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As most of our calendar year end clients have now closed 2011 and are beginning the audit, review, or compilation process it may be time to look within your operations and assess the quality of internal fraud prevention controls.
Our second article addresses a recent challenge to the 9% production activities deduction and emphasizes the distinction between construction or substantial renovation and simple repair.
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Fine-tuning Your Internal Controls
If your company's internal controls are not up to speed, you're exposing your business to a number of risks. Without adequate internal controls, you may be making decisions based on inaccurate financial information. Moreover, weak internal controls heighten the possibility that your company could fall victim to theft and fraud.
Contractors are particularly vulnerable to accounting errors and outright fraud since they often have operations at several different work sites. Fraud is a particularly serious issue: Businesses lose an estimated 5% of annual revenues to fraud each year, according to the Association of Certified Fraud Examiners. Areas that your company should pay particular attention to include the handling of cash, accounts receivable, and accounts payable.
Handling Cash
You may be leaving your company open to a fraud opportunity if you give sole responsibility for processing cash transactions to a single employee. All cash-related functions should be shared by two or more employees as a safety precaution. Be sure that bank account reconciliations are done monthly, and consider requiring two signatures on checks, especially for large disbursements and payroll.
Personally reviewing your bank statements can alert you to potential problems. Have the statements sent to you electronically and promptly review them. Watch out for out-of-the-ordinary items, such as unfamiliar payees. If employees know you review the statement that may be enough of a deterrent.
Reviewing Accounts Receivable
As a practical matter, you should track amounts owed and when accounts are due if your company is to maintain a healthy cash flow. Establish procedures that ensure bills are prepared promptly. Follow up on accounts receivable on a standardized schedule, and record and deposit all cash receipts, segregating collection and bookkeeping responsibilities. You should preauthorize any amounts that are written off as uncollectible.
Tracking Accounts Payable
This is an area of construction where the potential for fraud and accounting errors is high, particularly if your company is working at multiple job sites. You can limit the potential for losses by instituting tight controls on materials and purchasing. Consider requiring management authorization for job site material purchases, and be sure to set limits on the amounts site managers can spend without authorization from an additional, higher level of management.
You should put procedures in place to make sure that delivery receipts are being checked to ensure that all ordered items have been received. And track whether ordered materials and equipment are being used as intended by requiring written verification and receipts for returned items.
Implementing and consistently enforcing effective internal controls can help your company control costs, maintain profit margins, and reduce the potential for fraud and theft. If you would like to know more about improving your internal controls, please consult with us.
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What Work Qualifies for the Domestic Production Activities Deduction?
One attractive tax break available to many construction companies is the domestic production activities deduction (DPAD), which is basically a tax deduction for a percentage of a company's "qualified production activities income" (or taxable income, if less). The applicable deduction percentage is currently 9%.
A recent Tax Court decision* in favor of a construction firm clarifies some of the issues surrounding the DPAD and provides important guidance in several areas.
Case Background
The firm involved in the case is engaged in engineering and heavy construction activities, including erecting or rehabilitating bridges, streets, airport runways, and other related real property. For the 2006 tax year, the firm reported $25.9 million in domestic production gross receipts (DPGR) for work it did on improving a series of old bridges and repairing other inoperable bridges. The work entailed adding lanes, ramps, driveways, traffic rails, bridge decks, and retaining walls to existing roads.
The firm claimed its receipts from the bridge projects were eligible for the DPAD since the work consisted of erecting or substantially renovating real property. The IRS disallowed the deduction, claiming the firm had no DPGR for the year in question. The IRS said the firm's work was routine maintenance that simply restored the bridges' operating condition. The IRS also claimed the company was engaged in repair work since not all of the bridges' components were replaced.
Repair or Substantial Renovation?
The distinction between "repair" and "substantial renovation" is important because activities performed in connection with a project to substantially renovate real property can qualify for the deduction. The DPAD regulations define substantial renovation as renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs its useful life, or adapts the property to a new or different use.
Taxpayer Victory
The court ruled in favor of the construction firm and allowed the tax deduction. It noted that the receipts in question qualified as DPGR because the firm's work:
o Materially increased the value of the bridges
o Significantly prolonged the bridges' useful lives
o Helped adapt the bridges for new and different uses
Can Your Company Qualify for a DPAD?
To claim the DPAD (activity deduction) for construction work, a contractor must:
o Be engaged in the active conduct of a trade or business treated as a construction activity
o Carry out construction activities involving real property in the U.S.
o Derive DPGR (gross receipts) from the construction activity
Real property includes buildings and inherently permanent structures (other than machinery) and their structural components, inherently permanent land improvements, oil and gas wells, and infrastructure. Structural components include walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, elevators and escalators, and other similar property. Infrastructure includes roads, power lines, water systems, railroad spurs, communications facilities, sewers, sidewalks, cable, wiring, and inherently permanent oil and gas platforms.
Again "The distinction between 'repair' and 'substantial renovation' is important...."
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JHS is a full service CPA firm specializing in construction accounting and auditing, tax planning and preparation. We also consult with management to assist with business growth, maintenance, succession and financial forensics.
Sincerely,
Jones, Henle & Schunck
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