and continuance Talk to client about fraud and their risk and yours Address in engagement letters

39. Construction Accounting and Auditing Update for 2006 Industry Developments Rising Interest rates, Energy costs , debt levels and softening housing market Heights risk on issuing financial statements over recognition of income and going concern issues Viability and liquidation risk Overvaluation of assets and working capital short falls effecting job continuance and provision for loss considerations

40. Construction Accounting and Auditing Update for 2006 Inventory obsolescence ( as if effects service contractors, quarry operators and manufacturers) Customers with high levels of debts and negative working capital issues Signals going concern issues and provision for losses on uncompleted contracts Impairment and recoverability of assets Equipment not in use ( FMV write downs)

41. Construction Accounting and Auditing Update for 2006 Layoffs and Lack of Qualified Help Ability of contractor to complete work � going concern possible Outsourcing ? � not considered a big risk to the construction industry Raising capital and Baby Boomer Transitions More difficult for the construction industry Consolidators are on the rise again mainly in the capital markets Be careful of buyers who do not understand the industry Observation -Pension plans are being liquidated or transitioned in to plans more controllable for funding by employers

42. Construction Accounting and Auditing Update for 2006 Mergers and Acquisitions are heating up FAS 141 has changed accounting methods for M&A Internal controls are perceived weaker with M&A transactions Possibility of worsened financial performance with contractors consolidated as in the past Statistic- 80% of buyers are paying more than exit price FMV Attacks on IT Fraud risk to accountants Know your clients computer controls

43. Construction Accounting and Auditing Update for 2006 Improper Accounting to be aware of Revenue recognition ( percent complete measurements) Accounting for insurance contracts ( self insurance arrangements with under funded liabilities) Business combination accounting ( to much value on amortizable intangible assets) New Bankruptcy laws Positives � easier collection of debts Negative � harder to rid debt under ch. 11 Word of caution � screen the law firms and get approved by the bankruptcy trustee before you pick up your pencil!! 2.40

44. Construction Accounting and Auditing Update for 2006 THE END If you have questions or concerns I would be glad to talk to you individually