By Mahki Abner of Old Republic Surety Company

Underbillings come with a number of intricacies impacting contractor financials. Along with overbillings, underbillings highlight a critical intersection of cash flow, earned profit, working capital, and performance where accounting rules meet the limitations of construction contract invoicing. This collision can obscure accurate reporting of contractor performance, despite the structure of percentage-of-completion accounting. Here are some strategies for managing and mitigating underbilling risks.

Many conversations between contractors and the surety team (bond producer and surety underwriter) revolve around the financial balancing act of overbillings and underbillings. These terms represent a complex intersection of cash flow, earned profit, working capital (WC), and operating performance. At this intersection, accounting rules meet construction contract requirements, often creating ambiguities in reporting contractor performance. Understanding these nuances is critical for both contractors and the surety team, as missteps can lead to overstated WC and net worth (NW), profit fades, and even financial instability.

What Are Underbillings?

Underbillings are costs and earned profit in excess of billings. This can occur when a contractor incurs costs and earns profits that have not yet been billed to the project owner. These are essentially “work-in-progress” entries in percentage-of-completion accounting, often caused by timing differences, unapproved change orders or disputed work.

Conversely, overbillings (billings in excess of costs and earned profits) occur when a contractor bills the project owner for more than the costs incurred and profits earned to date.

The Underbilling-Profit Fade Connection

Underbillings can signal deeper financial challenges, particularly when they contribute to profit fades. Profit fades occur when the actual costs of a project exceed initial estimates, eroding profitability.

For contractors, underbillings tie up cash in work yet to be billed, reducing liquidity and potentially forcing reliance on short-term borrowing to fund operations. This not only increases financial risk but can also diminish profitability. For the surety team, these dynamics are a key consideration in evaluating contractor risk.

Through the three-party relationship of a surety bond, the contractor and the surety teams’ success is of importance to the surety to reflect the risk the surety has taken.

Common Causes and Red Flags

Underbillings often arise from:

● Timing Differences — For instance, purchasing materials with long lead times that are not billed until delivery to the jobsite.
● Accounting Disfunction — Poor communication between project managers and office staff or lack of robust cost-tracking systems.
● Unapproved Change Orders — Additional work agreed to verbally but not yet formalized in a contract.
● Disputed Work — Unresolved disagreements over scope or payment terms.

Sureties often use trend analysis to evaluate a contractor’s history of converting underbillings into receivables. A consistent pattern of delayed or uncollected underbillings may signal deeper systemic issues that warrant closer scrutiny.

Methodology in Action

In a recent analysis by Old Republic Surety, underbillings inflated one contractor’s WC by nearly $3 million. This overstated the contractor’s financial position, which could have skewed its ability to secure a significant surety program. By comparing their year-end work-in-progress (WIP) schedule with subsequent financial statements, the analysis uncovered red flags, such as late-stage underbillings on loss-making jobs.

For example, one of the contractor’s projects—97% complete at year-end—carried $296,000 in underbillings. Six months later, with the project 99% complete, underbillings had grown to $419,000, despite ongoing losses. This trend indicated a low likelihood of collection, leading to the disallowance of these amounts from the contractor’s WC calculation.

Late stage underbillings can make a surety underwriter doubtful. In the previous scenario, Old Republic Surety would disallow this underbilling unless there was a sound understanding for it and the job was still profitable.

This was just one job in the analysis, and there were 10 more similar jobs. Thankfully, this contractor had an otherwise healthy balance sheet, so the potential $3 million disallowance would still allow the contractor to qualify for surety credit. But going forward this contractor’s underbillings were given additional scrutiny.

The methodology presented through the analysis is a direct visual for bond producers and surety underwriters on how the jobs are progressing and whether things are heading in the right direction. This methodology could be used to develop questions to a bond producer about a contractor to understand the contractor’s billing practices and for the surety team to be able to assist in possible remedies via new processes.

Contractor Best Practices

To minimize underbilling risks and prevent profit fades, contractors should incorporate the following best practices:

● Develop Accurate Estimates — Engage experienced estimators and implement multi-layered review processes.
● Negotiate Favorable Billing Terms — Create schedules of values that align cash flow with project milestones.
● Foster Interdepartmental Communication — Ensure field management and office staff collaborate effectively to track costs and submit timely billings.
● Leverage Technology — Use integrated accounting and project management software to maintain accurate and real-time job cost data.

Tools for Financial Stability

A proactive chief financial officer (CFO) and robust accounting tools can provide contractors with the foresight to identify financial risks early and take corrective actions. A CFO plays a crucial role for a contractor regarding planning, reporting, analysis, and cash flow management. Without a proactive employee in this position, it could be difficult to monitor jobs and initiate corrective actions in real time.

To better monitor these things as they occur, the contractor’s accounting and field management team can utilize a quality internal accounting and project management software program to accurately track the progress of jobs. Along with the CFO, these measures enhance transparency and ensure that the contractor’s underbillings are properly managed to avoid overstated financials.

The Role of Communication

Communication is the lifeline of any relationship, and transparent communication between contractors and the surety team is key. Underwriters rely on accurate information to assess risks and provide tailored advice. Contractors who proactively share the context behind underbillings can often secure more favorable considerations.

Underbillings are more than just accounting entries, they are a financial signal that warrants careful analysis and proactive management. By understanding underbilling causes and implications, contractors, bond producers, and surety underwriters can better navigate the complexities of construction accounting, ensuring a contractor’s financial stability and long-term success.

Mahki Abner, AFSB, is an Associate Underwriter with Old Republic Surety Company, based in Milwaukee, WI. He can be reached at mabner@orsurety.com or 262.754.2131.