Can You Trust Your Financial Statements? What to Watch For

Do your financial statements tell the real story of your business?

In this episode, Wade Carpenter and Stephen Brown break down the red flags that construction CPAs and bond underwriters spot immediately — from under-billings and WIP errors to inflated receivables and round-number gross profits.

Learn how one contractor went from a $3M loss to a $2M profit just by correcting their billing — and what you should be watching in your own financials before presenting them to a banker or bonding company.

Sign up for group coaching to get your Cash Flow MRI

Topics covered on this episode include:

• 00:00 Why Numbers Feel Wrong
• 00:42 Construction Lens on Financials
• 01:53 Case Study Massive Billing Swing
• 03:29 WIP Billings and Collectibility
• 05:59 Underwriter Red Flags Checklist
• 08:00 Cost to Complete and Margin Fade
• 11:02 Surety Trust and Communication
• 11:57 Growth Cash and Working Capital
• 12:55 Receivables Payables and Debt
• 17:32 Backlog WIP Oddities and Round Numbers
• 19:52 Change Orders Concentration Risk
• 23:38 Wrap Up Know Your Numbers

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com

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TRANSCRIPT

Wade Carpenter: [00:00:00] I don’t trust my numbers. I hear that from contractors all the time. Maybe you get financial statements every month. Maybe everything balances. Maybe your accountant tells you it’s [00:00:10] right, but you look at those numbers and think, “That is not what I’m seeing in my business.”

Today, we’re gonna show you why that instinct may be telling you something important.

This is the Contractor [00:00:20] Success Forum. I’m Wade Carpenter with Carpenter Company CPAs, alongside Stephen Brown with McDaniel Whitley Bonding and Insurance.

Stephen, you and I both have looked at contractor financial statements where something [00:00:30] immediately jumps out at us and we say, ” That can’t be right.” And sometimes those statements were prepared by perfectly competent accountants. What is it that we [00:00:40] see because we understand construction?

Stephen Brown: Wade, we see a lot of things. You know, numbers tell a story. There means something behind every [00:00:50] number. There’s some meaning behind it, and if you don’t know what that meaning is then as a operator of a construction company, you need to learn that, and you can learn that from [00:01:00] your accountant, and you can learn that from your bonding agent.

But looking at numbers, if say you were a unit price contractor, you had given a unit price bid [00:01:10] in, and you had no idea how much material was actually being delivered or purchased, it’s the same as numbers. If you can’t measure it, you can’t [00:01:20] manage it, you know? I mean, if that makes sense.

Bond underwriters are looking at your numbers for all sorts of different reasons, and we’ll get into that as the [00:01:30] podcast goes on if you like. But when we look at a financial statement, immediately we’re looking at the big picture and whether it makes [00:01:40] sense, and there’s a million things that have to make sense, within that.

I don’t know, maybe a million is, that’s going too far. But there’s at least a dozen or two [00:01:50] things that bond underwriters are always looking for, and if they’re looking for it, you need to be looking for it because it affects the financial health of your company.

Wade Carpenter: I know this sort of like sparked a [00:02:00] nerve yesterday when I had a situation with a client, but I started thinking about it like you and I see this stuff all the time, that we look at it and recognize it immediately.

[00:02:10] And this particular one was pretty big, but this contractor, and it was actually a unit-type contract like you were talking about. I actually picked them up the first of the [00:02:20] year because they had a competent CPA and they were sending the stuff in and it just did not sound right. And they had some issues with joint checks and such.

[00:02:30] Well, long story short, they were way under-billed. Obviously there was a lot of costs and that kind of stuff that were not captured and we started working [00:02:40] with them. When we first picked them up, they really didn’t have an idea on where they were.

We’ve actually put in a payable system and we have pretty much real-time costing. [00:02:50] We were about to send a financial statement to the bond agent, believe it or not, a $3 million loss. I started looking at it like, that can’t be right. All the [00:03:00] banks are tied in, the credit cards are tied in, we had everything job costed, but they’re also not picking up the under-billing.

Strangely enough, I’m cutting to the chase here, but when we looked at [00:03:10] what was under-billed, that $3 million loss turned to a $5 million dollar under-billing, believe it or not. Turned into a $2 million profit. Huge swing. [00:03:20] And those are the kind of things that we see all the time.

It’s just like it was gut instinct from their CPA’s like, “Okay, this is perfect.” I was like, “No, that’s not right.” [00:03:30] And I think you and I see that stuff all the time.

Stephen Brown: Oh, Wade, especially with billings. Under-billings and over- billings and what story that tells you when you look at [00:03:40] a financial statement.

It’s so frustrating to try to understand why do you have so many underbillings? Why aren’t you billing this? Or why do you [00:03:50] have so many overbillings? These generally say overbillings means, you know, I’m able to pre-bill some stuff. I’m able to get paid on some stuff I haven’t incurred the cost yet.[00:04:00] 

So it’s even more important than ever to have a good quality WIP, work in process report that shows that you have current estimated cost in there. [00:04:10] And you can look and see how far along was the job at this end of this accounting period? Were my costs reported accurately? Have I billed it [00:04:20] correctly?

And is this billing that I billed for collectible? So many people don’t even ask that. What are the odds of this being disputed? What if they can’t afford to [00:04:30] pay me? What if they go bankrupt?

I kind of put that to analysis as if you’re fishing. You don’t get to count the fish till you get it in the boat. You get it [00:04:40] close to the boat, that doesn’t cut it.

And so from a bonding situation, we have seen more claims and so many of the biggest claims due to those kind of [00:04:50] issues.

Wade Carpenter: Yeah, it’s easy to see. You start billing ahead and if you’re just doing accrual accounting, it looks like you’re making a profit, and that’s part of some of the [00:05:00] stuff we see all the time.

But I think you and I both see like we’ll pick up a financial statement from a competent CPA firm and look at it and say, “Okay, there’s no WIP schedules”. [00:05:10] You know, just several things like, okay, there’s no retainage on here. They didn’t pick up retainage right. There’s things like that I see all the time, and I know you do the same thing. Same thing with the [00:05:20] tax returns. There is no way that calculates.

We were talking beforehand. You said you had, what, 16 different things that you’re taught [00:05:30] as a underwriter or whatever. I think our listeners need to understand that before you turn in something to your bonding company, sometimes you can get something by a banker and they don’t know the [00:05:40] difference.

If you’re trying to get a bond, or if you’re actually really trying to understand where you are, I think you’re fooling yourself if you’re constantly overbilled or [00:05:50] underbilled and it looks like you’ve got no profit. You want a accurate picture.

So I didn’t know if you wanted to kick through some of those things that you were talking about beforehand, and there were some [00:06:00] things I wanted to go to about different levels, but what do you think?

Stephen Brown: I think this is a great idea, and we can go through them relatively quickly. Profit doesn’t translate into [00:06:10] cash. You’re reporting profits, but you have very little cash. What’s going on there? It’s just something that you look at quickly and you say, ” Need to look [00:06:20] into that a little bit more and get some answers.”

One thing that really smooths the bonding process too, is when an underwriter has these questions, if you have the kind of [00:06:30] relationship with the construction-oriented CPA, and you just get them on the phone and say, “Hey, we had three or four questions,” and the CPA could either explain them quickly what it [00:06:40] meant or get back to us with information that helps as well.

And then bringing the contractor on board of saying, you know, this translates into [00:06:50] being a problem we need to talk about. Are you aware of it and how are you gonna address it?” The WIP profits don’t match what’s happening in the field, so [00:07:00] change orders aren’t approved. There’s a significant amount of unresolved claims, maybe billing disputes. That’s another one.

Wade Carpenter: Let me just piggyback on one you just [00:07:10] said. The same client, but the bonding company asked me to look at this thing. The books still needed some work, but at the end of the year I had picked up the [00:07:20] financial statements and they gave me access to their QuickBooks and I dove in there and, you know, 10 minutes I’m like, “Okay, well, these guys are actually healthier than you think they [00:07:30] are,” because they were missing some of these billings.

Sometimes contractors will do things at the end of the year trying to knock down their taxes and they don’t think about the bonding picture [00:07:40] or if you pay all your payables at the end of the year.

You run out your cash, well, you bumped up that… You know, are you capturing all the cost to [00:07:50] complete? So sometimes that bumps up the cost to complete which bumps up your profit and if you’re not capturing it. That’s where I wanted to go from it.

But like I said, this is the kind of thing [00:08:00] that a trained CPA or bond agent is gonna pick up on really quickly.

Yeah. And that was literally the next one, estimated cost to complete are too optimistic and are they [00:08:10] current? Do we believe they’re current? I mean, honestly, I’ve heard contractors say, “Well, they better be current.” And I’m like, “Oh, great answer. Wonderful answer. Oh, [00:08:20] so if they’re not, it’s somebody’s ass, huh?” Well, no, it’s your problem. You know, I’m sorry.

Stephen Brown: Gross profit percentages suddenly change. What does [00:08:30] that say when you’re looking at a WIP? you are projecting great gross profit margins, generally on your WIP. You see some that have been fading on your WIP [00:08:40] report, and you’re saying, ” Hmm, well, what’s going on with that job? It doesn’t seem to be holding the profit that you’ve estimated, and this one’s showing great profits.” Do we trust [00:08:50] these numbers at all? I mean, really, do we trust them?

Here’s the thing. You got one project going on, you can manage the cost and everything pretty well. [00:09:00] You have multiple projects going on all showing different fluctuations of profit in there, then something may be wrong with your accounting. It may be [00:09:10] exactly accurate. But either way, the bonding company will want to know why is there so much up and down with these profits? You have a key margin you’re [00:09:20] trying to hit. Why aren’t you hitting it?

Wade Carpenter: Let me jump in on those. If I could.

Stephen Brown: Yeah.

Wade Carpenter: So two things on the back to the estimated cost to complete. That is one of the problems what we have [00:09:30] is trying to get this out of a contractor who’s like, “Okay, we really bid it at this margin or the cost you know but there’s change orders in there, and they don’t take [00:09:40] into account the change orders. They don’t take into account what the costs have risen or whatever. They both play into the second part you were talking about is at the end of the year.

So [00:09:50] we do a financial statement, and we report this project in progress is gonna make 20%, and then next year it comes in at 5%. Well,[00:10:00] that’s exactly what you’re talking about. The bonding company’s not gonna trust that.

A lot of CPAs don’t even think about that kind of stuff. We reported it 20, this year [00:10:10] it came in at five. Well, personally as a CPA that pays attention to this, I’m like, “Okay, this is my reputation.”

Stephen Brown: And, you know- Exactly. It’s your reputation. [00:10:20] It’s why I say all the time, find a construction-oriented CPA. There’s a huge difference. I’m sorry. I had to say that.

Wade Carpenter: It’s one thing if you’re doing an audit. You [00:10:30] can test things but sometimes, if you’re trying to get it out by, say, March 15th so that the bonding company can see it, sometimes you don’t have all the history and things don’t necessarily go [00:10:40] wrong.

But other times they are trying to pump it up to make your financial statements look better Sometimes they just don’t know, but, it really does reflect on [00:10:50] the contractor when they don’t– exactly what you were saying, it’s like that you don’t start to not trust the numbers because, if you can explain something that happened that went [00:11:00] wrong, then sometimes you can mitigate that. But if you do that year after year and contract after contract, you could tell me what you guys think.

Stephen Brown: That’s right. If you don’t trust your [00:11:10] numbers, you can’t expect your surety to trust your numbers. That may not mean a lot if you’re not needing a bunch of bonding. You know, that may not be an issue. So when I say [00:11:20] that, if you don’t need any bonding, you can do whatever you want.

Well, no. The two go hand-in-hand. What the surety underwriter looks for, you should be looking for. You’re [00:11:30] not at odds. They want you to finish a project and make money. They want to celebrate with you. And why not pick their brains and say, “What are you [00:11:40] seeing here?” Why not communicate that with them?

And again, I’ve told you many times, so often a contractor does not take the time to meet with their underwriter [00:11:50] on at least a semi-regularly basis. Maybe once a year if it’s a big account. They need to be in constant contact, with that surety because everything [00:12:00] changes throughout the year, not just at the fiscal year-end.

Next one, Wade, revenue grows much faster than your working capital. Working capital is your current [00:12:10] assets minus your current liabilities, and that is your liquidity. From a bonding company, that’s your ability to cash flow your project and to make ends [00:12:20] meet.

Unapproved change orders you’ve incurred cost on. Where does that come from? Cash, disputes, on anything, where does that come from? Cash.

The [00:12:30] last podcast we did was on the billing cycle. You’re never really caught up till the end of the project. We talked about that. Cash. You wanna expand, you wanna grow, you wanna hire [00:12:40] new people. Cash.

When your sales are going up, you say, “Well, how are things going?” Could be better. You know, we’re doing twice the volume we did last year. Is [00:12:50] equity and cash tracking along with that growth?

You see that and you’re like, if it’s not dead even or better, you’re asking a [00:13:00] whole lot of questions as an underwriter.

Accounts receivable doesn’t make sense. It reconciles properly, but there could be [00:13:10] all kind of problems in there.

We talked about it. Mainly I was thinking about accounts receivable is it collectible? Bonding companies look for 30, 60, 90-day [00:13:20] receivables, and anything over 90 days they just toss out of their working capital calculation.

To tell you what whether you’re where they think you need to be. [00:13:30] So a lot of times I have certain contractors that have certain customers that are huge, and they know because of the nature of their business, it’s gonna be slow pay. [00:13:40] But they know how big the contractor is, and they know that type of industry is slow pay, and that industry is financing that. So they’ll give credit for [00:13:50] that.

But for the most part, what would you say, Wade, would be a situation where accounts receivable didn’t make sense?

Wade Carpenter: Well, I can think of several different cases [00:14:00] where we’ve seen the receivables are… like, we’d pick one up, I guess, and maybe they had a review the previous year and [00:14:10] the receivables were, I don’t know, say, $2 And then this year we come to the end of the year and okay, well, the revenue hasn’t changed, but the receivables are showing, or [00:14:20] over under billings is showing significant, like, $200,000.

If their revenue didn’t drop, I mean it could happen, but then that’s the [00:14:30] point where you start asking questions.

Thinking one in particular, we didn’t see the retainage. The CPA had fixed it. Their numbers, they didn’t have that stuff in place to be able to do that. So [00:14:40] that’s part of the idea is you’ve gotta have the basic systems to be able to have that in place.

Same kind of thing with, I was just, the other case. If you’re gonna turn something [00:14:50] into your bonding company and you don’t trust… I mean you may think it’s right and that was part of the five levels of trust I was gonna go through today, but I’m not sure if we’re gonna have time, but, [00:15:00] like, one of the things is it can calculate fine, but does it make economic sense?

Stephen Brown: Mm-hmm. Yeah. Anyway. Make economic sense. That’s so true. And hopefully these two [00:15:10] will tie together. So many times you can kind of fluff up a fiscal year-end financial statement, to look pretty for a bonding company or you’ve got tax issues and [00:15:20] stuff. There’s tricks to doing that.

But the bottom line is what’s the equity look like? What kind of profit did you make? And do we trust that profit? Is that [00:15:30] measurable, and are we okay with it? You know, all of those things go together.

Quickly talking about accounts payable are increasing. The main things I wanted people to know [00:15:40] about that is, are your taxes current? Are your payroll obligations current? are you paying your subs within the normal terms of how you usually do [00:15:50] it, or, are you running short of cash? Some vendors might be giving you favorable terms, so we’d look at that and we’d say, “Okay, that makes sense.”

Debt is [00:16:00] increasing while equity doesn’t. It would show you that your whole organization and may be more intent on borrowing than you, than it needs to be.

Wade Carpenter: Yeah, like I said, there’s so many [00:16:10] things we could unpack. We could probably do a couple of hours on this one if we really wanted this whole topic, but just payables that come to mind, like, okay, if your payables as a [00:16:20] percentage or a relative to your receivables and current assets, is that climbing?

And if it’s climbing and the numbers are right, [00:16:30] then You’re probably having problems that may surface other things.

Stephen Brown: I’ll tell you what, good bond underwriters, good companies that we work [00:16:40] with, they take the information you give them, and they process it a thousand different ways. Not only for a reconciling basis, but for looking at [00:16:50] historical trends from previous years, all these things.

And when you see their charts of analysis, you see what stands out as good or bad. And that doesn’t [00:17:00] necessarily mean it’s a deal breaker for them saying yes for your bonding. But is it a concern?

It may or may not be, but it still [00:17:10] raises an issue. And this is an issue that everyone in the surety organization can see and is aware of. And it’s why we at McDaniel-Whitley want to do [00:17:20] business with underwriters that know what they’re doing.

Otherwise, you’re arguing with someone that doesn’t know what they’re doing about trying to get a bond approved, and it’s just going nowhere, because they don’t [00:17:30] know what questions to ask or they don’t know this is legitimate.

Don’t you seem to understand what I’m telling you? And we can prove it. Look here, here, here, here. The [00:17:40] backlog doesn’t match the financial capacity. Your backlog is running so hard and your cash flow, your cash, your [00:17:50] working capital is not keeping up with it in any way, shape, or form.

You know, how many podcasts have we done on that sort of thing, Wade? The balance sheet [00:18:00] improves at the year-end. Okay, that’s good, right? But how much did it improve, and does it make sense of why it improved? It seems simple, doesn’t it? [00:18:10] But I can’t tell you how many times that comes up.

Large unexplained changes in the WIP schedule, raises a red flag. Can management explain what those [00:18:20] changes are and why? Using round numbers in estimated cost and an estimated profit.

Every profit has 10% estimated profit on [00:18:30] it. That might be fine. You might be saying, “We put 10% on there. Now, we better do better or somebody’s gonna lose their job, but we’re putting 10% on [00:18:40] everything.”

But why not actually put the percentage you think you’re gonna make on it and track it?

In other words, why show a set of books with 10% on there [00:18:50] when you think you could be doing better? All right, well, fine. You want to be conservative on your estimates of gross profits. It always looks better when you’re conservative and whether [00:19:00] you’re telling the bond, you go, “Oh, no, no, no, we’re making 47% profit on this.”

And they’re like, “That’s great, I’m happy for you, but I’ll believe it when I see it.” [00:19:10] And that’s exactly, what I’m talking about.

Wade Carpenter: Let me jump in on that one. I just have to ’cause- … it’s like, it’s like the round number thing. It’s like a bank forecast or…

[00:19:20] But same thing with a WIP schedule. If you’ve got a gross profit that just absolutely perfectly hits 20%, sometimes when we’re working with a contractor, they are a yes, [00:19:30] but the idea is that you gonna put systems in place where you can track that.

I see the exact same thing. It’s like, okay, it happened to be exactly [00:19:40] 15% on the nose. Do you trust that? I mean, all of them down the schedule are 15%.

You’re smiling too, you know what I’m talking about.

Mm-hmm.

That is the kind of thing that, [00:19:50] when you start, you probably have to work into some of that stuff, but the round number thing, that’s just definitely something that raises a flag.

Stephen Brown: That’s true. [00:20:00] And another one is the change orders are doing too much work or there’s just dispute claims in there that are causing numbers to be off. You would [00:20:10] think that would show up pretty well. But sometimes you look at a schedule and it’s got 30 or 40 jobs on there and by the time you look at a WIP that long, it’s a size [00:20:20] four font and you look at the columns and you see what the columns tell you, and then you break each individual job down to see what it’s telling you. Uncollected [00:20:30] change orders or you got all your eggs in one basket. You might have eight huge jobs with one customer, and that customer goes under, you know, [00:20:40] you’re out of business.

Just like you told the story about the very large contractor that wasn’t billing and how that put him under, I can tell you so many [00:20:50] stories about a contractor literally not realizing how they are financing a job for someone that doesn’t have the money to pay them.

As a contractor, you [00:21:00] know how many projects are out there for bid and how many entities that are putting it out for bid don’t have the money to pay you.

They’re fishing, they’re trying to get some costs together. [00:21:10] They do not have the money. You know, it doesn’t blow your mind to know that public entities do that all the time. You would think, oh no, this money’s approved, it’s set aside. Oh, this is a [00:21:20] big project. No. No, it’s not. So please be careful about that.

I see that all the time, and I’ve seen contractors go under [00:21:30] so many times because of that very situation.

All right, and then like we mentioned, one job carrying the whole company for the year. That could be [00:21:40] fantastic. that could be really scary, having all your eggs in one basket.

And then the last one is management explanations don’t match the numbers. Tying in with the five levels of trust [00:21:50] that you had, does it calculate? Does it tie together? Does it make economic sense? Does it behave like we expect, and do we believe it? Kind of tells to me the [00:22:00] story of every number has a story.

Every number has a story behind it, and that’s why you do what you do. That’s why you [00:22:10] know that accounting is more interesting than people just calling you a bean counter, okay? That is not what you do, Wade. You’re thinking deeply about [00:22:20] what affects everything. Because at the end of the day, accurate information that bears out profit is so rewarding.

You’re doing your job to help the [00:22:30] contractor get there. I’m getting bonds for them, so I’m getting paid. I don’t get paid if I don’t get you bonds. That’s a fact. I care about that. All your vendors [00:22:40] care about it. Surround yourself with people that care about your profit and can give you good advice about your profit and whether things make sense.

And if they don’t make sense, [00:22:50] what are you gonna do about it? Don’t ever sweep anything under the rug and say, these numbers better be accurate like I said.

When I mentioned that earlier in the [00:23:00] podcast, Wade, it was so painful to me because I was just in a meeting where that happened. All I could do is just put my head down because I was like, [00:23:10] please just get on board. If youo’ve ever seen bond underwriters and a good construction CPA as a bond agent that trust each [00:23:20] other and they’re going back and forth with questions and you know whether the CPA is answering correctly to the underwriter. You know [00:23:30] whether the underwriter’s asking something that’s important or just ridiculous, and you can step in and go, “Well, what’s that all about?”

And to be in those meetings over and over again [00:23:40] and see how that plays out when the relationship is good, is really good. So I would want to end this podcast by saying think about that, please.[00:23:50] 

Wade Carpenter: Well, like I said, I think we’ve gone through a lot of things today with it. We could only scratch the surface and that whole five levels of [00:24:00] trust, I know you skimmed through it and that’s where I was going with this podcast.

But it may be a subject of another one, but we’ve said it a few different times. If there’s a reason, we don’t [00:24:10] trust it or you should understand what these numbers are. And it’s whether you can get a bond or whether you’re worried about taxes or whether you’re getting a loan or whatever [00:24:20] it is, the idea behind these numbers is you’re running a healthy company and you know where you are so that you can make informed decisions.

So that would be my take, and [00:24:30] maybe we’ll revisit this on some of a couple of different levels ’cause I truly enjoy this, just thinking through like how many things that we see we probably couldn’t [00:24:40] count. It’s just one of those things that’s instinct.

But for our listeners out there, if this made you think about any of this, it really work on your numbers and know [00:24:50] where they are and understand what it looks like before you present it to your bond agent, before you present it to your banker.

If all you’re worried about is tax return, that’s one thing, but you also [00:25:00] need to think about like long-term health of your company and are you profitable. So that’s my two cents on it.

Stephen, thanks for bringing all this to us today and hopefully, [00:25:10] it made our listeners think some more.

With that, we appreciate you listening. If you’re still with us, we appreciate it if you’d like, share, subscribe to the channel. It helps us out [00:25:20] and we do this every single week and we will see you on the next show.