INCREASING SHAREHOLDER VALUE: THE IMPORTANCE OF

ESTABLISHING INTERNAL CONTROLS

THERAN J. WELSH

THERAN J. WELSH joined SVA (formerly Suby, Von Haden & Associates, S.C.) in December

2005 as lead principal of the construction industry services group. He is a CPA advising

construction clients to help them better understand their cost structure, with a specific focus on

improving profitability. He also assists clients in developing cash flow projections, analyzing

overhead recovery methods, recommending tax structure, identifying areas of tax exposure, and

determining specific opportunities for tax savings. He is the past president of the associate

members of the Associated General Contractors (AGC) of Wisconsin and a frequent author on

industry issues for local and national industry publications. He can be contacted at

welsht@sva.com.

Construction companies should consider forming advisory boards to help develop their

growth strategies.

The economy has required many contractors over the last four years to focus on internal procedures to improve

efficiency while challenged with a lack of construction projects; they are often forced to reduce their employee staff

bases, who are vital to the procedures I will be addressing.

All contractors must have strong internal controls to protect. This initiative flows from the top down to create a

culture where employees are working to achieve maximum profits; this contributes to increasing shareholder value.

This article will focus on five areas demanding strong internal controls:

1. Is the customer a priority?

2. Have we assessed the contract terms?

3. Are we creating alliances with the subcontractor community?

4. What are we doing with change order management and claims?

5. How do we ultimately put a great report card together at the end?

The first key internal control area is deciding whether to work with a customer. It is very important to evaluate the

years of experience of your owner and what kinds of projects the owner has been soliciting bids for in the past. If

owners are experienced in the commercial market and are now deciding to pursue residential construction, this

should be a red flag to those of us who are interested in pursuing their work.

These questions and answers should be ferreted out at the beginning of any kind of relationship with a customer:

1. Do they have the capability to finance projects?

2. Do they have personnel on board who understand the language and the various documents who are

capable of signing a contract for that work?

The second key area where internal controls are important is contract terms. We hear of situations with contractors

executing on projects without the correct legal documentation in place. Contract terms, material price escalation,

and contract completion should all be considered when signing a contract for a project.

Construction has a complex project cycle requiring extensive reporting as you manage that job. It is imperative that

your employees have the expertise, the capability, and, most importantly, the authority to pursue actions when

contracts and profits start heading south.

It is extremely important to be proactive with your associates who are involved with a project. There is tremendous

stress on a project when the field supervisor is late with paperwork, the accounting department is negligent in

crosschecking the actual orders with the material used on the job, and there is a late work produced in process

schedule, which has not been verified by enough third parties. These are the scenarios in which construction

projects have the best chance of going awry.

Work-in-process (WIP) reports are essential to assuring risk has been identified and insuring profitability. When

there are manual processes involved with old data, it makes it difficult to track down the actual information needed to

provide an accurate template for the readers of that WIP report; ultimately, this also makes it difficult for the

individual who is putting together the package to request a draw on the work to-date.

The third area that requires a lot of internal control due diligence is the management of subcontractors. It is very

important to have multiple quotes from subcontractors as you prepare a project budget. Oversight is also very

important for project managers who continue to use similar subcontractors on jobs. Oversight is key because of the

opportunity for collusion as the job is progressing; it could eliminate possible kickbacks.

You will often rely on software personnel for the budget on a project, the actual costs on the project, and the vendor

billings. You should be comparing the actual subcontractor language and retention terms being withheld to the

contract. It is very important the key personnel within your organization have expertise to provide accurate and

timely billing to the owner for subcontractor work.

Recently, we have seen a trend where general contractors request a subcontractor to prequalify, which involves a

substantial amount of background information on bonding capacity, cash flow, and available lines of credit. It can be

very time consuming for staff to evaluate the prequalification of a subcontractor. It is extremely important for you to

consider a few key indicators. For those jobs where there are substantial penalties on late delivery dates, the

bankruptcy of a subcontractor in a key role within that project can end up being extremely costly for a contractor.

Document management obtaining the validity of insurance certificates by subcontractors is key. This will also help

you to identify when there may be a lien on your project because of actions taken by certain subcontractors. The

analysis of a subcontractor should also include burden rates on payroll that will be assigned to the job.

The fourth area for internal control effort is regarding change orders. This starts with communication to your project

managers on-site that they need to identify early those situations that arise outside the scope of the original

contract. It is very important in today's society to have a written change order signed by both parties. Ideally when

those signatures are recorded, the change order is presented to the owner in a regular fashion, so that decisions

can be made immediately about that change order.

Change orders may arise because of scenarios that are outside a contractor's control, such as weather or different

material specification on a job; there may also be a design change from the architect's standpoint. Again, because

of the complexity of a single construction project, it is important that procedures be communicated up front so the

project owner knows how you will be handling them. It is your ability to enforce your rights, which are ultimately

going to determine the profitability of your project and whether you can bring it in within the range of your initial

estimate.

The last step requiring oversight for internal controls is for the final project wrap-up to deliver your report card. The

key is relying on the WIP schedule to identify the level of success and the profit being reported on these projects.

Normally, most of the profit variation on a construction project can come in the 30-80 percent completion phase.

This 30-80 percent phase is the most crucial time for accountants to be working with project managers on-site to be

sure that all paperwork is being completed in a timely manner, that the WIP schedule is being updated in a timely

manner, and that any variances are being identified. Checking the original estimate of all the costs and comparing

subcontractor commitments and invoicing to the actual budget will help identify any variances.

The other concern with project close out, obviously, is cash flow. Per original contract terms, it is important that the

terms of the contract have been adhered to as you look at that final 20 percent close-out phase. This may require

communication with an attorney to follow up on some past due payments. It may also involve additional time spent

with the project manager to complete the actual paperwork and make sure that the latest draw request has been

concluded. This will necessitate a discussion with the superintendent on-site with regard to determining the final

punch list and future work you have to do to complete the project. Without certain habits in place, doing all of that

without communication makes it difficult to close a project with the targeted gross profit and timely cash flow you

need.

The easiest analysis you can do to evaluate a successful project is identify the under-billings reported on a firm's

current financial statement. As you close out the project, make sure errors and all confirmations and necessary

signatures have been tracked. In addition, a review on a timely basis of your aged receivables shows you which

projects are performing and whether or not there are concerns with completing projects. It is the role of the project

managers to collect this information with the assistance of internal accounting. As the project manager has been in

regular communication with the owner, it should fall on his shoulders. You should consider additional compensation

for those who can bring projects in at more successful gross profit percentages.

Having good solid practices within your organization involves internal accounting, field labor, technology, and a

competent software system that tracks detailed information when you need it. As you move through your budgeting

cycle next year and look at trying to increase your growth profit percentages, it is very important for you to identify

resources to enhance these internal control areas. By doing so, you will have a greater chance of increasing

shareholder equity.

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