The clauses requiring the most attention in a construction contract, whether it is a standard or customized contract, are progress payment and retainage clauses. Other clauses also deserve special attention from both the contracting parties and the practitioner because they have financial statement and tax implications.
The change order clause permits additions, deductions, or changes to the contract after work has begun. If the change order clause is not included in a Fixed-Fee Contract, additional work will have to be negotiated. Typical reasons for change orders are as follows:
- Owner or designer change of opinion or preference
- Code changes
- Schedule slippage
- Unexpected weather conditions
- Change in owner available funding
- Design error or omission
As with most construction contracts the owner typically withholds or retains a percentage of the progress payments due the contractor until project completion. The contractor, in turn, retains a portion of the payments due subcontractors. The purpose of retainage is to provide the owner security for costs incurred to repair defective work, to settle claims from parties not paid by the contractor, and more importantly to ensure that work is completed in accordance with the contract. The contractor’s cash flow and profitability can be significantly affected if the retention is not received on a timely basis because the retention may be as much as, or more than, the contractor’s profit on the project.
Disputes sometimes arise between a contractor and owner when plans and specifications are not clear or when a work item not addressed by the plans are encountered. For example, there have been instances where structures have collapsed, resulting in personal injury or loss of life. In cases such as this the owner may believe that there were errors made during the construction phase of the project, whereas the contractor may believe that the problem was the result of a design flaw.
Regardless of the cause of the claim, the claims clause in a construction contract will stipulate the procedures that a contractor will need to follow in order to have a chance of being reimbursed for the additional unanticipated costs. If a claim cannot be settled agreeably then it is deferred until the project is completed, typically with the contractor working under protest. Generally, it is not a good idea for a contractor to cease working as he runs the risk of breach of contract by doing so.
In construction contracts, the contractor is generally required to warrant that the work performed is free of defects in material and workmanship for a period of one year from completion. While the contractor warrants his own work to be free from defects, he does not warrant against failures that may occur prematurely due to design deficiencies.
Although the clauses discussed above are generally the most significant clauses, it is important to understand all of the contract terms and the impact they might have on the project and the related financial statements.
The importance of performing an in-depth review of the contract terms cannot be overemphasized. The contractor’s accountant, whether internal or a public practitioner, must have a thorough understanding of a contract’s terms in order to properly account for all activity throughout the contract’s life. An auditor must also review the basic terms of significant contracts during the planning phase of an engagement to properly plan the audit.
Julio Barina, CPA joined Hill, Barth & King, LLC in 2006 and serves as a supervisor in the Fort Myers, Florida office. Hill, Barth & King, LLC is the 71st largest public accounting firm in the country (Inside Public Accounting, 2011). Julio can be contacted by telephone at 239-482-5522 or via email at email@example.com.