Best Practices Can Help Contractors Improve Financial Reporting and Accountability

By Samuel E. Johnson, Cherry, Bekaert & Holland, L.L.P. (CB&H)
Email: sjohnson@cbh.com

In response to an erosion of public confidence in the financial reporting process and the effectiveness of independent audits, a number of new accounting regulations and requirements have been issued within the last several years. Although the most costly and time consuming requirements are only applicable to SEC registrants, the complexity and cost of financial reporting and compliance has increased for even the smallest privately owned businesses.

This new age of accountability presents real estate and construction companies with a unique challenge given the constant need to maintain solid relationships with lenders, suppliers, and construction bonding companies. However, owners and managers of real estate and construction companies can take advantage of this “trickle down” effect to better position their businesses for future success by adopting best practices as they relate to financial reporting, corporate governance, and financial accountability.

The New Management Letter
The management letter that independent auditors issue at the completion of a financial statement audit or review can be the first step in helping business owners create a secure, reliable information system that reinforces the organization’s overall high quality. In the past, such letters have addressed, in a variety of forms, the segregation of duties and the difficulty of segregating duties in a small company environment. Most likely the comments were not labeled as a material weakness, and ownership of the company was encouraged to remain continually active in the oversight of the company’s financial affairs.

But many companies have noted that the management letters related to their 2006 audits have taken a different tone, and consequently may have become the subject of greater discussion than in previous years. Effective for fiscal years ending on or after December 15, 2006, independent auditors are now required, under generally accepted auditing standards, to communicate matters identified in the audit that relate to the company’s internal controls over the financial reporting process.

Under the new standards, if a company’s auditors prepare its financial statements or provide significant assistance in the preparation of the statements and related notes, then the company’s independent auditors are now required to assess whether or not management: (1) has the ability to prepare such statements in accordance with generally accepted accounting principles (GAAP); or (2) would have the ability to identify material departures from GAAP in the statements and related notes, when such statements are prepared by the company’s external auditors. This is a significant departure from past requirements, and requires independent auditors to employ greater scrutiny of a company’s internal accounting capabilities, which in the past may have been viewed in a more complimentary light.

Under the new standards, management will receive written comments documenting the existence of a significant deficiency in internal accounting controls over financial reporting if the company’s auditors and not the company’s internal accounting staff: (1) make significant adjustments to the company’s financial records; or (2) assist in the preparation of the company’s financial statements.
Failure of the auditor to conclude that management is capable of preparing the statements, even in circumstances where the auditor has assisted with only the most complex areas of accounting and disclosure, will result in the auditor issuing a management letter that identifies this apparent incapability as a significant deficiency in the company’s internal accounting controls.

Although not maintaining an accounting staff with the requisite qualifications may very well be the most cost effective and practical means of operating a company, such a letter could leave the user of the company’s financial information with an unfavorable impression regarding the company’s ability to accurately report interim financial information to lenders and others.

In every event that such a letter is received, the company’s management should formulate a response and insist that this response be included as a formal part of the letter. In addition to this response, management of the company should consider the following:

• Clearly communicate to the users of the company’s financial information the extent of auditor assistance in preparing the financial statements.
• Carefully review the company’s interim reporting requirements and discuss with the financial statement users the accounting staff’s abilities to prepare such information. Proactively assure the users of such information that the information is accurate and has been prepared in a manner required by the user. Tell the users the steps that have been taken to assure its accuracy, and only agree to interim reporting for which the company’s accounting staff is qualified to accurately and completely prepare.
• Develop compensating controls. Consider hiring as a consultant a qualified accountant experienced in the real estate or construction industry, and have this individual assist and review interim and annual financial statements prior to its presentation to the financial statement users or independent auditors.
• Make a critical assessment of the complexity of the company’s financial reporting requirements and the abilities of the company’s accounting staff.
• Encourage continuing education and training among existing accounting department personnel.
• Maintain a reasonable library of technical resources specific to the industry, and request that the company’s external auditors provide the company’s accounting staff with disclosure checklists and other nonproprietary tools that may assist in the preparation of financial statements in accordance with GAAP.

Corporate Governance and Accountability
As a result of the corporate scandals of the last decade, much has been written about corporate governance and accountability. The boards of large, publicly held businesses are now much more likely to quickly call for the removal of a chief executive officer at even the slightest hint that financial transactions have been entered into without the greatest of care or at any indication that errors in financial reporting were not forthrightly and completely corrected without delay.

In most privately owned businesses, ownership, management, and the company’s board of directors are one and the same. Quite often, this single group is a family that controls the business, and that family may well have founded the business or inherited the business from an earlier generation. In such environments, corporate governance or the manner in which the company’s board of directors manages its responsibilities to its owners or stakeholders may be difficult and full of potential conflicts of interest.

Even though the company’s management, ownership and board of directors may essentially be the same people, it is extremely important that this group act like a larger corporation, instill the level of formality required by the laws of its state of incorporation, and meet the basic requirements of the company’s stakeholders.

A regular and careful review of the company’s articles of incorporation, its bylaws and its shareholder agreements can help determine the level of formality required, as can frequent interaction with legal counsel regarding what the company’s board should be considering and acting upon. Failure of a company to act appropriately could have significant negative consequences as to its status as a corporate entity, and may subject some of the company’s activities to additional scrutiny by the IRS or the DOL.

A company should conduct annual meetings of its shareholders to consider and vote upon governance issues, and these meetings should be documented and signed off on by a representative of ownership. Directors of the company should also meet consider items normally considered by boards, such as offers to buy the company, ratification and approval of all major contracts and commitments, approval of officer compensation, review and approval of annual financial statements, budgets, and major acquisitions. These meetings should be documented as well.

Regular and contemporaneous documentation of a variety of matters can go a long ways towards the satisfactory resolution of disputes among shareholders regarding such matters as buy/sell agreements and the reasonableness of shareholder/manager compensation. Copies of board meeting minutes are routinely one of the first items requested in an examination of a company by the IRS.
A company should also consider the value that might be obtained by inviting certain outsiders to sit on the company’s board. The value brought by having someone from outside the company on the company’s governing board is immeasurable. For example, an outsider on the board can foster a greater sense of independence, openness, and transparency to the users of the company’s financial information, and bring fresh thought leadership and a challenging sense of objectivity to the board.

In addition to the board oversight of a company, all but the smallest of companies should consider the need for and appropriateness of having the company’s accounting and financial reporting policies and procedures documented. Users of a construction contractor’s financial statements and information have every right to know that there are documented procedures in place, which are subject to periodic review and revision.

Among other things, a construction contractor should document the company’s: (1) monthly, quarterly, and year-end close-out processes; (2) disaster recovery plan, relating to financial information; (3) internal controls over inventories and equipment stored at various job site locations; and (4) internal controls over the company’s bid acceptance and qualification process and over the company’s establishment of various estimates critical to revenue recognition. The establishment of a policies and procedures manual will send a clear message to those involved in the process that accuracy in financial reporting is of utmost importance to the company.

Audit committees can also be a powerful way to positively impact an organization’s commitment to financial accountability and transparency. Furthermore, an audit committee can tremendously improve the audit process, and improve auditor independence and objectivity. In order to be most effective, an audit committee should be comprised of outside directors or non-directors acting in an advisory capacity to the company’s board of directors.

Good audit committee members will be naturally curious, tenacious, and have good common sense. Unlike many large public companies, most construction contractors will not be asking their audit committee members to have an understanding of complex financial instruments, complex internal control systems, or an ability to comprehend large international transactions. What’s most essential is a willingness to continue to ask questions until satisfied, and the ability to listen and help the contractor make good judgments about financial accountability.

Conclusion
Financial reporting for both publicly held companies and small private companies carries with it a tremendous amount of responsibility. Accuracy, clarity, and a sense of openness in the conduct of a company’s financial affairs are critical to management’s success and an important component of the company’s relationships with its many stakeholders, including employees, customers, and creditors.

The role of independent auditors is to enhance the reliability or credibility of financial information, but financial information is first and foremost the responsibility of the ownership and management of a company. Recent changes to professional standards and regulations regarding financial reporting may have resulted in increased cost and complexity, but they have also increased opportunities for management and ownership of well-run companies to improve the financial reporting and oversight process. Companies that fail to embrace these opportunities and discover cost-effective means of dealing with the new era face the possibility of strained relationships with their stakeholders.

A longer version of this article appeared first in Construction Accounting and Taxation, No. 1, 35.
© 2008 Thomson Tax and Accounting. Reprinted with permission.

Sam is an Audit Partner with CB&H and a member of the Firm’s Real Estate & Construction Industry Group.