Business Finances

The Business Finances section, accounting for 15% of the law and business exam, is designed to test a contractor's knowledge of key financial management principles essential for running a successful construction business. This includes the ability to manage cash flow, create and adhere to budgets, and understand tax obligations. The section also covers financial reporting requirements, including the preparation of balance sheets and income statements, which are critical for assessing a business's financial health. Additionally, this section emphasizes the importance of accurate recordkeeping and inventory management to ensure that the business can meet its financial and operational goals. Proficiency in these areas is crucial for maintaining profitability and compliance with regulatory standards.

Taxes

Business owners are required to pay taxes and fees at federal, state, and local levels. Businesses might need to prepay or pay estimated federal and state income taxes quarterly. The IRS receives estimated federal income taxes, while the Franchise Tax Board (FTB) receives estimated state income tax. Contractors must also obtain the necessary city or county permits before starting a job. Business licenses and construction permits are essential costs of doing business. Moreover, the contractor must be aware of zoning laws and building codes.

Sales Tax and Use Tax

California requires a Seller’s Permit for businesses that sell goods. Sales and use tax are paid to the California Department of Tax and Fee Administration (CDTFA), formerly known as the Board of Equalization. This payment may require a deposit of the estimated sales tax for the first six months. The contractor must collect the required sales tax from the customer, unless the tax on materials was paid when purchased.

Use tax is applied to out-of-state goods, typically those bought online. However, it also applies to goods purchased in person from an out-of-state vendor. The use tax functions like a sales tax and uses the same rate.

Property Tax

All businesses are legally required to complete, sign, and submit a Business Property Statement (BPS) form provided by their County Assessor. A business with personal property and fixtures valued at $100,000 or more must submit the BPS form, even if they did not receive a notification from their County Assessor.

Businesses must pay taxes on real property (land, buildings, improvements, and fixtures) and personal property (equipment, portable machinery, office furniture, supplies, and tools). Business inventory is excluded as it is non-taxable property.

Cash Management

Cash management involves handling the financial aspects of a business. This includes revenue collection, cash concentration and investment, and managing other liquid assets of the organization.

Cash Flow

Cash flow tracks all incoming money and expenditures to suppliers or subcontractors during a construction project. This helps the contractor ensure sufficient working capital for job completion. To maintain a positive cash flow, contractors should keep accurate records of accounts receivable and payments made for all past and current projects.

Collecting Accounts Receivable

Accounts receivable represents money owed to a contractor for goods and services delivered. To maintain healthy cash flow, regular and prompt invoices detailing payments and terms should be sent to clients. For example, an invoice might state 'Net 10', indicating that the net payment is due within 10 days.

Notes receivable refers to a written promissory note issued to a seller after the provision of products or services to a buyer. The seller can transfer these notes to meet current financial obligations. Typically, notes receivable have a longer maturity than accounts receivable, but less than a year.

A systematic process should be adopted for maintaining funds. This process should appear professional, with all services and dues clearly itemized. If the buyer fails to pay the amount owed within three months, a sternly-worded letter should be attached to the next invoice, urging immediate payment. Should this step prove unfruitful, it might be necessary to employ a collection agency.

Bad Debts: Bad debts arise when a client defaults on credit extended. They negatively impact cash flow and should be avoided whenever possible. Notably, the IRS permits the deduction of bad debts from gross income for tax purposes.

Financial Disclosures

Financial disclosures are the process of presenting a company's financial status to its managers, investors, government entities, and the general public. This is typically done through the use of balance sheets and income statements, which serve as summaries of the company's internal financial information. These documents chronicle the company's profits and losses over an annual period, offering a comprehensive view of its financial strengths and weaknesses.

Balance Sheet

Often referred to as a "snapshot", a balance sheet provides a summary of a company's financial standing at a specific moment in time. It is standard practice for an accountant to present two balance sheets, detailing the financial state of both the current and prior year.

A balance sheet provides readers with a clear view of a company's current and fixed assets, its financial commitments, and investments made by the ownership. Typically, a balance sheet is split into two sections: the left side outlines the assets, while the right side details the company's liabilities and stockholder's equity, also known as the owner's investment. As suggested by its name, a balance sheet always maintains equilibrium, with both sides always equal in value.

For example: If a company secures a loan of $10,000, this sum would be reflected in the company's current assets (cash account). Simultaneously, the $10,000 debt owed to the lender would appear on the liabilities side of the balance sheet.

Assets

Assets are sorted based on liquidity, which is the speed at which an item can be converted into cash. The organization's ability to settle its debts also factors into this order. Current assets, which can be quickly turned into cash, are listed at the top of the left side of the balance sheet. These include the company's cash reserves and any goods that can be readily converted into cash. Examples of current assets are cash on hand and in the bank, retentions, accounts receivable, prepaid expenses, and inventories. Fixed assets like property and equipment are listed after current assets on the balance sheet. Here are some definitions of assets:

• Cash: This refers to immediate liquid assets.
• Retentions: These are specific amounts (usually about 10%) held from progress payments to the contractor until the project is finally accepted. Retentions are essentially earned but still unpaid amounts.
• Accounts Receivable: This is the money owed to the contractor for any completed construction projects, excluding any withheld retention.
• Inventory: This includes labor, all the materials used, and both direct and indirect overhead for any ongoing jobs.
• Prepaid Expenses: These are future expenses that have been paid in advance for later value, such as insurance premiums. Prepaid expenses are recorded as assets on the balance sheet until the expenses are used up or incurred.
• Fixed Assets: Also known as property, plant, and equipment, these are physical resources that a contractor owns or acquires for use in their operations and are not intended for resale.
• Other Assets: These are any other resources not listed in the previous groups, such as scrap materials or equipment being held for resale, and any long-term receivables.
• Accumulated Depreciation: This is the total sum of all depreciation expenses previously recorded as assets. It is also referred to as a contra account, which is an account associated with another account. Contra accounts operate through an opposite normal balance and are reported as a deduction from the balance of the other account.

Depreciation

Depreciation is the procedure used in accounting to allocate the cost of a tangible asset over its estimated useful lifespan. The calculation of depreciation for a tangible asset can be done using two main methods.

Straight-line Depreciation: With the straight-line depreciation technique, it is assumed that the tangible asset will lose an equal amount of value after each accounting period, which is typically a year. The annual depreciation is calculated by subtracting the residual, or salvage, value of the tangible asset from its initial cost and then dividing that figure by the asset's lifespan. The formula for calculating straight-line depreciation is as follows:

Depreciation per year = (Original cost – Residual value) / Useful life of tangible asset

Note: The residual value or salvage value represents the projected amount that can be obtained from selling a tangible asset after its useful lifespan.

For instance, if a company buys a tangible asset for $30,000 with a projected lifespan of five years and a residual value of $6,000 after five years, the annual depreciation using the straight-line method would be $4,800, as demonstrated in the formula below:

Depreciation per year = ($30,000 – $6,000) / 5

The asset's value would decrease by $4,800 each year. If the asset, such as a piece of equipment, is only used for six months of the year, the depreciation for that year would be halved (6 months out of 12). The depreciation would then be $2,400.

Accelerated Depreciation: The accelerated depreciation method permits faster deductions in the early years of a tangible asset's useful lifespan. This method of depreciation is often employed to decrease tax liability in the early life of a tangible asset.

Liabilities

Liabilities are financial obligations or debts that a company is required to pay, either in the form of money or services. They are classified under two categories on the balance sheet: current liabilities and long-term liabilities. Understanding the relationship between a company's current and fixed assets and its current and long-term liabilities is crucial for proper financial statement analysis.

• Current Liabilities: These are debts the company has to pay within one year from the balance sheet date. The means to pay these debts comes from the company's current assets. It's important for management to ensure they have enough assets to cover these liabilities.
• Accounts Payable: This consists of the money a company owes to subcontractors and suppliers, or any goods bought on credit. For instance, a purchase order (PO) is an official document from a buyer to a seller specifying the details of the products or services ordered, their quantities, and agreed prices.
• Notes Payable: This represents the balance of the principal amount owed on a promissory note.
• Accrued Expenses Payable: This category includes money owed for services, interest, insurance premiums, and other fees not included in accounts payable. These are expenses that have been incurred but are not due for payment within the dates covered by the balance sheet.
• Accrued Payroll: This covers salaries, wages, commissions, bonuses, and benefits owed to employees.
• Miscellaneous Taxes Payable: This is an estimated amount owed to state and local government agencies during the current accounting period.
• Federal Income Taxes Payable: This is an estimated amount owed to the federal government, determined by the contractor’s form of business organization.
• Long-Term Liabilities: These are notes or mortgages that are due more than one year into the future.

Stockholders' Equity

Stockholders' equity, also referred to as "net worth", signifies the claim of the owner(s) on the assets of the business, which is the result of their invested capital.

• Capital Stock: This denotes the overall amount of capital infused into the business by a contractor or investors in return for a proportionate share of common stock at its face (par) value. This amount does not necessarily have to coincide with the current market price of the share.
• Retained Earnings: These are the cumulative corporate earnings since the inception of the business, deducted by the declared dividends (distributions made to owners) since the corporation was established.

Accounting

Cash Method of Accounting

The cash method of accounting is a straightforward approach where sales or revenues are recorded when payment is received, and expenses are noted when payments are made. This method is a favourite among small businesses due to its simplicity.

NOTE: It's worth mentioning that manipulating reported earnings is possible if the cash method is used. The IRS often raises eyebrows at businesses that employ this method of accounting.

Accrual Method of Accounting

The accrual method of accounting is where revenues are recorded on an income statement at the time of the transaction when payment is received, not later. This method also affects the balance sheet in the same manner. Most construction businesses are advised to use this accounting method.

For instance, consider a scenario where a contractor invoices on December 15th, 2020 and receives payment on January 8th, 2021. In the cash method, the revenue would be accounted for in the fiscal year 2021, as that’s when the payment was actually received. However, the accrual method would account for the revenue in 2020, aligning with the actual transaction date.

Accounting based on accrual for long-term projects often divides into the completed contract method and the percentage of completion method.

Completed Contract Method

With the completed contract method, the income or loss from a project is documented in the year the contract is concluded. If this method is employed for long-term contracts, the possibility of incorrect cost allocation and overstated deductions arises.

While this method can be advantageous as it postpones taxation, the records it creates may be less transparent than those generated using the percentage of completion method because contract losses can only be written off after the contract's completion.

Method of Percentage Completion

The percentage of completion method allows for the regular declaration of profits and losses that correspond with the actual work completed per project. For instance, if a job has incurred 50% of the total projected costs, it should be considered half complete and half the revenue should be accounted for in the books.

The method's main drawback is its reliance on estimates. The actual project completion figures could vary significantly due to estimating both the project's degree of completion and its associated income and expenses. Each project's completion percentage calculation is done independently. The formula used to determine the completion percentage is:

Percentage of completion = Project costs incurred to date / Estimated total project costs

Financial Calculations

Current Ratio

Current ratio = Current Assets ÷ Current Liabilities

Current ratio = $120,000 ÷ $180,000 = 0.67

In this example, the organization has fewer assets coming in over the next year than the debt that must be paid out during the same period. This ratio, being less than 1, is unfavorable as it signifies that the current liabilities exceed the current assets.

Quick Ratio

Quick Ratio = (Current Assets – Inventories) ÷ Current Liabilities

Quick Ratio = ($120,000.00 – $80,000) ÷ $180,000 = 0.22

The quick ratio, also known as the acid test ratio, gauges a company’s liquidity and its capacity to meet its obligations. It's calculated by deducting inventories from the current assets and then dividing by the current liabilities. The quick ratio acts as an indicator of a company’s financial strength or weakness (higher numbers are better). In the example company, for every dollar of current liabilities, there are 22 cents of easily convertible assets. A quick ratio of 1.0 or more is preferable among creditors, though these ratios differ among industries. This ratio indicates the degree of safety for the creditors if the company were to default on its debts.

In these examples of current and quick ratios, a bank may not suggest a line of credit or short-term loan since a company with low ratios is less likely to repay the debt.

Working Capital

Working Capital = Current assets – Current liabilities

Working Capital = $120,000 - $180,000 = -$60,000

Working capital is the measure of a company's available liquid assets to grow its business. The figure can be either positive or negative, depending on the company's debt amount. A company with a substantial amount of working capital is more likely to succeed as it has the resources to enhance and expand operations. If a company has a negative working capital, it implies excessive debt and a lack of necessary funds for growth. Working capital is also known as net current assets or current capital. A thriving business requires a reasonable amount of working capital. Lack of adequate working capital often leads to the failure of small businesses.

Income Statement

An income or profit-and-loss (P&L) statement is prepared for a specific operation period such as a year, quarter, or month. Income statements display business revenues, expenses, and profits or losses for the relevant accounting period. The revenues are then matched against the incurred costs and expenses, and the difference is the corporation’s profit or loss. This profit or loss is referred to as the “bottom line”. Understanding the relationship between the various expense categories and total revenues is crucial for effective management of the organization. Refer to the below image.

Income Statement Components

The Cost of Operations section of an Income Statement comprises several critical values, namely:

Direct Labor: This is the total labor payroll for all jobs undertaken within the designated period of the income statement. It is essential to consider both the volume of direct labor and its percentage relative to the total project cost. Direct labor is a fundamental variable in determining a company's overall profitability and is an indicator of workforce efficiency.

Direct Labor Burden: This encompasses all costs linked to the labor payroll, such as insurance, payroll taxes, and employee benefits. If the workforce is unionized, direct labor burdens must also include union benefit assessments and membership fees.

Materials Used: Materials utilized on a job often constitute the most significant expense item on an income statement. Given their substantial role in contracting costs, it's crucial to monitor this amount closely to manage and control expenses.

Other Direct Costs: This refers to all costs associated with individual jobs that have not been previously listed, such as permits, insurance, equipment rentals, and bonds.

Administrative and General Expenses: These are general expenses that are not directly linked to any single job. In the example provided in the above image, a separate schedule is used to summarize annual expenses alongside the income statement.

Income Before Provision for Federal Income Tax (Pretax Income): This is calculated by deducting total operating expenses from the sales of residences. For corporations subject to federal taxation, this figure is referred to as "Income Before Provision for Federal Income Tax". Some businesses are exempt from paying taxes on income as a business, with this income instead appearing on the personal tax returns of the owner(s). This shows how a contractor's choice of business organizational form influences financial statements.

Net Profit for Year (Net Income): This is often known as net income and represents the revenues minus expenses (including taxes, if applicable). This is typically referred to as 'the bottom line' of an income statement. Investors utilize the income statement to evaluate a business's profitability. If the net profit is negative, the company will experience a loss in net worth.

Financial Reporting

Financial reporting is the process of disclosing the financial status of a company to its internal management, investors, governmental organizations, and the general public. The principal tools for summarizing the financial data of a company are balance sheets and income statements. These documents provide a comprehensive record of a company's financial performance over a year, highlighting its financial strengths and weak points.

Accounting Recordkeeping

For efficient business management and compliance with state and federal laws, it is standard practice for a company to maintain accounting records. The specific recordkeeping requirements may vary between different state and federal laws. However, Section 7111 of the Business and Professions Code stipulates the following:

1. A licensee's failure to create and maintain records documenting all contracts, documents, records, receipts, and disbursements in relation to all contractor transactions, or the licensee's failure to make these records accessible for inspection by the registrar or a duly authorized representative for a period of no less than five years after the completion of any construction project or operation to which these records refer, or the licensee's refusal to comply with a written request from the registrar to make these records available for inspection, will be grounds for disciplinary action.
2. If a licensee, applicant, or registrant who falls under the provisions of this chapter, without a lawful reason, delays, obstructs, or refuses to comply with a written request from the registrar or designee for information or records, or fails to provide that information or make those records available, when the information or records are required in the execution of any duty of the registrar, this will be grounds for disciplinary action.

Keeping accurate accounting records enables a contractor to revisit completed projects and use these records as a reference for future projects.

Inventory of Resources

Before jumping into the creation of a contracting business, it's critical to reflect upon various aspects to pinpoint potential challenges that could hinder the successful running of the operation:

• Analyze the financial resources at your disposal and estimate the financial needs of your upcoming business. New ventures necessitate resources like equipment, office facilities, and substantial funds for payroll and personal expenses.
• The nature of construction comes with inherent risks. Consider factors like fluctuating costs and availability of necessary materials and services, potential delays due to weather or regulations, necessary inspections, and reliance on architects.
• Assess the local building activity. Will it be sufficient to support your new business? What strategies will you use to secure business? Contractors might need to rely on marketing, networking, or in the case of public works, the ability to secure competitive bids.
• There are various kinds of contracting businesses, each with their specific pros and cons. Decide on the specialized areas you intend to focus on, such as custom building, speculative building, tract housing, remodeling and home improvement, general contracting, public works projects among others.
• Consistent maintenance of financial records and books is crucial for planning, coordinating jobs, and attracting investors with balance sheets or income statements.
• Develop a strategy to manage personnel, financial, and legal reporting requirements.

A contractor intending to start a business should first devise a comprehensive business plan and secure the necessary resources, ensuring the smooth operation of the business.

Business Finances

Every business, including contracting, requires diligent accounting. The collection and examination of this accounting data aid in generating crucial financial documents such as balance sheets and income statements. These documents illuminate the overall operational costs, specific job costs, and other expenditures that impact a contractor's profitability. Reliable records also serve to track cash inflows and provide a framework for controlling outflows. Through these records, contractors can understand cash flow patterns from finished jobs, which can assist in predicting future job costs. This section will cover the financial necessities for launching a business, including resources needed, taxes and permit requirements, and different accounting methods for income analysis and cash flow management.

Inventory of Resources

Setting up a contracting business involves many intricate details. By thoroughly contemplating the following points, potential hurdles in successful business operation can be identified:

• What financial resources are at hand, and what does the new business require? A nascent business requires equipment, office space, and considerable funds to cover payroll and personal living expenses.
• The construction industry is fraught with risks. These include the cost and availability of materials and services, potential delays due to weather or regulatory constraints, compulsory inspections, or reliance on architects.
• Is the local building activity robust enough to support a new business? What strategies will be employed to generate business? Contractors may need to resort to marketing and networking tactics or, in the case of public works projects, the ability to secure competitive bids.
• There are numerous kinds of contracting businesses, each with their unique pros and cons. Consider the specialized fields to concentrate on, such as custom building, speculative building, tract housing, remodeling and home improvement, general contracting, public works projects, and many others.
• The maintenance of financial books and records is critical for planning and coordinating jobs and can be employed to attract investors through balance sheets or income statements.
• A strategy should be in place to handle personnel, financial, and legal reporting requirements.

Before starting a contracting business, a contractor should formulate a business plan and secure necessary resources to ensure smooth business operations.

Capitalization

Capitalization, typically, is a term that relates to the amount of money that a business has at its disposal, and how that money is utilized for various expenses. Furthermore, capitalization also pertains to the different financial resources that a business can tap into for funding, which could include options like company stock, earnings that have been retained, or debts that are long-term in nature. Capitalization is a crucial aspect of acquiring necessary assets and covering business costs, such as:

• Procurement of tools, equipment, vehicles, and office supplies
• Payments for payroll and operational expenditures
• Expenses related to bonding, insurance, and licensing

At the inception of a business, a contractor could have access to two primary sources of funding:

Owner Equity

Owner Equity is the capital invested by the owner of a business or its shareholders. It comprises both the capital paid in and the earnings that have been retained. The term Paid-in capital refers to the funds that a business collects from the sale of its ownership shares, while Retained earnings refer to the profits that a business reserves for future expenses and does not distribute among shareholders as dividends. In scenarios where a business secures funds in return for a share of its ownership, it is essentially selling a part of its ownership. For instance, an investor might invest $10,000 to acquire a 10% stake in the business. As this funding source involves relinquishing a part of the business's ownership, it is not advisable during the initial stages of setting up a business. This is because the profits generated in the future will have to be shared with the investors.

Debt Financing

Debt Financing refers to the capital that a business borrows in the form of bonds sales or bank loans. In such situations, the business has to repay the loan along with the interest over a defined period. The lender does not gain any ownership or control over the business in this case.

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