Construction Industry Audit Technique Guide (ATG) - Chapter 1
Publication Date - May 2009
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Chapter 1: Introduction to the Construction Industry
- Intended Audience
- Participants in the Construction Industry
- The Contracting Process
- Contract Income
- Types of Contracts
- Building Permits
- Notice of Completion
This Industry Guide is intended for examiners conducting audits in the construction industry and as information for taxpayers and practitioners associated with the construction industry. Review of this guide is recommended prior to initiating an audit. Users of this guide may need to augment these guidelines by researching specific tax issues and new tax law.
Participants in the Construction Industry
Numerous participants in the construction industry play a distinct role in the process. The key participants are discussed below.
Contractors perform the construction work in accordance with the plans and specifications provided by the owner and are required to be licensed by state law.
General or Prime Contractors
A general contractor's principal business is the performance of the construction work in accordance with the plans and specifications of the owner. A general contractor takes full responsibility for the completion of the project. The general contractor will normally subcontract out a substantial part of the work, while maintaining overall control through project managers and onsite supervision. The general contractor may utilize specialty subcontractors, but can perform any portion of the work. Generally contractors are licensed. If the contractor is a corporation or partnership, an officer or partner, the contractor must be licensed.
Generally, the construction manager does not perform construction work on projects, but is an agent for the owner. The construction manager may be engaged in lieu of or in addition to a general contractor. As an agent, the construction manager coordinates the construction project, but has no contractual relationship with the subcontractors. Generally, construction managers only provide services. Construction managers do not perform any construction work. Construction managers are not liable for defects in the construction. However, the construction manager may be liable for design defects.
Commercial contractors specialize in commercial construction projects. These projects may include the construction of a single building or any number of buildings. Commercial projects include:
- Retail project like shopping centers, restaurants, and grocery stores;
- Rental facilities like office buildings, industrial parks, and apartments;
- Business locations like company headquarters, manufacturing plants, and insurance companies;
- Municipal buildings like city halls, prisons, schools, and hospitals; or
- Special projects like amusement parks, racetracks, coliseums, and churches.
A commercial contractor constructs nonresidential buildings, such as office buildings, warehouses, and shopping centers.
Commercial Project Owners
The owner of a construction project may be an individual, corporation, partnership, or government body. The owner evaluates whether a project is feasible and will provide the future benefits desired. The owner then engages an architect or engineer to design the plans and specifications of the project. Normally, the owner secures the necessary financing for the project for both the construction period and permanent financing upon completion. The owner will retain title to the project throughout the construction phase, subject to liens from construction loans and mechanics liens. The general contractor may or may not have an ownership interest in the project. The contractor may own a percentage interest in one of the following ways:
- Owning stock in the corporation that owns the project;
- Being a partner in a development partnership; or
- Owning the property or an interest in a joint venture as an individual.
Residential Construction Developer
The examination of residential developers is different than the examination of a contractor who builds in accordance with a contract for an owner. The developer is generally the owner and the builder of the residential development. The developer acquires land, obtains approval, secures construction financing, and begins construction of the residential development in stages or phases of construction.
The initial phase is sold, and the construction process begins on the next phase. This process requires the builder allocate a per-unit cost to each unit sold. The cost of each unit (on-site costs, such as direct materials and labor, and an allocated portion of off-site costs such as streets and amenities) must be matched with the sales price of each unit sold. The sales price is often based on what the market will bear under the current economic environment.
The largest number of taxpayers in the construction industry is a specialty subcontractor. They can range from one-man operations to nationwide, publicly traded corporations, or divisions of larger corporations. Subcontractors are distinguished from the general contractor by the limited scope of their work, which usually involves a special skill, knowledge, or ability.
Subcontractors include specialists, such as plumbers, electricians, framers, and concrete workers. They generally enter into contracts with the general contractors, and may provide the raw materials used in their specialty areas.
The general contractor, not the owner of the property, will usually pay the subcontractors. Materials purchased by the subcontractors are generally delivered directly to the job site. The subcontractors' work may be completed in stages, or it may be continuous.
Highway and street contractors require specialized equipment and techniques. The equipment includes bulldozers, graders, dump trucks, and rollers. Examples of highway construction include city streets, freeways, country roads, highway bridges, and tunnels.
Heavy Construction Contractors
Heavy construction contractors require large and complex mechanized equipment, such as cranes, bulldozers, pile drivers, dredges, and pipe-laying devices. Some examples of projects in this category include dams, large bridges, refineries, petrochemical plants, nuclear and fossil fuel power plants, pipelines, and offshore platforms. Most industrial plants are classified in this category because of the complexity of the work. The largest engineering and construction firms are included in the heavy construction classification.
Architects and Engineers
The architect or engineer designs the plans to be used by the construction contractors. The plans provide the necessary detail (dimensions, materials to be used, location of fixtures, etc.) to the contractors. When the project is started, the architect or engineer may monitor the contractor's progress and often approves progress payments to the contractors. The architect or engineer will make modifications (change orders) in the plans as needed. Change orders are written revisions to the contract, which increase or decrease the total contract price paid to the construction contractors. The change order document contains the change order number, change order date, a description of the change, and the amount of the change order. The contractors under the terms of the contract can also issue change orders.
Material suppliers provide the raw materials used in the construction project. Material supplies are purchased by the subcontractors and installed by them in accordance with their contract. General contractors often write joint checks to subcontractors and material suppliers to ensure that all parties have been properly paid. Materials are generally delivered directly to the job site and are direct job costs, which are not normally inventoried by the contractor. In some situations the contractor will maintain inventories of frequently used miscellaneous yard stock.
The construction lender provides the necessary funds to pay contractors on a progress basis. In return for making the loan, the lender receives interest on the outstanding loan balance. Construction period interest costs ("soft costs") paid by the owner to lenders must be capitalized during the construction period. Interest and other loan costs are often taken directly from the loan principal as a result of the institutions interest provisions.
As construction work progresses, the construction lender (bank, savings and loan, insurance company, etc.) will advance the funds based on the work performed or based on a payment schedule. The construction loan is generally secured by the land and construction in progress. When construction is completed, the owner will secure permanent long-term financing.
Sureties are generally insurance companies who provide bonding to contractors. Bonds provide a form of insurance to the owner. Performance bonds protect the owner if the contractor fails to complete the construction work. Performance bonds are typically a percentage of the contract amount.
Bid bonds guarantee that the contractor will sign the contract after it is awarded and furnish the necessary performance and payment bonds within a specified time. Contractors must submit detailed financial data to the surety company to secure a bond.
Financial statements prepared in accordance with generally accepted accounting principles (GAAP) are often furnished to the surety on a quarterly basis or more often. Supporting schedules included in these financial statements provide extensive job information, required by the surety in order that they may analyze and limit their risk. Personal financial statements are usually required to be supplied from officer shareholders.
Each of the above participants can and often has multiple roles in the construction process. For example, the owner could also be the general contractor (builder or developer). The general contractor in addition to providing supervision may also do specialty work that would typically be subcontracted (for example, concrete work). Design-build companies are growing.
Construction lenders frequently hold an equity position in a development partnership in order to participate in the management decisions and to share in the profits. Anchor tenants, such as major department store chains participate in the development partnership in exchange for signing long-term leases. Contractors and material suppliers can obtain rights in the project by filing mechanics liens against the property.
The Contracting Process
When the owner determines that the project is feasible and construction financing is available, he will solicit bids from general contractors and/or specialty contractors. Owners will use trade publications and newspapers to invite contractors to bid for the construction contract.
The notice will provide the contractors with the procedures to be followed in submitting a bid. The bidding contractor obtains a copy of the plans and specifications from the owner to prepare the formal bid. The bidding contractor solicits bids from subcontractors, estimates direct material and labor costs, and evaluates the ultimate profit potential of the contract. The amount of the bid covers the estimated costs and profit for the construction project.
The owner evaluates the submitted bids and will award the contract to the successful bidder. The contract document contains the contract amount, project start and completion dates, progress billing procedures, insurance requirements, and other pertinent information. There are standard cost manuals that a general contractor can use as a guideline in computing the bid. These guides contain a compilation of cost data for each phase of construction.
It is important to realize that the cost of bidding a job can be considerable. The costs include reviewing and reproducing the job specifications and blueprints, calling in subcontractors to get bids on the work involved, developing the total cost figure for the project, and preparing a formal bid. The preparation of the bid is the first step in the cost control system. The bid becomes the budget by which the actual expenditures are measured.
The object of the cost control system is to provide the general contractor with information regarding actual project costs versus anticipated or budgeted costs. These cost comparisons are essential for internal control as well as for auditing purposes.
You may see situations where a contractor might pursue a "break-even" bid to generate enough cash flow to meet payroll, particularly in recession periods. The general contractor solicits bids from subcontractors in the various trades, the subcontractors bid for the jobs in much the same way owners do.
The general contractor is expected to schedule the subcontractors so that the construction runs smoothly and is completed on time. The various specialty areas include, but are not limited to, the following:
- Site Work
This list conveys some of the complexity inherent in the construction process. It reflects the necessity of scheduling the work of subcontractors and using a budget, bid costs, and actual cost variances for cost control purposes. Budgeting and scheduling are critical factors in determining the success of the contractor.
Most companies use a standard construction contract. The most important information contained in the contract is the amount and how often the general contractor will be paid. The contract will state whether the contractor will bill monthly, at the completion of the contract, or at certain stages of the project. The billing invoices may include copies of the subcontractor bills and lien releases.
The owner may have a supervisor at the site that confirms that the contractor has completed the work for which he has billed. The contract may also include provisions for retainages that are usually withheld from the general contractor until the project is complete. Retainages are usually withheld at a rate of 10 percent of the billed amount but the percentage may decrease over the life of the project. The general contractor, in turn, will retain a portion from the amounts owed to the subcontractors.
Types of Contracts
Short-term contracts are contracts started and completed within the taxpayer's taxable year. For short-term contracts, construction costs are treated as current period costs under all methods of accounting except the cash method. Under the cash method, construction costs are treated as current period costs for a short-term contract only if the expense is also paid during the year.
Long-term contracts are defined in IRC section 460(f)(1) as any contract for the manufacture, building, installation, or construction of property, if such contract is not completed within the taxable year in which such contract is entered.
Fixed Price or Lump Sum Contracts
A fixed price or lump sum contract states that the contractor will complete the project for an agreed price, despite unforeseen costs that might exist during the construction phase. Some fixed price contracts, in reality, provide for some variations for economic price adjustments, incentives, etc. If any modifications to the original contract occur, change orders are executed. These often increase or decrease the contract amount.
Cost-plus contracts stipulate that the contract amount will be the cost of the construction project plus a fee. The fee may be earned in various ways.
A fixed fee is generally earned evenly throughout the term of the contract. A percentage fee is frequently based on the amount of cost incurred. Most cost-plus contracts have a guaranteed maximum to protect the owner from cost overruns. Many cost-plus contracts allow the contractor to share in cost savings if the project is completed under budgeted cost. The contract will specify which costs are included in the contract amount. Generally, the contract will include a clause that allows the owner to review or audit those costs.
Time and Material Contracts
Time and material contracts are contracts that provide payments to the contractor based on direct labor hours at a fixed rate plus the cost of materials and other specified costs.
Unit Price Contracts
The unit price contract method is a variation of the lump-sum (or fixed price) contract method where the contractor bids a set price per unit item. The unit-price method is generally used in cases in which the number of units required has not been determined when the contract is bid.
The contractor or the owner can initiate change orders. A change order modifies the original contract, and either increases or deceases the contract costs and/or contract price.
Owners often require the general contractor to be bonded. In these cases, the general contractor is required to purchase a guarantee or surety bond. The purpose of the bond is to guarantee to the owner and lender that, should the general contractor fail to finish the project, the funds will be available to hire a replacement. A general contractor's bonding capacity is based upon their financial statements and past performance. A bond request will be denied if it exceeds the bonding capacity.
A contractor may leave what appears to be an unusually large amount of cash in the company for the purpose of increasing his or her bonding capacity. This should be considered when determining whether or not accumulated earnings tax is applicable. The following types of bonds are available:
- Bid bonds provide for payment to the owner of the difference between the bid that is accepted and the next lowest bid if the general contractor with the accepted bid fails to enter into a contract.
- Contract bonds indemnify the owner against the failure of a general contractor to comply with the requirements of a contract.
- Performance or completion bonds guarantee completion of the project by the general contractor.
- Labor and material payment bonds guarantee the owner that all costs of labor, material, and supplies incurred by the general contractor in connection with the project will be paid, thus voiding mechanics' liens.
- Maintenance bonds guarantee the owner against defects in workmanship and are usually one year in duration.
- Subcontracting bonds are performance and payment bonds issued by the subcontractor to the general contractor to guarantee the subcontractor's performance and payment of obligations required under the contract.
State and federal contracts usually require surety bonds. In other cases, collateral bonds in which the contractor pledges real or personal property as collateral with value equivalent to the contract price may be used.
When a performance bond is defaulted, it is not unusual for the insurer or bonding company to hire the defaulted contractor to complete the job, because they are familiar with the project. Most bond defaults result from financial difficulties with the project at hand, rather than from the lack of technical ability on the part of the contractor. Thus, the bonding company can act as another third-party control on the business and accounting practices of the contractor.
Before construction can begin on a project the necessary building permits must be received from the appropriate municipality. The specifications and blueprints of the project are turned into the Building Department, along with an application for a permit. The issuance of a permit may take time, because the approval process is likely quite involved, especially in the case of new construction.
The general contractor or owner may have to submit results of soil testing, environmental impact studies, or other information. Sometimes a public hearing is mandated, if opposition to the project is known. However, in most cases, the permit is issued within a few months. The cost of the permit may be the responsibility of the general contractor. The owner may pay for it, however, along with the costs of any related studies.
Construction projects follow the standards of the Uniform Building Code. A Building inspector examines the project at various stages to verify that the project is being constructed according to this Code.
Notice of Completion
Once the building is completed, a Notice of Completion is requested. The project must pass a final inspection. Once the project passes that inspection a Notice of Completion is issued by the municipality, along with a Certification of Occupancy. These documents are recorded at the office of the local recorder. At this point the property is appraised for property tax purposes. Note: Several appraisals are made throughout the construction process that addresses timing or allocation issues.