BL 7:6

Contract Financing

For many business owners, contract financing offers an excellent cash flow solution. Today’s well-funded, well-established contract financing companies work quickly and efficiently to provide businesses of all sizes the cash they need for operating expenses. The good news for business owners: contract financing provides working capital without debt, because it’s not a loan. Contract financing companies simply advance business owners what they’ve already earned and will earn on their contracts with customers.

Basically, contract financing is a type of short-term financial arrangement where the contract finance company provides advance funding to a business that fulfills single or multiple contracts and orders. The business receives payment for their ongoing work upfront from the contract financing company, even if the contracted work has not been completed and the client has not paid yet. This kind of financing is critical for cash flow and growth for any business that performs work on contract.

If your company is paid only after your contract or order has been completed, you may have questions about how contract financing works. Interstate Capital, one of the country’s leaders in contract financing, provides answers to common questions below.

What is contract financing?

Many times companies have ongoing or fixed contracts with their customers. Problems arise when you have to wait 30, 60 or even 90 days for your customers to pay, but you need capital now for payroll and other expenses every week. Your company may not have 90 days of reserve funds to keep operating. A contract financingcompany advances you the cash that you are due, minus a small factoring fee. Small businesses often seek out contract financing when they land a larger-than-usual order or contract and need to make sure they have enough working capital to fulfill the needs of the customer.

How does contract financing work?

With contract financing, you will send your monthly or periodic invoices to the financing company. Within hours or a few days (depending on the contract financing company’s terms and conditions), you will receive the advance payment either by direct deposit or by wire into your checking account. The contract financing company then collects payment directly from your customers when they pay, in 60 days, 90 days, or whenever your contract had specified.

Who offers contract financing?

This type of financing isn’t generally available from banks or traditional financing institutions. Contract financingfirms, also known as factoring companies, provide this service.

Interstate Capital has been providing flexible contract financing solutions to North American businesses for nearly 25 years at affordable contract financing rates. This contract financing company tailors funding programs to businesses in various industries. One of the reasons businesses choose to partner with Interstate Capital is the company’s emphasis on customer service and processing speed: you can be approved for funding promptly after your application paperwork is complete and you typically receive same-day payment on your submitted contracts.

At Interstate Capital, financing solutions are available for both small and large contracts.

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What are the benefits of contract financing?

You can reap a number of benefits when you work with a good contract financing firm. First, unlike borrowing from a bank or other lender, you won’t be putting your business at risk by incurring debt. Second, you will speed up your cash flow and be able to keep up with paying staff or other monthly expenses. Third, you can outsource the cumbersome process of ensuring your invoices are paid as the contract financing company will collect directly with your client, saving you time and the expense of hiring collectors.

In addition, you can quickly and easily qualify for contract financing at Interstate Capital, enabling you to receive your funds right away. Interstate Capital analyzes your application based on the creditworthiness of your customers, not your own credit report. Once you qualify, your own credit report can improve as you will be able to honor your financial commitments on time with your new infusion of cash.

When should you use contract financing?

If your business works on contract or fills orders and is typically not paid until the work is completed or the order is delivered, then you could consider contract financing. This funding method gives you the ability to pay expenses and maintain your cash flow, regardless of your client’s payment terms.

You could also consider this type of financing if you need a quick solution to cash flow problems. With some factoring companies, especially an independent company like Interstate Capital, you can be approved for financing very quickly – much more quickly than the loan approval process at a bank. When business owners partner with Interstate Capital for contract financing, they are often impressed by how quickly they are set up and receive the funding they need to complete their work.

If your business has secured contracts, but needs working capital to fulfill those contracts, then Interstate Capital’s flexible financing solutions can assist you in getting the cash flow you need to succeed. Because Interstate Capital evaluates your application based on your customer’s payment history, you can qualify even if you’ve been turned down for a bank loan or line of credit in the past due to lack of collateral or your credit rating.

This short-term solution ensures that your business has the cash flow it needs to complete your contract or order.

Need more information about contract financing? Contact Interstate Capital or click here for an instant rate quote today:

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About Interstate Capital

Interstate Capital has funded over 10,000 companies since 1993, making it one of the oldest and largest factoring companies in the alternative funding market. Interstate purchases nearly $1 billion dollars of invoices annually from hundreds of clients in a wide range of industries throughout North America and each client receives individual attention from a dedicated account manager. Get in touch with us so that you can learn more about our contract financing programs. Let us customize a program for you!

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Accounting Methods for Long-Term Contracts: Completed Contract Method, Percentage of Completion Method

2019-03-11For short-term contracts, the taxpayer will use either the cash or accrual accounting method, but for certain long-term contracts, there are additional choices provided by IRC §460.

Long-term contracts that qualify under §460 are contracts for the building, installation, construction, or manufacturing in which the contract is completed in a later tax year than when it was started. However, a manufacturing contract only qualifies if it is for the manufacture of a unique item for a particular customer or is an item that ordinarily takes more than 1 year to manufacture. Long-term contracts for services do not qualify as a long-term contract under §460.§460 Long-Term ContractA contract that spans more than 1 tax year for building, installation, or construction. Manufacturing contracts may qualify either if the item ordinarily takes longer than 1 year to manufacture or if the item is unique and manufactured for a particular customer on demand. So if a contract is started December 20, 2015 and ends on January 10, 2016, then, even though the contract is for less than 1 month, this contract is a long-term contract for a calendar year taxpayer but a short term contract for a fiscal year taxpayer.Small ContractorA contractor with average annual revenue of $10 million or less for the preceding 3 years.Large ContractorA contractor whose average annual revenue is greater than $10 million for the preceding 3 years.Home Construction ContractA contract for the construction of residential buildings, where each building consists of 4 dwelling units or less.

Long-Term Methods of Accounting

There are 2 primary methods of accounting to determine when revenue is recognized for long-term contracts:

1. completed contract method (CCM)
2. percentage of completion method (PCM)

Because the CCM allows the deferral of taxes, a large contractor must usually choose the PCM, but a small contractor can choose CCM if the estimated life of the contract is 2 years or less.

Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, large contractors with revenue not exceeding a $25 million average within the 3 years prior to the current year may use the PCM, or any other allowable method. Moreover, construction companies are no longer required to use the PCM method, if the contract was entered into after 2017, is expected to be completed within 2 years, and is performed by a taxpayer satisfying the $25 million gross receipts test.

Completed Contract Method

Using the completed contract method, the taxpayer does not recognize revenue until the contract is completed and accepted by the customer. Except for home construction contracts, CCM can only be used by small contractors for contracts with an estimated life that does not exceed 2 years. There should be no terms in the contract with the only purpose of deferring tax.

The CCM is required for home construction contracts that are for the construction of residential buildings with 4 or fewer dwelling units, where at least 80% of the estimated cost is for the dwelling units and related land improvements, even if the contract is for longer than 2 years or the contractor is a large contractor. Other types of construction contracts qualify for the completed contract method if they satisfy the general CCM requirements.

Home construction contracts have obvious tax advantages, in that the recognition of income can be deferred for years, especially for large projects involving the construction of many housing units. The IRS sees many abuses in this area, where either construction contracts are improperly classified as home construction contracts or the date of completion is extended by contrivance. One common maneuver that contractors use to defer taxes is to construct numerous houses on a large residential plot, while delaying the completion of common improvements, such as roads and sewage, as long as possible. Therefore, the contractors argue, the construction of any one home is not complete until all the common improvements have been finished. However, the IRS is taking the position that a home construction contract is considered completed when it is sold. (See Super Completed Contract Method for more info.)

Disadvantages of the completed contract method are that income from multiple projects may have to be reported in the same tax year, and any losses on any of the contracts cannot be deducted until the contracts are completed and the income is recognized for tax purposes.

If the taxpayer or the contract does not qualify for the completed contract method, then the percentage of completion method must be used.

Percentage of Completion Method

Except for home construction contracts, large contractors must use the percentage of completion method for long-term contracts. PCM must also be used to determine liability under the alternative minimum tax(AMT) system. Under the PCM, the amount of progress on the project is determined by the total costs actually incurred as compared to the total estimated cost. Hence, revenue in any given year is determined by the actual contract costs incurred for that year divided by the total estimated cost multiplied by the total contract price:

Reportable Income

=

Contract Price

×

Annual Contract CostEstimated Total Cost

If there is a dispute in regards to the contract price, and the amount of the dispute is small in relation to the total amount of the contract, then reportable income is determined by subtracting the contract price by the amount in dispute. The disputed amount will be recognized when the dispute is resolved. Any additional costs incurred in completing the performance of the contract are deductible against the recognized disputed revenue.

The revenue reported for the last year is equal to the total revenue received minus the total reported revenue. Because the total cost of the contract is estimated, there may be an underpayment of taxes if costs were overestimated or an overpayment of taxes if costs were underestimated. The revenue that was actually reported may differ from the revenue that should have been reported based on actual costs. Therefore, upon completion of each contract, the revenue that should have been reported for each tax year must be calculated and compared to the revenue that was reported for those previous tax years. If there was an overpayment of tax, then the taxpayer is entitled to interest from the IRS based on the overpayment; on the other hand, an underpayment of tax requires that the taxpayer pay interest to the IRS. This look-back interest calculation is figured on Form 8697, Interest Computation Under the Lookback Method for Completed Long-Term Contracts, which can be avoided if estimated and actual costs are within 10%. A corporate taxpayer can deduct the payable interest but an individual taxpayer cannot, since it is considered nondeductible personal interest.

There is also a 10% rule, whereby, if the taxpayer so elects, the recognition of income and the deduction of expenses can be delayed until the tax year in which at least 10% of the cumulative, allocable contract costs have been incurred.

Example: Look-Back Method

You have a construction contract worth $4 million to be completed over 3 years. Originally, you estimated the cost to be $3,200,000. Your actual costs for the 1^st year turned out to be $300,000, which is less than 10% of the total estimated costs, so you did not report income or deduct expenses for that 1^st year. However, after you have completed the contract, your actual cost was $2,900,000, so the $300,000 of costs that were incurred in the 1^st year exceeded 10% of the total actual costs. Therefore, you must use the lookback method to calculate the amount of interest that you will have to pay, based on what you should have reported minus what you actually reported.

Per Return	Year 1	Year 2	Year 3
Cumulative Incurred Costs	$300,000	$1,500,000	$2,900,000
Estimated Total Costs	$3,200,000	$3,200,000	$2,900,000
Completion Percentage	9.38%	46.88%	100.00%	= Cumulative Costs / Estimated Total Cost
Total Contract Price	$4,000,000	$4,000,000	$4,000,000
Reported Income	0	$1,875,000	$2,125,000	= Total Contract Price × Completion Percentage, if Completion Percentage ≥ 10%, else income does not have to be reported.
Deducted Expenses	0	$1,500,000	$1,400,000
Per lookback	Year 1	Year 2	Year 3
Cumulative Incurred Costs	$300,000	$1,500,000	$2,900,000
Actual Total Costs	$2,900,000	$2,900,000	$2,900,000
Actual Completion Percentage	10.34%	51.72%	100.00%	= Cumulative Costs / Actual Total Cost
Total Contract Price	$4,000,000	$4,000,000	$4,000,000
Lookback Gross Income	$413,793	$1,655,172
Lookback Expenses	$300,000	$1,200,000		Note that because income must be claimed for the 1st year, deductions of actual expenses must also be claimed. Therefore, in the 2nd year, the amount claimed in the 1styear must be subtracted from the amount originally claimed of $1,500,000.

Under the regular tax system, the lookback method does not apply to home construction contracts or any other contract completed within 2 years of commencement and performed by a small contractor. There is also a mandatory de minimis small contract exception that applies to both the regular and AMT tax system, where the lookback method does not apply to any long-term contract completed within 2 years of commencement and where the contract price does not exceed the lesser of:

• 1% of the taxpayer’s average annual gross revenue of the past 3 years or
• $1 million

Note that the $1 million exception would apply to contractors with revenues greater than $300 million over the previous 3 years.

Exempt Percentage of Completion Method

A hybrid variation of accounting for long-term projects is the exempt percentage of completion method (EPCM), where general and administrative costs and directs job costs are deducted with the accrual method, which are deducted when the liability for those costs are incurred. The main advantage of EPCM is that income is reported over the life of the contract and any losses will be recognized based on the percentage of the contract completed, which is referred to as the completion factor. The completion factor is the amount of work that has been completed compared to the estimated amount remaining. The completion factor must be certified by an engineer or an architect, or supported by appropriate documentation. The contract price must include cost reimbursements, all agreed changes to the contract, and any retainages receivable. Retainage is the amount earned by the contractor, but retained by the customer for payment at a later date until the quality of the work can be ascertained.

Percentage of Completion-Capitalized Cost Method

There is also a percentage of completion-capitalized cost method (PCCM) that can be used for residential apartment contracts, where at least 80% of the total contract cost is attributed to the construction of the buildings. Under PCCM, 70% of the contract is reported under PCM, while the remaining 30% is reported under EPCM. Treas. Reg. §460-4(e)

Allocating Costs

Since contractors often work on several contracts simultaneously and because contractors often incur costs that are not specific to a particular contract, these costs must be accumulated and allocated to specific contracts. The costs are not deductible until the income is recognized. Although the contractor has discretion in accumulating and allocating costs, the basis for cost allocation must be reasonable.

There are 2 types of costs:

1. general and administrative costs
2. job costs

General and administrative (G&A) expenses are those expenses incurred to run the business and are not allocable to a particular job. Job costs are the direct costs of a particular job, which are grouped into 2 categories: direct job costs are those that can be allocated to a particular job; indirect job costs are those incurred in performing the contract, but cannot be allocated to a particular job, such as utilities, repair maintenance for both equipment and facilities, and for tools and equipment. The distinction between indirect job costs and general and administrative costs is that indirect job costs directly benefit more than one job, whereas administrative costs would be incurred even if the contractor had no particular jobs.

Alternative Minimum Tax

Except for home construction contracts, the PCM method must be used for all current CCM contracts to determine any alternative minimum tax (AMT) liability, and the lookback method must be applied to determine any overpayment or underpayment of interest.

References

• Instructions for Form 8697
• Construction Industry Audit Technique Guide (ATG) – Chapter 5
• Industry Director Directive on Super Completed Contract Method
• 26 CFR 1.460-6 – Look-back method.

◄ Previous Accounting Methods: Cash, Accrual, and Hybrid

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Completed-contract method

The Completed-contract method is an accounting method of work-in-progress evaluation, for recording long-term contracts. GAAP allows another method of revenue recognitionfor long-term construction contracts, the percentage-of-completion method. With this method, revenue is recognized when the contract is fulfilled. The contract is considered complete when the costs remaining are insignificant.

Contents

• 1General description
• 2When to use
• 3Balance sheet presentation
• 4References
• 5External links

General description

Accounting for long term contracts can be done in two ways: through the completed-contract method and the percentage of completion method. The choice between the two depends on the provisions of SOP 81-1 from the AICPA. The completed-contract method recognizes income only when the contract is completed or substantially completed.^[1]

When to use

The completed-contract method is used when costs are difficult to estimate, there are many ongoing small jobs (one time work), and projects are of short duration. This method can be used only when the job will be completed within two years from inception of a contract. ^[2]

Balance sheet presentation

• In current assets is shown excess of costs over billings: the current asset accounts are “due on accounts”, a receivable account, and “construction in progress” (“CIP” – or “costs in excess of billings”).
• In current liabilities is shown the excess of billings over costs (“progress billings”): these are progress billings on uncompleted contracts in excess of costs.

• Completed-contract method

Categories: 

• Accounting systems
• Methodology

Contracts Are Assets Not Weapons

    June 26, 2015 | By Laura Fagundes | Compliance, Contract Risk, Contract Reporting

With litigation on an alarming upward trajectory, a lot of companies view contracting as a necessary evil of conducting business. It would be impossible to complete transactions without the terms of an agreement formalized in writing. But, contracts aren’t just about portraying obligations and responsibilities in a textual format. Rather, contracts as a whole are meant to create value and yield economic benefits to the companies involved.

Lawyers tend to serve as the primary contract negotiators and drafters.  Because they are both trained and paid to mitigate risk, contracts are usually teeming with definitions and clauses aimed at doing just that. According to a recent report by IACCM, this is one of the ten pitfalls to avoid if you want to maximize contract ROI. To start getting the most from your contracts, you should view them as assets, not weapons. 

Focus on Increasing Value, Not Just Mitigating Loss

It is understandable that companies want contracts to spell out the possible consequences if a party fails to comply with the contracts’ terms. There is no denying that contracts have to contain these terms and conditions to some degree, but they do not need to dominate the discussions or become an oppressive part of the final agreement.

Companies have far more to gain from their contracts by conveying the value they add to the contractual relationship and by eliciting this information from the other prospective parties to a contract. Harmonious contractual negotiations should focus on creating a relationship that will provide the maximum reciprocal benefits possible, and this should be reflected within the contract itself. By ensuring that both parties stand to benefit generously from the arrangement and making this abundantly clear in the contractual language, the likelihood of encountering compliance issues and the accompanying losses diminishes greatly.

Foster Positive Incentives Rather than Negative Consequences

Fostering positive incentives within contracts corresponds nicely with using contracts to add value to the business. Of course, there may be some instances in which it is necessary to include some of the more traditional negative consequences, such as specific damages clauses. However, including too many or overly-taxing negative measures may end up backfiring.

For example, trying to impose excessive damages clauses may sour a potential relationship altogether, preventing the contract from ever being executed. Alternatively, negative consequences may cause the parties to proceed with an abundance of caution or result in tepid relations. 

Rather than feeling threatened by negative possibilities, positive incentives will encourage contract performance and compliance. These can include any number of economic benefits, such as discounts when certain goals are met or business referrals for solid performance, among other options. Ultimately, it is important to frame the contractual relationship in a positive manner, so that all parties are motivated to perform and not merely acting to avoid disaster.

Look at Contracts Collectively, Not Just As Individual Documents 

Companies usually consider all of their resources and assets when making business decisions, and the contractual portfolio should be no exception. It is important that contracts are negotiated, executed, and managed in an efficient manner, keeping in mind all existing and any future arrangements. A comprehensive approach to contracting and contract management will help companies avoid unnecessary overlaps or redundancies. This is particularly important, as money is often wasted because companies are simply unaware of all of their existing contracts.

By ensuring that each contract adds value to the business in a distinct way, that the relationships with each party to a contract is based on mutual benefit, that contracts are framed in a positive fashion, and that there is a coherent contract portfolio (not merely a handful of disparate contracts), companies are far more likely to maximize the value of their contracts.  

Topics

• Agile Contract Management (10)
• approvals (1)
• Artificial Intelligence (14)
• business contracts (1)
• cloud technology (1)
• Compliance (33)
• contract amendments (1)
• Contract Automation (13)
• Contract Database (10)
• Contract Disputes (9)
• Contract Drafting (27)
• Contract Lifecycle Management (17)
• Contract Management (150)
• Contract Management Basics (11)
• Contract Management Best Practices (63)

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Valuation of “Intangible” Assets

What is an “Intangible” Asset?

“Intangibles” such as customer goodwill, name recognition, and customer lists are valuable non-material assets that can be appraised just like physical equipment, real estate, accounts receivable, and securities. In order for your business to be successful, you’ll want to understand the importance of intangibles. Below are some of the most important intangible assets, and some ways they are valued.

Brand Names or Trademarks: Brand names and trademarks can be extremely valuable. Some, such as “jello,” “xerox,” and “kleenex” have nearly become generic terms. A common valuation method is based on how much more a company can charge for its products than relatively unknown competitors.

Contracts: Certain contracts, such as employment, affiliation, advertising, or sales contracts, can be treated as intangible assets because they add value to a company. For example, a long-term lease at below-market rates can represent a huge overhead savings. Or, when a business is sold, the president of the selling company may contract to remain for a certain period. This contract is valuable because it saves the cost to replace the president with a new executive who would have to learn the business and take time to become as effective. Other types of valuable contracts might be subscription contracts (for example, a cable company’s revenue is based largely on subscriptions) or long-term service contracts sold by the company.

Franchises and Other Licenses: Franchises that are well-recognized and have a long track record are valuable. One common way to value franchises is based on profit advantage over similar businesses by virtue of the franchise.

Goodwill: Goodwill is based on your company’s reputation and relationships with customers, vendors and the community, and its participation in trade-related activities. In broad terms, goodwill is a measure of your company’s reputation, and of how willing these individuals would be to continue doing business with your company. Goodwill is often lumped with other intangibles in valuation because it can be difficult to separate the value of each intangible. At a base level, goodwill can be considered the value of having an established business, so that a buyer would not have to assemble the business and seek customers from the ground up.

Patents and Patent Applications: The value of a patent depends on its economic and legal lifespan. The value of a patent application depends on the strength of its claims.

Proprietary Lists: Many types of lists, such as customer or subscription lists, are often compiled for internal use, bought, or sold. Lists are especially valuable if they represent ongoing business relationships. For example, if a newspaper gets 80 percent of its advertising revenue from companies on a customer list, that list is a critical business tool. Values may be based on the cost to replace a list, or the repeat sales generated.

Secret Processes, Methods, and Formulas: Often these assets are not patented, and valuation must be made based on profit advantage or cost savings provided by the asset. Because these assets are volatile-secrets are precarious-an appraiser’s judgment often plays heavily in these valuations.

Tax Credits For Past Losses: The IRS allows certain losses to be carried back or carried forward. If a company has losses, they may be carried forward for a certain number of years to offset profits, resulting in a tax saving. The anticipated tax saving can often be estimated, providing a value for this asset.

Technical Libraries and Other Specialized Information Repositories: Many libraries contain nearly irreplaceable material, and can be extraordinarily difficult to recreate. These assets are often valued by the cost of recreating them, minus losses for obsolescence.

Next Steps

As a small business owner, you likely have questions about how to value intangible assets in your company. Let a legal expert skilled in business and commercial law assist you today.

BL 7:6