Managing and analyzing working capital, valuing accounts, and trying to raise company value are constants for construction company executives and construction financial managers (CFMs). The end of every year requires those parties to get the balance sheet right and the financials reported accurately. This must be accomplished according to Generally Accepted Accounting Principles (GAAP), but to present the best and most accurate picture, construction industry participants must understand their company’s overall default risk and exposure to write-offs.
Determine If Accounts Are In a “Secured Position”
Construction industry participants are in a uniquely good position to secure their receivables. This ability is built directly into the law through the use of mechanics lien and bond claim rights. When a party has complied with the necessary requirements to preserve these rights, that party is in a “secured position.”
However, a party is not in a secured position solely because they file a lien or bond claim against a project. In fact, though, companies are in a “secured position” whenever they are capable of filing a valid lien or bond claim. This means that a party can remain in a secured position for much of the project, and for some time after, all without ever filing a mechanics lien claim. Whenever the right to file is preserved, the security right in the collateral is preserved as well, and as such, the company retains its secured position.
In most situations, preserving the security right (maintaining the secured position) requires the company to send a preliminary notice at, or near, the start of work. Generally, if this is done, the company will maintain its “secured position”, and retain the ability to file a valid lien or bond claim, if the need arises.
Whether or not a company maintains a “secured position” is important for many reasons, but one particular reason is that the nature of the debt greatly alters the collect-ability of the debt, and thus, how that debt may be reported.
Secured and Unsecured Debt Is Different, and Can Likely Be Reported As Such
While GAAP allow for different calculations in reports of earnings and assets, the calculation must be accurate and “conservative”. This means that the company has an obligation to conservatively determine or forecast the portion of receivables that ultimately will not be collected, and will be written off. Typically, companies accomplish this by establishing an allowance for doubtful accounts, and applying that allowance to their outstanding A/R.
For example, this process can work as follows: If a company has $100,000 of receivables on the books at the close of a fiscal year, and the company conservatively expects that it will write off 5% of those receivables, the outstanding receivables would be reported as $95,000 on their balance sheet. It is important to note, however, that companies cannot just pluck that 5% figure out of thin air.
GAAP dictate the parameters by which this allowance figure must be calculated. And, as noted above, the core characteristics of the calculation should be accuracy and conservatism. This does not mean that a company is mandated to apply one formula to the entire A/R sheet, however. Companies may use one method to measure the allowance figure across all receivables, or they may break their receivables into classes and use multiple methods to measure the allowance. And, in fact, using a different method for each different “class” of receivable may be the most accurate method for arriving at the allowance for each particular class.
When multiple methods are used, however, “accountants must exercise judgment when choosing which method to use.” Catherine Finger presented some explanations related to this process in Using Judgment to Measure the Allowance for Doubtful Accounts, a 2010 academic paper published in Bryant University’s Global Perspectives on Accounting Education.
Ms. Finger notes that:
Accountants…must decide whether different classes of receivables (e.g. receivables with different ages, for different products, and from different classes of customers) exhibit collection patterns that are different enough to justify the use of multiple default rates.
This segregation of “classes” of receivables dove-tails nicely with the above discussion of secured or securable receivables. A/R that is actually secured, or for which the company is in a secured position, consistently outperform unsecured receivables by a significant margin. A company that segregates these two classes of receivables and applies a different allowance, therefore, would likely report increased and more accurate earnings.
Default Risk Is Much Lower for Secured A/R
The risk of default is a company’s risk that they will sustain losses as the result of non-paying customers, and default risk is typically reported by a company within their annual reports if they are publicly traded, or reporting to private investors. In many aspects, default risk tracks with customer base – if a company has one customer, their default/credit risk is quite high because that one customer holds the entire company’s fate in its hands, whereas companies with a broad customer base face a significantly lower default risk.
Even companies with very broad and far-reaching customer bases, bear some mentionable refit/default risk, however. Grainger, which noted in an investor report that “[t]he company has a broad customer base representing many diverse industries doing business in all regions of the United States, Canada, Europe, Asia and Latin America. Consequently, no significant concentration of credit risk is considered to exist” reported a 2.06% allowance for doubtful accounts (during the recent recession). While this has since stabilized and retreated, credit/default risk is measurable even when spread across a diverse customer base.
The default risk on secured debts for companies in the construction industry, however, is much lower than that for unsecured A/R. Since A/R can be segregated between secured accounts and unsecured accounts, understanding this distinction would enable construction companies to more accurately account for, and report, risk and earnings. As an offshoot, this knowledge would also likely influence construction companies to increase the usage of security right, as doing so would increase earnings.
Security is available to an extremely wide variety of participants in the construction industry, and the secured position of an account has real measurable impact on corporate figures. Accountants, executives, and CFMs should to pay closer attention to the security position of their accounts, and leverage the same to increase their earnings and performance metrics. It’s not good business not to.