You use the same familiar process every year. Your accountant reviews your financials and asks a few questions, makes a few changes, and each year the tax returns are submitted then you move on. 

When you are ready to take the business to market your broker uses those same financials.  Then, quietly and without warning, a single figure sitting in your accounts hands the buyer a reason to walk away. Not to renegotiate. To walk away entirely.

That figure is your Work in Progress.

The Most Misunderstood Number in a Builder’s Accounts

Work in Progress, or WIP as it is commonly known, is the most frequently misrepresented figure I encounter when valuing building and construction businesses. It appears, in the vast majority of cases, as an asset on the balance sheet. In nearly every instance, that is incorrect.

The concept of Work in Progress has its origins in manufacturing. In these businesses, raw materials arrive and then they get transformed into finished goods: At any given point in time, the factory has a product that is neither the raw material that arrived, nor is it the finished product. Stuff that is partially through the production process is a genuine asset called WIP. The raw materials have had labour applied to them. The goods are not yet finished, but they have accumulated added value. In that manufacturing context, WIP as an asset is accurate and appropriate.

A builder, however, is not a manufacturer. The flow of money is fundamentally different, and it is this distinction that most accountants, and most valuers, fail to properly recognise.

Where the Error Occurs

A residential builder collects staged payments throughout the course of a construction project. A deposit is received before materials are ordered. Progress claims are drawn down as the build advances. In many cases, the builder invoices and receives the client’s money before the corresponding costs are incurred.

When those monies are received, it is accepted as income; (Even though the actual work and costs of that work has not yet been booked or acknowledged). The materials are then ordered, when the invoice eventually arrives from the supplier, that liability is entered into the accounts payable and the expense recorded. 

Here is where the problem takes hold. Rather than recognising the income as a pre-payment (a liability) the builder sees income that isn’t real.

This is not a simple timing problem that fixes itself, nor does the approach “She’ll be right mate” come close. This is a fundamental management mistake that experts suggest 95% of builders make.

Work in Progress must be adjusted out of “Income” if it to remain on the asset side of the balance sheet. The result, if it is not adjusted, is a fabricated asset. The income is overstated. The liability is understated. The business appears more valuable than it is.

Most accountants apply the manufacturing model to construction without understanding the difference in cash flow. Most valuers then rely on those accounts without applying a construction-specific lens.

How many builders do you imagine walk into a business sale with their Work in Progress correctly calculated? In my experience, the answer is very few indeed. That is not a criticism of builders. It is a reflection of how universally this error is embedded in the management of housebuilders. 

What This Costs You When the Buyer Arrives

I have seen this problem end deals. Not slow them down. End them.

Some years ago, I was engaged to value a business in a specialised sector. In the course of preparing that valuation, I identified that the inventory figure was materially incorrect. The same double-counting principle was at work: costs had been recorded in such a way that the business appeared to hold significantly more value on its balance sheet than it actually did. I raised this with the business. The financial controller stood in front of me and told me, directly, that the numbers were correct and that I was wrong. I produced the valuation, noting the concern.

The purchaser’s due diligence team subsequently identified precisely the same error. Their response was unambiguous. They said, in effect: if we cannot trust your accounts, we cannot trust you. The risk of proceeding has now exceeded our threshold. And they walked away.

The deal was lost. Not because the underlying business was flawed. Not because the parties could not reach agreement on price. Because the accounts could not be defended.

A second transaction, involving a pest control business, collapsed for the same reason. In that case too, the first contract fell over because the buyer, having uncovered an inconsistency in the financials, determined that the risk of proceeding was too great. The deal was not renegotiated. It simply ceased.

Why Year-End Accounts Make This Worse

The 30th of June is precisely the moment at which Work in Progress calculations are most likely to be incorrect in a building and construction business. Subcontractor invoices are delayed. Progress claims do not align with actual costs incurred. The snapshot provided by the year-end accounts, which is the document most valuers use as their primary reference point, reflects a position that has not been accurately reconciled.

A standard valuer, working from those accounts without an accounting background and without intimate knowledge of the construction industry, will not detect the error. The figure will be accepted as presented. The business will be valued on a foundation that does not reflect commercial reality. And the buyer’s due diligence process will find what the valuation did not.

The Difference That Expertise Makes

I have practised as a qualified accountant and as a specialist business valuer for over thirty-five years. In that time, I have represented buyers and sellers across a wide range of industries, and I have applied the same rigorous process to both sides of the transaction. The building and construction sector is one in which I have extensive and specific experience.

When I conduct a business valuation, I do not simply accept the accounts as presented. I examine the flow of money. I look at the relationship between staged payments received, costs recognised, and liabilities recorded. Where the WIP figure does not reconcile with the underlying transaction flow, I identify it, I raise it, and I advise on what needs to be corrected before the business goes to market.

That is not a step most valuers take. It is, however, the step that protects a business sale.

A corrected set of accounts, produced before the business is introduced to prospective purchasers, is accurate, it is defensible, and it does not give a buyer a reason to doubt the integrity of the information presented to them. Had the vendors in the transactions I described above taken that step, both deals would have proceeded.

Action Step

If you are considering selling your building or construction business, or if you are an accountant or solicitor advising a client who is, I would urge you to examine the Work in Progress figure in the accounts before the valuation commences. Ask whether it has been calculated as a manufacturing item or as a construction-specific liability. Ask whether the staged payments received have been properly reconciled against the costs recorded. The answer to those questions will determine whether your sale succeeds or fails.

At Negotia Group, our valuations are conducted in full compliance with the International Valuation Standards and are supported by detailed financial analysis drawn from decades of hands-on experience in business sales and acquisitions. We do not produce valuations that cannot be defended. We produce valuations that hold up under scrutiny, because in a business sale, scrutiny is precisely what they will face.

To speak with Kevin Lovewell directly about your business valuation, or to discuss the sale of your building or construction business, call 1300 551 757. We are here to provide the expertise, the accuracy, and the support that your business sale deserves.

Business Valuer | Business Broker | Negotia Group

www.negotia.com.au  |  1300 551 757  |  in**@*********om.au