Architect's HandBook of Professional Practice: Objective 2.1 & 2.2

Chapter 7

7.2 Financial Management Overview Steve L. Wintner, AIA Emeritus Financial Management involves the ongoing monitoring of a firm's financial resources to allow firm principal(s) to exercise sound business judgment in response to developing trends. INTRODUCTION The basic knowledge needed for the financial management of a professional design firm includes a clear understanding of the component parts of each of the two primary financial reports—the Profit-Loss Statement and the Balance Sheet—and how to inter- pret these reports. Knowing how to calculate the seven key financial performance indicators of the profit-loss statement and the four key financial performance indica- tors of the balance sheet will facilitate a firm leader's response to developing trends, whether positive or negative. An in-depth knowledge of accounting is not required to develop the skills to learn any of the above. Two essential components of a financial management system are the Annual Budget and the Profit Plan. These two components are closely interrelated, and decisions about elements of one component will likely have an impact on the other component. For example, overhead projections made for the profit plan will play a key role in the development of the annual budget. Therefore, it is important that these two compo- nents be developed concurrently. Since these two components are developed for each new coming year, it would be advantageous for their development to begin before the coming year commences. Even if the final results of the current year are not yet available, it is acceptable, as a place to begin, to use the data from the latest of a firm's 4th-quarter accrual-basis financial reports and their calculated key indicators. Once the final, previous year-end data is available, adjustments for the coming year can be made to the budget and profit plan and their key indicators. Getting an early start will enable firm leaders to respond more effectively to new opportunities using the most current data. These two components, when fully developed, provide a basis for comparing the anticipated financial perfor- mance of a firm with its actual financial performance in the periodic monitoring of its accrual-basis profit-loss statement. Distinctions Between Accounting Reports and Financial Management Reports A comprehensive financial management system is based on a firm's accounting system, but there are distinctions between their respective reports. Accounting reports and their generated data are the responsibility and realm of a firm's accounting personnel and its outside tax consultant. Financial management 410 Financial Management PART 2: FIRM MANAGEMENT reports are the responsibility and realm of firm leaders, even though others might develop and compile these reports. While the basis (timesheets, incoming payments, and outgoing invoices) of the financial data is essentially the same for the accounting and financial reports, each report type is formatted differently to suit their respective purposes and use by each party. Accounting reports focus primarily on cash-flow management, accounts payable, and defining the firm's quarterly and annual tax liability, which are identified in the cash-basis reports. A firm leader's focus will be on reviewing and monitoring the key indicators from the financial data provided in the accrual-basis reports. Both reports facilitate making sound business decisions to enhance a firm's effectiveness, efficiency, profitability, and the achievement of its professional goals. An understanding of the following basic accounting terms is also necessary for skillful financial management. FINANCIAL PLANNING Applications of the Cash-Basis and Accrual-Basis Reports Depending on the size of a firm, one or both types of reports may be used. The account- ing process for most sole proprietors (those without any paid staff) would be on a checkbook-like basis (dollars received, dollars paid) and therefore would likely use only the cash-basis report. Almost all other size firms with employees would use both types of reports. The cash-basis profit-loss statement indicates only the income received and the amounts paid out for expenses to others within a specific accounting period. Because certain expenses, such as salaries and most vendor invoices, are paid shortly after the obligation is incurred, and income from invoices may not be received for 30 to 120 calendar days, or more, after the work is actually done, there is no timing cor- relation between income received and expenses paid. The cash-basis profit-loss state- ment establishes a firm's cash-flow management effectiveness and its tax liability, not its net profit. Unlike the cash-basis profit-loss statement, the accrual-basis profit-loss statement does not consider the actual receipt or payment of any money. Rather, the accrual report reflects the invoices sent to clients for monthly revenue earnings, based on hours worked and expenses incurred to complete that work, in a given accounting period. The accrual basis profit-loss statement establishes the net profit for a firm and the calculation of its seven relevant key financial performance indicators. These two reports do, however, have a connection. For example, consider the rela- tionship between cash available on-hand and the distribution of any net profit. Ulti- mately, the availability of cash-on-hand will have a significant impact on the decisions made about the size and timing of net profit distributions. For the sake of this article and in general, the "modified" accrual-basis is the industry-accepted method employed for the accrual-basis profit-loss statement. The modified version records only the revenue from fees and expenses that have been invoiced to clients. It would also include the fee and expense amounts invoiced to the firm by outside project consultants and other vendor and general expense amounts that were incurred in a specific accounting period. It does not include the value of earned fees unbilled ("work-in-progress"). Introduction to the Mattox Format The use of conventional accounting formats, while perfectly acceptable, nevertheless do not allow for an easy calculation of the seven key financial performance indicators for the profit-loss statement. As an alternative to conventional accounting formats, there is a unique format that was developed by Robert F. Mattox, FAIA, (retired) designed to facilitate easy understanding of financial performance indicators. CASH-BASIS AND ACCRUAL-BASIS REPORT DIFFERENCES This example illustrates the differences between the cash- basis and the accrual-basis reports. The cash-basis accounting for this firm recorded a net cash income of $21,000 for the current month. However, much of this income comes from the collection of months of previous invoices that were not paid until the current month. The accrual-basis accounting for this same firm indicates a net profit of $18,000, on the current month's invoices of $100,000. Since net cash income and net profit are generated by different monetary resources, it is not appropriate or realistic to compare the actual income ($ received) in the cash-basis report to the earned "net profit" (based on dollars invoiced) in the accrual-basis report. The cash-basis report indicates income received and payments made. For this reason, only the cash-basis profit- loss report is to be used to determine the firm's quarterly and annual tax liability. The modified accrual-basis report provides an accurate snapshot of a given accounting period, generally one month and the year-to-date. It records only the invoiced amounts sent to clients for the firm. This report does not indicate any actual income received or payments made. Current Month—Cash Basis Income received for previous invoices (for fees and expenses): Current month invoices (for fees and expenses): Total Current Month Income: Total salaries paid: Total expenses paid: Current Month Net Cash Income: Current Month—Modified Accrual Basis Net operating revenue earned (for invoices sent): Direct labor expenses incurred: Indirect expenses incurred (labor and expenses): Total labor and expenses incurred: Current Month Net Profit: $70,000.00 $5,000.00 $75,000.00 −$45,000.00 −$9,000.00 $21,000.00 $100,000.00 $32,000.00 $50,000.00 $82,000.00 $18,000.00 AN INTRODUCTION TO THE MATTOX FORMAT In the late 1970s, Robert F. Mattox, FAIA, (retired) developed an alternative to conventional accounting formats, particularly designed for use by professional design firms. The AIA Press first published this format in 1978 and 1980 in the two manuals authored by Mattox, titled "Standardized Accounting for Architects" and "Financial Management for Architects." Identified herein as the Mattox Format, this system was developed to enable design professionals to quickly ascertain firm profitability and measure its performance with key financial indicators. While the Mattox Format differs somewhat from a conventional accounting format, it is entirely consistent with generally accepted accounting principles (GAAP). The significant difference between the Mattox Format and a conventional accounting system is the structure of its chart of accounts and the format of the major components of the profit-loss statement and the balance sheet, based on their respective chart of accounts. For the profit-loss statement, the Mattox Format comprises four major components: revenue, direct labor, indirect expenses, and miscellaneous revenue and expenses. Together, these four components will provide a firm's true overhead rate, net profit, and five other key financial performance indicators. Although the Maddox Format is not widely known or recognized by accounting professionals, the method has proven to be beneficial to many professional design firms. The Mattox Format is currently only available in one of the three integrated accounting software systems developed for professional design firms. PART 2: FIRM MANAGEMENT While conventional accounting systems are capable of providing these same per- formance indicators, the results will be more laborious to calculate and will not neces- sarily provide as accurate a result for some of these key indicators. The reason for this is that conventional accounting systems are set up with certain data shown in portions of the report that make it necessary to extrapolate and reorganize these data to allow for the calculation of these seven key financial performance indicators. 412 Financial Management Performance Goals Every professional design firm would do well to establish specific goals for its financial performance for each coming year. In order to provide a realistic set of performance goals, these goals need to be reviewed and modified to suit the current status of the firm's finances and the current and anticipated condition of the market for the firm's services. Because each firm is unique, these goals will vary from firm to firm. For many firms these goals are based on established mission and vision statements. Among the financial performance goals to consider are the following: • Projected net billing and revenue • Project consultant fees (as a percentage of total billing) • Project-relatedexpenses • Staff size and salary expense • Overhead expense and break-even rates (as a percentage of direct labor) • Net profit (as a percentage of net operating revenue) Included in these goals will also be the development of a competitive hourly billing rate for every member of the firm and their respective, targeted utilization rates for the coming year. It is recommended that every firm establish these performance goals before the start of the coming year. Once established, these performance goals will provide firm members with an opportunity to be as efficient and effective as possible through regu- lar monitoring of daily project activities and the accurate tracking of time spent each day on projects. Projected Net Billing and Revenue Financial planning begins with the projection of what the firm principal(s) believe to be a reasonable expectation of how much net billing (fees billed exclusive of expenses and consultants) and revenue the firm can create for the coming year. This would entail identifying current projects under contract that will carry over into the coming year and the balance of fees remaining to be billed on those projects in the coming year. This is commonly referred to as "backlog." Most firms maintain an ongoing backlog report to facilitate this process. Then, taking into consideration all outstanding project proposals and categorizing them as either a "prospect" (better than a 50 percent chance of being awarded) or a "suspect" (less than a 50 percent chance of being awarded) it is possible to assign a percentage of them being awarded to the firm and calculating their respective projected fee values. In addition, a firm's marketing plan will identify poten- tial new prospects and suspects, based on the current and anticipated market conditions and the opportunities to submit future proposals for these yet to be identified new projects. With these resources identified, a realistic, conservative net billing and reve- nue projection goal for the coming year can be established within the profit plan. Project Consultant Fees (as a Percentage of Total Billing) A firm's total revenue generally also includes other fees to be billed in addition to their own. Most common among these are the fees for project consultants. Refer to industry guidelines for what would be an appropriate percentage of a firm's total billings allocated to the fees of their project consultants. It is also advisable for each new prospective project, prior to submitting a fee proposal, to send a comprehen- sive request for proposal (RFP) to each of the required project consultants to be retained. Then, adding the project consultant's proposed fees to the firm's calculated net fee, the total fee can be established and the actual percentage of the total fee allo- cated to the project consultants can be determined. This percentage would then be compared to what the industry guidelines suggest to be reasonable and fair. This process will enhance a firm's ability to be more responsive to an existing or new client's request for a fee proposal for future work and result in the potential for increased profitability. Project-Related Expenses Each project, based on the fee basis stipulated in the contract, will have expenses that can be invoiced and subsequently reimbursed or expenses that will be a part of the total fee, as in a lump sum fee basis and not individually reimbursed. In addition, even for those proj- ects that have reimbursable expenses, there likely will be other expenses that will be non- reimbursable (e.g., in-house reproduction expenses for coordination, local mileage, unauthorized overtime, etc.). Because these common, project-related, non-reimbursable expenses reduce a project's profitability, they should be identified as a part of the fee-setting process and a unit cost established for each such expense. Doing so will result in establish- ing a more accurate net operating revenue and net profit for the prospective project. Staff Size and Salary Expense One of the performance goals to consider is a strategic plan for the staff size of a firm. The impact of the market and its economic condition will almost always play a role in establishing the number of employees in a firm. The great majority of firms in the United States are considered to be small firms. "Small," in this reference, is defined as fewer than 10 people, including the principal(s). Regardless of a firm's staff size, it is still important to plan for the annual cost of its employees and principals. Proportionally, annual salaries are the single largest expense for any firm. For most firms, approximately two-thirds of their total annual salaries will be project-related and will be the primary source of a firm's generated revenue and income. Of critical importance is the balance between staff size and the available project work. This balance is reflected in one of the seven P-L statement indicators: the ratio of the total direct labor expense to net operating revenue (net multiplier). To best reflect this balance, the total direct labor should be in the range of 28 to 32 percent of net operating revenue. If the ratio is considerably lower than 28 percent, it is a possible indication that there are insufficient hours being charged to project-related assignments. This might be the result of a reduction in project workload caused by a client stop-work order, or something affecting the entire industry like an economic slow-down. What- ever the reason, there will be times when the project workload is insufficient to allow staff to charge their "normal" number of direct hours (based on their respective, targeted utilization rates) and this will reduce the percentage of direct hours to NOR. If the ratio is considerably higher than 32 percent, there are several possible explanations: 1. Hours in excess of those budgeted or allocated are being charged to project-related activities. Potential negative impact is that a project's total fee is being used too quickly and profit is being consumed to cover these additional hours. 2. A large volume of overtime hours are being charged to project-related activities. This would be added to the project fee if the client authorized and was paying for these overtime hours at regular or premium billing rates. If not, since firms usually do not pay overtime for salaried professional staff, these overtime hours, while still charged to the project, would not have any cost related to them. They are charged as hours with a zero-cost impact on the project budget or overhead burden. While these hours do not increase direct labor expense (in dollars), they should be recorded for an accurate measure of direct hours required for project completion. This is important for establishing reliable historical data on how many hours it actually takes to complete a certain project type. 3. A business decision was made to spend the hours to "catch up" with the project schedule. If no compensation is made for these hours, it is the same as the situation described in number 2 above: zero-cost. If compensation is being provided, it is similar to number 1 above: potential fee drain and profit loss. For any and all of these above reasons, it is essential that the project hours charged are accurately and timely entered on each respective employee's daily timesheet. 414 Financial Management Overhead Rate and Break-Even Rate (as a Percentage of Direct Labor) The overhead rate and the break-even rate are inextricably related: • The overhead rate comprises two components: indirect labor and general and adminis- trative (G&A) expenses. Even though many G&A expenses are common to most firms, what these expenses specifically include will be a reflection of a firm's uniqueness in its operations and the types of discretionary benefits it offers its employees. Refer to the sample accrual profit-loss statement and the most common G&A expenses. • The break-even rate is equal to the overhead rate plus an assigned unit cost of 1.0 for hourly salaries. A firm with an overhead rate of 1.30 would have a corresponding break-even rate of 2.30 (1.30 + 1.0). Once a firm's overhead rate has been established, the break-even rate for every employee can also be calculated, based on their respective hourly salary rate. Example: For an employee who is paid a salary equal to $20 per hour ($41,600/2,080 hours) in a firm with an overhead rate of 1.30, the break-even rate for such an employee would be: $20.00 × 2.30 = $46.00 per hour. That means for the firm to break even on this particular employee's hourly salary and their respective portion of the firm's overhead cost, the hourly billing rate for their direct labor can be no less than $46.00 per hour. To include profit at a targeted percent- age of 20 percent, divide the break-even rate by 80 percent (the complement of 20%). This will establish an hourly billing rate of $57.50 ($46.00 ÷ 80% = $57.50; to check: $57.50 × 20% = $11.50 + $46.00 = $57.50). Net Profit On the accrual profit-loss statement, the net profit is considered to be a firm's "bottom line." It is the total dollars earned after all salaries and expenses have been deducted (regardless of payment) from the net operating revenue. The only thing remaining at this point, if a profit was earned, is the decision about its distribution to the staff and principal(s). The need to define the actual available cash-on-hand that would cover such distri- butions was previously discussed. There are examples of firms that, in spite of having earned a net profit, did not have adequate available cash-on-hand to make the distribu- tions they deemed appropriate. To supplement their available cash-on-hand and pay for these distributions, the principal(s) sometimes decide to tap into the firm's line of credit. In the case of firms that do not have a line of credit, some have been known to apply for a loan. While these are individual business decisions, they need to be consid- ered carefully as to the wisdom and soundness of this course of action. If the firm is extremely well-managed, the repercussion of such decisions might never be negatively experienced, but for most, taking on debt to pay bonuses is a decision laden with risk. Sometimes a firm has available cash-on-hand, but does not have any earned net profit at the end of the year. In this scenario, some may decide to go ahead and make modest distributions. Again, this is a business decision, but not necessarily a prudent one. Planning for profitability and its eventual distribution is a process to engage in before the start of each coming year to provide a firm with the best advantage to succeed. PROJECT CONTRACT-RELATED FINANCIAL MANAGEMENT ISSUES Most project contracts contain information that will require a keen awareness of its impact on potential project profitability and the periodic monitoring of a project's progress. Among the information to review and monitor carefully is the fee basis type, the basic scope of services, scheduled invoices, and other opportunities that might lead to supplemental/additional services, revenue, and income. Fee Basis Types Every project will have a designated type of fee basis. There are several types, and each basis has its own nuances and financial management implications. The following are the most common types: • Stipulated lump sum • Fixed fee + expenses (with or without a cap limit on expenses) • Percentage of construction cost • Hourly to a maximum + expenses • Hourly—open-ended (no established maximum) + expenses • Fee per unit/sf (mostly used on residential projects) + expenses For most project contracts the client will stipulate the type of fee basis. Public sec- tor (government, institutional) projects will almost always be on a stipulated lump sum or a percentage of construction cost fee basis. Private sector projects could be any one of the above types, depending on the client and the project type. Regardless of the fee basis type stipulated, each type affords a certain number of benefits and disadvantages, all of which need to be considered as one part of a "go/ no-go" decision to respond to a RFP. Scope of Services The scope of services is a portion of the project contract that bears careful scrutiny. The scope of services in many project contracts is not clearly defined, which leaves too much to interpretation by the reader. This can lead to disastrous results for the archi- tect, primarily in the area of lost revenue and subsequent lost income. To keep this from happening, it is advisable to have at least two senior members of the firm read and review the scope of services requirements to ascertain if any portions are unclear. There may be a need to stipulate the number included of a certain kind of meeting or the number of design scenarios per design phase to be prepared for client approval. Anything that is left open-ended and subject to interpretation may lead to a "bottomless pit" of expectations by a client. In addition to the above, certain words that are used in contracts with owners are likely to result in a difference of interpretation of what the client was requiring, or what the legal implications might be, and/or how the requirement might affect the profes- sional liability insurance carried by the firm. The most detrimental example is the words used in the indemnification clause of the contract. It is advisable to have a firm's legal counsel and their professional liability insurance carrier's representative review the contract to avoid any potentially expensive surprises. CONCLUSION Since each professional design firm is unique, so will be its respective operational policies and procedures. Therefore, prior to adopting any of the contents of this article, it is rec- ommended that firm leaders seek professional input from trusted outside sources famil- iar with the firm. At a minimum, firm leaders are urged to review and discuss this article with accounting advisers, both in-house and outside. Once discussed, any decisions to adopt specific changes to their current accounting system should be implemented by the accounting staff and as much outside professional guidance as is available. As a summation, the following are the main points of each of the major subtopics in this article: • Accounting and financial management reports: The essential distinction between accounting reports and financial management reports relates to the parties for whom these reports are created. Accounting reports serve to identify the external realm of a firm's financial performance as it relates to tax liability. Financial management reports serve to facilitate the internal decision-making process by a firm's leader(s). PART 2: FIRM MANAGEMENT 416 Financial Management • Cash-basis and accrual-basis reports: The two types of financial reports—cash basis and accrual basis—respectively serve a firm's accounting and financial management needs. These reports are interrelated in that they share the same data for time and money, but organize these data in different formats and with a different focus and purpose. In accounting parlance, the use of these two types of reports is referred to as "double-entry bookkeeping." • The Mattox Format: This article introduces a different approach to the accounting process and the concepts of financial management for professional service firms. The Mattox Format is a proven viable alternative methodology to what is generally commercially available for AE financial software systems. The Mattox Format has a 30-plus-year legacy since its introduction in the late 1970s and early 1980s by its designer and developer, Robert F. Mattox, FAIA (retired). • Performance goals: With planning and monitoring as two critical elements in any successful business operation, it is essential that a set of performance goals be estab- lished and reevaluated on an annual basis to allow for developing trends, operational and policy changes, and to remain competitive and profitable. BACKGROUNDER KEY FINANCIAL PERFORMANCE INDICATORS (METRICS) Steve L. Wintner, AIA Emeritus The profit-loss statement and the balance sheet each have a relevant number of key financial performance indicators that provide firm leaders with valuable metrics to assist them in understanding their firm's financial condition and guide them in making sound business decisions. THE PROFIT-LOSS STATEMENT The profit-loss statement includes the following seven indica- tors to calculate from each month's financial report (in no particular order): 1. Utilization rate: Measures the overall efficiency and effec- tive use of labor, not a measure of productivity. This also is not a measure of the number of hours billed, only hours charged to projects. Formula: direct labor hours ÷ total labor hours × 100 (as a %) Example: 32 hours ÷ 40 hours = 80% Target: Entire firm: 60-65% Professional-technical staff, including principals: 75-85% 2. Overhead rate: Measures the cost of operations not directly attributed to projects. Formula: total indirect expenses ÷ total direct labor (in $$$) Example: $308,241 ÷ $200,914 = 1.53 (for an hourly salary of $10/hr., the overhead cost would be 1.53 × $10 = $15.30) Target: 1.30 to 1.50 of total direct labor 3. Break-even rate: Measures the total cost of operations for every dollar spent on direct labor. Formula: overhead rate + 1.00 (represents the unit of cost for an hour of salary) Example: 1.53 + 1.00 = 2.53 (for an hourly salary of $10, the break-even cost would be 2.53 × $10 = $25.30) Target: 2.30 to 2.50 of total direct labor 4. Net multiplier: Measures the revenue generated for every dollar spent on direct labor. This indicator must be greater than break-even rate for a net profit to be realized. Formula: net operating revenue ÷ total direct labor (in $$$) Example: $622,207 ÷ 200,914 = 3.1 Target: Greater than break-even rate (industr y benchmark: 3.0+) 5. Profit-to-earnings ratio: Measures the firm's effectiveness in generating a net profit (as a %). Formula: net profit (before distributions and tax) ÷ net operating revenue Example: $108,817 ÷ $622,207 = 17.49% Target: Equal to or greater than the anticipated net profit in the annual profit plan (20% or greater) 6. Net revenue per employee: Measures the revenue earnings for each employee. Based on targeted net profit, this indicator contributes to the establishing of the net operating revenue in the coming year's annual budget. Formula: annual net operating revenue ÷ total number of employees Example: $622,207 ÷ 6 employees = $103,701 per employee Target: In excess of $100,000.00 per employee 7. Aged accounts receivable: Measures the average time interval in days between the date of outstanding invoices and the date payment is received. Formula: average annual accounts receivable ÷ (net oper- ating revenue ÷ 365 days) = calendar days before pay- ment is received Example: $245,090 ÷ ($622,207 ÷ 365 = 1,705) = 144 calendar days Target: 60-90 calendar days (Anything over 90 days means the firm is "lending" money to client at zero cost.) THE BALANCE SHEET The balance sheet includes the following four indicators to cal- culate from each month's financial report (in no particular order): 1. Solvency: Measures a firm's ability to pay current debt. This is also known as the "current ratio." Formula: total current assets ÷ total current liabilities Example: $521,667 ÷ $218,658 = 2.39 Target ratio: Min. 1.5 to 1.0 2. Liquidity: Measures a firm's ability to convert assets to cash. This is also known as the "quick ratio." Formula: (cash + accounts receivable + revenue earned, not billed ["work in progress"]) ÷ total current liabilities Example: $518,194 ÷ $218,658 = 2.37 Target ratio: Min. 1.0 to 1.0 3. Leverage: Measures a firm's ability to manage debt effec- tively. This is also known as "debt-to-equity" (as a %). Formula: total liabilities ÷ total equity × 100 (as a %) Example: $280,738 ÷ $949,451 = 29.57% Target: Less than 35% 4. Return on equity: Measures the accumulated amount of money returned on a stockholder's investment for their risk and efforts. Formula: (total net operating revenue − total expenses) ÷ total equity × 100 (as a %) Example: ($622,207 − $509,156) ÷ $949,451 × 100 = 11.9% Target: Equal to or greater than the anticipated net profit in the annual profit plan (20% or greater) PART 2: FIRM MANAGEMENT 7.3 Financial Management Systems Steve L. Wintner, AIA Emeritus The primary function of financial management systems is to provide firms with numerous effective financial and project reports and supporting techniques to enhance the achievement of a firm's long-term financial goals. INTRODUCTION To ensure the financial success of any firm with at least one or more employees, it is essential to have a comprehensive financial management system that includes a number of types of reports and resources. These reports and resources will facilitate a firm leader's ability to manage the financial operations of the firm. Every firm leader needs to understand and be responsible for this process of management. This is one respon- sibility that is not to be delegated to anyone lacking this understanding and knowledge. Steve L. Wintner is the founder and principal of Management Consulting Services, a Houston- based firm specializing in design firm management. Wintner has more than 35 years of experience in design firm management and is the coauthor of Financial Management for Design Professionals: The Path to Profitability (Kaplan Publishing, December 2006). 418 Financial Management The reports and resources providing basic information as a part of this financial system include the chart of accounts, the annual budget, the profit plan, daily timesheets, project contracts, financial management reports, key financial performance indicators, and project reports. CHART OF ACCOUNTS The development of a chart of accounts is the foundation of every accounting system and its means of organizing a firm's financial data. The chart of accounts, reflecting the Mattox Format, represents sets of properly organized, multi-tiered, interrelated, numeric codes and/or account numbers. Each one serves as the repository and record for every dollar received, paid, and billed by a firm as shown on a profit-loss statement and balance sheet. The hierarchy of the numeric codes and/or account numbers starts with a "major" code or account and then is further defined by a series of sub-codes or accounts. Most comprehensive AE accounting software systems provide for a four-digit numeric code and/or account number. Each account number and designation will match a firm's general ledger listing of the income, expense, and asset accounts. It is recommended to seek the guidance of an outside consultant (management, software representative, and accounting) to assist with establishing these numeric codes and/or account numbers, especially if applying the Mattox Format (see Table 7.1). A "master" chart of accounts is developed for the profit-loss statement and the bal- ance sheet. The accounting software will provide a means for switching between the cash-basis and accrual-basis reports for these two documents and their respective numeric codes and/or account numbers. ▶ Financial Management Overview (7.2) further describes the Mattox Format. MATTOX FORMAT FOR THE CHART OF ACCOUNTS The following is a sample of the structure for the chart of accounts in the Mattox Format for the accrual-basis profit- loss statement and the balance sheet. Only major headings are shown in most accounts; for more detailed information, see "7.4 Developing Annual Budgets and Profit Planning." TABLE 7.1 Chart of Accounts Account ID Account Description Account Group Notes 4100 Fees Billed Fees Billed Positive dollars 4110 Architect Fees Billed Fees Billed 4120 Consultants Fees Billed Fees Billed 4130 Markup on consultant fees billed Fees billed 4150 Reimbursable Expenses Billed Reimbursable Expenses Billed Positive dollars 4170 Outside Consultants' fee invoices rec'd Outside Consultants Negative dollars 4190 Project-Related Expenses (reimb.+ non-r.) Project-Related Expense Negative dollars A. Total Net Operating Revenue (NOR) Baseline at 100% 5110 Direct Labor: Principal Direct Labor Expense 5120 Direct Labor: Professional-Technical Direct Labor Expense 5130 Direct Labor: Administrative Direct Labor Expense 5140 Direct Labor: Contract Direct Labor ExpenseTABLE 7.1 (continued) Account ID Account Description Account Group Notes B. Total Direct Labor Expense (TDL) 6110 Indirect Labor: Principal Indirect Labor Expense 6120 Indirect Labor: Professional/Technical Indirect Labor Expense 6130 Indirect Labor: Administrative Indirect Labor Expense 6140 Indirect Labor: Temporary Indirect Labor Expense 6200 Payroll Taxes & Nondiscretionary Benefits Payroll Taxes & Nondiscretionary Benefits 6300 Discretionary Benefits & Professional Development Discretionary Benefits & Professional Development 6400 Office Lease & Facility Expense Lease & Facility Expense 6500 General Office Expenses General Office Expenses 6600 Business Insurance Business Insurance 6700 Auto Expense Auto Expense 6800 Bank Charges Bank Charges 6900 Professional Services Professional Services 7100 Depreciation/Amortization Expense Depreciation/Amortization Expense 7300 Tax Expense Tax Expense 7400 Marketing & Business Development Marketing & Business Development C. Total Indirect Expenses D. Total Expenses (Direct + Indirect) (B + C) E. Profit or <Loss> from Operations (A - D) 8100 Miscellaneous Revenue Misc. revenue 8500 Miscellaneous <Expense> Misc. <expense> F. Total Miscellaneous Revenue/<Expense> G. Net Profit (before distributions & taxes) (E - F) The "bottom line" 9110 Principal: Accrued Bonus Distributions 9120 Professional/Technical: Accrued Bonus Distributions 9130 Administrative: Accrued Bonus Distributions 9140 Temporary Accrued Bonus Distributions 9210 Principal: Paid Bonus/Draw Distributions 9220 Professional/Technical: Paid Bonus Distributions 9230 Administrative: Paid Bonus Distributions 9240 Temporary Paid Bonus Distributions H. Total <Distributions> I. Current Earnings (G - H) ANNUAL BUDGET The chart of accounts and the annual budget are interrelated resources. Each chart of accounts numeric code and/or account number represents a specific type of financial data that corresponds to a specific annual budget line item. PROFIT PLAN The "bottom line" of the accrual-basis profit-loss statement is the line item identified as "net profit." In order to arrive at a desired net profit at the end of each year, it would be a sound business decision to plan in advance for that to happen. The profit planning process entails a number of significant components, each one having an impact on establishing a certain number of parameters to be achieved. The achievement of each of these param- eters helps to enhance the chances that a year-end, targeted net profit would be realized. RECORDING DIRECT AND INDIRECT TIME Are timesheets generally treated as though they are one of the most important financial resources of every professional design firm? Sadly, the answer is a resounding "No!" Yet this is the only "commodity" that firms "sell" to their clients. Unfortunately, timesheets are seen by many employees as some form of diabolical, arbitrary ritual created by their bosses. At the same time, principals are often the worst offenders in terms of not filling out their timesheets in a timely and accurate manner. Clearly, few firm leaders and staff recognize that the timesheet is, in fact, one of the most important financial resources of every professional design firm. Here are some facts that confirm this assertion. The time reflected on a timesheet becomes the single most significant component of the accounting data-entry process. This is true because the hours charged to projects become the basis for the decision of how much to invoice for each project and subse- quently, affect a project's eventual profit or loss. The amount invoiced and payment received is the lifeblood of every firm. In addition, timesheets allow for tracking of effort spent on each project, which is critical to comparing project progress to the project budget and to allow timely adjustments as appropriate. Time spent on every project should be aligned with the allocated number of hours budgeted for each phase and task. Without timely, accurately completed timesheets, there is a real possibility of a disparity between the time spent and the dollars billed. Ideally, the fee amount value of each project invoice will be determined by the hours spent on each project each month. With untimely, inaccurate timesheets, there is a potential for a reduction of the targeted project profit. On a firm-wide basis, the total hours charged to projects is the denominator used in the calculation of a firm's net multiplier and overhead rate. The calculated overhead rate can then be extended to reflect the corresponding break-even rate, both of which are essential elements of developing hourly break-even rates for every employee. Fur- ther, this data provides historical information for project fee budgets during the fee- setting process, in response to a client's request for proposal (RFP). If the time entered on a timesheet is at best just an approximation, then the data- entry process compounds the problem by the incorporation of this unfortunate estimate of hours in the development of project, accounting, and financial management reports. The resulting totals and indicators will then provide misleading, erroneous infor- mation to the project managers and firm leaders. This is further compounded and harmful to the financial well-being of a firm when multiples of these guessed-at hours charged to projects on numerous timesheets become the basis of future overhead rates used in the fee-setting process for new projects. Measured over multiple active projects for a firm, it is easy to comprehend the increased magnitude of the problem and its potentially negative impact on each project and, overall, on a firm's annual profitability. Obviously, none of this is done with malice, just a lack of understanding about the true nature of what a timesheet represents in the total process of the financial manage- ment of a firm. With less than an hour's worth of training, every member of the firm can develop a better daily timesheet completion discipline. This would go a long way to enhancing a firm's efficiency, effectiveness, and profitability. These kinds of "savings" in lost revenue could mean the difference of a year-end net profit vs. a net loss. As such, it might also mean the difference in whether or not there will be a distribution of year- end bonuses and/or salary increases. All this exposure to undesirable outcomes results from a lack of understanding about the true nature of a timesheet and its critical role in every professional design firm's long-term success. The following are some simple techniques to adopt as a discipline for the comple- tion of a timely and accurate timesheet. • Develop a personal log and record the time spent before you start a different task, or phase. • Record time in not less than 15-minute increments. • Twice a day, enter on the timesheet the time spent in the morning, just before taking a lunch break, and again in the afternoon (evening), just before leaving the office for the day. • All authorized overtime hours spent are to be recorded. The local or state agency that governs the state labor standards and the terms of the project contract will be the determining factors in the hours having any cost to the project. Regardless of any cost impact, the hours must be reflected on the project reports. In any scenario, overtime hours do not incur the cost of any overhead burden. The overhead burden is only applied to the first 40 hours per week. Therefore, any overtime to be charged to a client, in accordance with the state labor standards and the project contract, will likely be at a lower hourly rate than the regular hourly billing rate, due to the absence of the overhead cost burden. FINANCIAL REPORTS The focus of this portion of the article will be an overview of the two most common financial reports: the profit-loss statement and the balance sheet. For the purposes of this discussion, the reference to the profit-loss statement and the balance sheet is to the accrual-basis report for each. The profit-loss statement and the balance sheet reports are developed at least once on a monthly basis. Each report provides firm leaders with different types of financial information for uniquely different purposes. The P-L statement reflects the results of a firm's operations in terms of its revenue, direct labor, indirect labor, indirect expenses, and net profit for a given accounting period (generally the current month and the year to date). The balance sheet provides a description of a firm's current financial condition for any given accounting period, even as short as a single day, of its assets, liabilities, and equity. In the review of each report, there are specific line items that are more significant than others and will provide tell-tale trends of how the firm is doing financially. Together, these two reports describe a complete picture of a firm's current financial status. Profit-Loss Statement (P-L) The P-L statement is the financial management report that will provide firm leaders with 7 of the 11 total key financial performance indicators. On the P-L, the four most significant line items are these: • Net operating revenue (dollars available for supporting daily operations and the baseline 100 percent value of the rest of every line item in the report) • Total direct labor, as a percentage of net operating revenue • Totalexpenses • Net profit (before distributions and tax and referred to as the "bottom line") Developing an annual budget for these line items and their respective sub- categories is advisable. The Key Financial Performance Indicators backgrounder article explains what to look for and how to interpret the implications of the developing trends for each of these line items. This understanding is essential to making sound business decisions to offset negative trends and to repeat activities that produce positive trends. "Executive Summary" Format The P-L statement that is provided to a firm leader needs to incorporate the same three "Cs" that are taught regarding the quality of construction documents: informa- tion that is "clear, concise, correct"—for all the same reasons and then some. A firm leader's time is of the highest value to the firm and its clients and therefore needs to be spent doing only the things that only they can do. As stated early on in this section, the management of a firm's financial operations should not be delegated to just anyone. The reading, review, and interpretation of the P-L are the first and most important aspects of managing a firm's financial operations. To make this process as effective and efficient as possible for the firm leaders, it is essential to create a single-page "executive summary" of the P-L. This condensed ver- sion includes every part of the full P-L, but not in detail. The chart of accounts numeric codes or account names should be condensed into a limited number of relevant line items for each of the four component sections of the statement. This will allow for the report to fit on just one page. Mattox Format P-L Statement The Mattox Format for the P-L statement includes the following four vertical compo- nent (row) sections (see Table 7.2): • Revenue • Direct Labor (Salary) Expense • IndirectExpenses • Miscellaneous Revenue and Expense Each of these four components has a group of line items that serve as a major description for its respective component. Each of these line items has, in turn, a limited number of subcategory line items for each description. The subcategory line items are up to the discretion of the firm leader(s), who can decide what line items they want to review for each major category. Awareness is required to main- tain the single-page format. In the event that any subcategory line item comes into question, all of the supporting financial details are available from the firm's account- ing system. The Mattox Format also includes six columns for component sections: • CurrentMonth • Percent for Current Month • Year-to-Date(YTD) • PercentforYTD • YTDAnnualBudget • Percent for YTD Annual Budget Each of these six columns reveals a specific detail about the firm's current and cumulative (YTD) quantitative data in dollars and percentages. Together, these horizontal and vertical components provide a very comprehensive summary of the firm's financial activity for the current month, the year-to-date, and a comparison to the corresponding year-to-date annual budget. MATTOX FORMAT FOR THE PROFIT-LOSS STATEMENT TABLE 7.2 Sample Profit-Loss Statement in the Mattox Format Sample/Example—Accrual Basis, Actuals Current Year-to-Date Profit-Loss Statement Month % Year-to-Date % Budget % Revenue Fees Billed (incl. consultants + markup) 93,599 142.22 1,113,654 141.02 1,184,738 142.28 Reimbursable Billed (incl. markup) 13,248 20.13 164,981 20.89 177,399 21.31 Outside Consultants (25,417) (38.62) (305,007) (38.62) (327,964) (39.39) Project-Related Expenses (non-reimb. exp.+ (15,618) (23.73) (187,411) (23.73) (201,517) (24.20) reimb. exp.) A Net Operating Revenue 65,812 100.0 789,738 100.0 832,656 100.0 Direct Labor (Salary) Expense Direct Labor: Principal(S) 7,950 12.08 96,760 12.51 95,000 11.41 Direct Labor: Professional/Technical Staff 9,996 15.19 125,022 15.83 126,834 15.23 Direct labor: admin. Staff 724 1.10 9,988 1.26 10,920 1.31 Direct Labor: Contract 2,100 3.19 28,000 3.55 30,000 3.60 B Total Direct Labor (Salary) Expense 20,770 31.56 259,770 32.89 262,754 31.55 Indirect Expenses Admin. Labor: Principal(S) 7,590 11.53 93,240 11.81 95,000 11.41 Admin. Labor: Professional/Technical Staff 2,740 4.16 31,623 4.00 29,811 3.58 Admin. Labor: Admin. Staff 1,690 2.56 21,212 2.69 20,280 2.44 Admin Labor: Temporary Help 0 0.00 6,017 1.10 4,330 0.52 Paid Time Off (total or by staff type)* 1,830 2.78 20,533 2.60 20,816 2.50 Payroll Benefits (FICA/Medicare, medical and 8,062 12.25 96,742 12.25 91,811 11.03 life insurance, etc.) Discretionary Benefits 395 0.60 4,355 0.55 4,746 0.57 Office Lease 3,325 5.05 39,900 5.05 39,900 4.79 Office Expense 2,120 3.22 26,498 3.40 24,980 3.00 Professional Liability/General Office Insurance 0 0.00 9,040 1.14 10,655 1.28 Interest Expense 0 0.00 7,477 0.95 9,322 1.20 Professional Business Consultants 1,000 1.52 10,891 1.38 12,736 1.53 Taxes: Local Property/Franchise 0 0.00 8,325 1.05 9,940 1.19 Depreciation/Amortization 6,372 9.68 6,372 0.81 7,987 0.96 Marketing/Business Development 974 1.48 19,679 2.49 21,524 2.58 C Total Indirect Expenses 36,098 54.85 401,904 50.89 403,838 48.50 D Total Expenses (B + C) 56,868 86.41 661,674 83.78 666,592 80.06 E Profit - Loss (A - D) 8,944 13.59 128,064 16.22 166,064 19.94 Miscellaneous Revenue/Expense Miscellaneous Revenue Interest Earned 613 0.93 9,675 1.23 11,300 1.35 Gain on Assets 0 0.00 0 0.00 0 0.00 Retained Bid Deposits 0 0.00 750 0.09 0 0.00 Total Miscellaneous Revenue 613 0.93 10,425 1.32 11,300 1.35 PART 2: FIRM MANAGEMENT 424 Financial Management Profit-Loss Statement Current Month % Year-to-Date % Year-to-Date Budget % Miscellaneous Expense Bad Debt (Write-Off) Allowance 0 0.00 (2,415) (0.31) (3,000) (0.36) Loss on Assets 0 0.00 0 0.00 0 0.00 Miscellaneous (Expense) 0 0.00 (545) (0.07) (188) (0.02) Total Miscellaneous Expense 0 0.00 (2,970) (0.38) (3,188) (0.38) F Net Total Miscellaneous Revenue/Expense 613 0.93 7,465 0.95 8,112 0.97 G Net Profit/(Loss) Before Tax** and Distributions (E + F) 9,557 14.52 135,529 17.16 174,176 20.92 Distributions Principal: Accrued Bonus 9,167 13.93 110,000 13.93 140,000 16.81 Professional/Technical: Accrued Bonus 1,250 1.90 15,000 1.90 20,000 2.40 Administrative: Accrued Bonus 250 0.38 3,000 0.38 4,000 0.48 Temporary: Accrued Bonus 0 0.00 0 0.00 0 0.00 Total Accrued Bonus 10,667 16.21 128,000 16.21 164,000 19.70 Principal: Paid Bonus & Draws (50,000) (9.53) (110,000) (13.93) (140,000) (16.81) Professional/Technical: Paid Bonus (7,500) (2.38) (15,000) (1.90) (20,000) (2.40) Administrative: Paid Bonus (1,500) (0.48) (3,000) (0.38) −4,000 (0.48) Temporary: Paid Bonus (500) 0.00 (500) 0.78 0 0.00 H Total Distributions (59,500) (12.4) (128,500) (16.21) (164,000) (16.81) Provision for Income Tax*** 0 0.00 (1,054) (0.13) (1,526) (0.18) I Current Earnings (G - H) 5,975 0.76 8,650 1.04 *This is an optional line item. If used, it must be added to both the direct and indirect labor line items to calculate total salaries. **This does not apply to S-corps, LLPs, partnerships, or sole proprietors. Discuss with your tax consultant. ***The provision for income tax is determined by the cash-basis income statement. The numbers are entered here only after being determined by the firm's accounting person. Revenue Component of P-L The Revenue component establishes the baseline value for the net operating revenue (NOR) at 100 percent. Every other line item in the P-L is a corresponding percentage of the NOR. The Revenue section is further divided into four sub-major line items: Fees Billed, Reimbursable Expenses Billed, Outside (Project) Consultants (O-C), and Project- Related Expenses. Each of these sub-major line items is further defined by a number of sub-categories. 1. Fees Billed for: a. Architect b. Outside Consultants c. Markup on O-C fees to be billed Fees Billed are shown as positive dollar amounts. 2. Reimbursable Expenses Billed for: a. Architect b. Outside Consultants (equal to the invoice amounts received from the O-C for the billing period) c. Markup on all expenses to be billed Reimbursable expenses billed are shown as positive dollar amounts. 3. Outside Consultants: Equal to the fee invoice amounts received from the O-C for the billing period Outside Consultants is shown as a negative dollar amount (debit to Net Operating Revenue). 4. Project-Related Expenses (for the following five types): a. Architect's reimbursable expenses, markup not included b. O-C reimbursable expenses (amount invoiced to architect), markup not included c. Project-related expenses included in all of the lump sum fee projects billed d. Project-related non-reimbursable expenses for the firm that are not allowed by clients, per the contracts e. Project-related reimbursable expenses that exceed any contract-stipulated maximum Project-Related Expenses are shown as negative dollar amounts (debit to Net Oper- ating Revenue). Notes: Items 4a + 4b equal items 2a + 2b less markup. Items 3 and 4b represent the dollar values of the invoiced amounts received from the O-C for the billing period. Balance Sheet The balance sheet is the second of the two primary financial management reports and represents an opportunity to look at the firm's financial condition at any time. Because the report is updated every time financial data is entered into the account- ing system, it is capable of providing an "instant snapshot" of the firm's financial condition. On the balance sheet, the four most significant line items are these: • Current Assets: Those easily converted to real dollars • Current Liabilities: Items that must be paid within the current 12-month period, irrespective of the calendar year, that diminish the value of a firm's retained earnings and thereby reduce equity • Long-term Liabilities: Items that must be paid beyond the current 12-month period and diminish the impact of the value of a firm's retained earnings (and thereby reduce equity) • Equity: The value of shares of stock, invested capital by shareholders, and the firm's cumulative retained earnings (or loss) • Current Assets (Cash-on-Hand, Accounts Receivable, and Fees Earned Unbilled [Work-in-Progress, or WIP]) are line items that need careful, regular scrutiny to ensure that the firm is maintaining a proper margin over its liabilities. The Cur- rent Liabilities to monitor and manage are Accounts Payables and Short-Term Notes Payable. Equity will reflect the cumulative Earnings (or Loss) over the life of a firm, based on each year's Current Earnings (or Loss) from the year-end P-L reports. Theterm"Balance"reflectsthatTotalLiabilitiesandTotalEquityalwaysequalthe Total Assets. This report will provide the remaining 4 of the 11 total key financial performance indicators. "Executive Summary" Format The balance sheet is less complex in its format than the P-L statement. Because this report is in a state of almost constant change, only a single column of figures is required. If a firm leader desires, the subtotals and totals for each section can be offset from the body of line item figures. Like the P-L, maintaining the single-page Executive Sum- mary format is also an important consideration. The balance sheet and the profit-loss statement share certain financial data. Among these are: • From the profit-loss statement to the balance sheet: Bad Debt, Current Earnings, and Accrued Bonus • From the balance sheet to the profit-loss statement: Accumu- lated Depreciation/Amortization Balance Sheet Components and Line Items There are two key words on the balance sheet that require a definition to clearly understand their respective mean- ings. The words "current" and "long-term" are referred to in connection with all three of the major components: assets, liabilities, and equity. These words occur through- out the balance sheet, both as major components as well as a number of different line items. Each time these words occur, they carry the same meaning. "Current" is the current 12-month period, irre- spective of the calendar year, and "long-term" is any time frame beyond the current 12-month period. Specific examples: • "Notes Payable—Current Portion" in Current Liabilities • "Notes Payable—Long-Term Portion" in Long-Term Liabilities Mattox Format Balance Sheet The Mattox Format for the balance sheet consists of five vertical component (row) sections, which include: two groups of Assets (Current and Long-Term), two groups of Liabilities (Current and Long-Term), and a single Equity component (see Table 7.3). The differences between the Mattox Format and a conventional balance sheet are related to subcategory line items and are minimal. Like the P-L Statement, each of these five component sections is further divided into a group of line items that serve as a major description for the component. Each of these major descriptions has a limited number of subcate- gory line items for each description. These subcategory line items, unlike the P-L statement subcategory line items, are not discretionary. They represent essential data that need to be shown to allow the report to be effectively reviewed and understood. In the event that any subcategory line item comes into question, all of the supporting financial details are available from the firm's accounting system. FREQUENCY OF DISTRIBUTION FOR FINANCIAL REPORTS The frequency of distribution for the Executive Summa- ries of the two financial reports is a decision to be made by the firm leaders and, in many situations, is a function of the size and complexity of the firm. In general, however, even in small firms, most firm leaders will expect to receive an updated set of financial reports on a monthly (30-day) MATTOX FORMAT FOR THE BALANCE SHEET The following is a sample of the balance sheet in the Mattox Format. TABLE 7.3 Balance Sheet Current Assets Cash (Checking, MMF, CDs, etc.) $56,768 Accounts Receivable 245,090 Allowance for Bad Debt (3,115) Fees Earned Unbilled (Work-In-Progress) 16,336 Prepaid Expenses/Insurance 4,588 Other Current Assets (Lease Security 2,000 Deposit, etc.) A. Total Current Assets $321,667 Fixed Assets Furniture & Equipment $68,058 Leasehold Improvements 20,465 Company-Owned Autos 28,788 Property and Buildings 103,436 Accumulated Depreciation/Amortization (12,225) B. Total Fixed Assets $208,522 C. Total Assets (A + B) $530,189 Current Liabilities Notes Payable—Current 12 Months $16,140 Accounts Payable 49,788 Fees Billed Unearned 15,750 Retainers/Initial Payments Unearned 7,500 Accrued Payroll Taxes (Employer's Portion) 4,128 Federal Income Taxes—Withheld 3,644 Accrued Vacation 4,663 Accrued Bonus 107,500 Other Current Liabilities $9,545 D. Total Current Liabilities $218,658 Long-Term Liabilities Balance of Notes Payable (not incl. $51,340 Current Installments) Other Long-Term Liabilities (Beyond Current 10,740 12 Months) E. Total Long-Term Liabilities $62,080 F. Total Liabilities (D + E) $280,738 Stockholder's Equity Common Stock (Par Value) $1,000 Additional Paid-In Capital 80,000 Current Earnings (at end of Current Yr.) 9,619 Previous Cumulative Retained Earnings 158,832 G. Total Stockholder's Equity $249,451 H. Total Liabilities & Equity (F + G) $530,189 Note: Total Liabilities & Equity always equals Total Assets (H = C) basis, if not more frequently. This timing rarely occurs at the end of a calendar month. Rather, it is related to the completion of the accurate entry of all of the relevant, cur- rent financial data into the accounting system. Firm leaders need these data as quickly as possible to allow them to have the best opportunity to respond in a timely manner to developing trends. Obviously, those firms with an integrated, computerized account- ing system will have a distinct advantage over those using less-sophisticated software. In addition to the firm leader(s), there may also be a need to provide a current report to governmental agencies, insurance companies, banks, and perhaps even new prospective clients. Having accurately completed daily timesheets once again becomes a key factor in the efficiency and accuracy of the accounting systems data-entry process and its final, monthly distributed reports. CONCLUSION In general, any well-designed and properly integrated financial management system will enhance a firm's opportunities for financial success. To do so requires the develop- ment of a number of properly formatted reports and data-tracking components for use in these reports. The regular, periodic monitoring of these reports will facilitate the necessary adjustments to maintain a firm's financial success. Prior to adopting any of the contents of this article it is recommended that each firm seek professional input from trusted outside sources familiar with the firm. At a minimum, firm leaders are urged to review and discuss this article with accounting advisers, both in-house and outside. Once discussed, any decisions to adopt specific changes to their current accounting system will need to be implemented with its accounting staff and as much outside professional guidance as is available. 7.4 Developing Annual Budgets and Profit Planning Steve L. Wintner, AIA Emeritus Developing an annual budget is an integral part of a firm's strategic planning process. When developed in concert with the profit plan, an annual budget is an essential resource that will allow firm leaders to compare a firm's actual year-to- date (YTD) financial performance to its YTD annual budget. DEVELOPING ANNUAL BUDGETS Introduction The annual budget, developed concurrently with the profit plan, affords firm leaders the best possible method of establishing guidelines for the firm's operations and finan- cial effectiveness over the course of the coming year. The annual budget utilizes numerous financial components that are developed by the profit plan. For this reason, among many others, it is important that these Steve L. Wintner is the founder and principal of Management Consulting Services, a Houston- based firm specializing in design firm management. Wintner has more than 35 years of experience in design firm management and is the coauthor of Financial Management for Design Professionals: The Path to Profitability (Kaplan Publishing, 2006). PART 2: FIRM MANAGEMENT 428 Financial Management two financial "tools" be developed concurrently to ensure the seamless sharing of essential data needed by both. The chart of accounts provides a foundational format for the annual budget, in that the budget will, in its most detailed form, utilize most, if not all, of the established major and subaccount line items. In fact, it would be advisable to use the chart of accounts as the primary organizing element for the annual budget. A detailed explana- tion and example follows. Because the development of the annual budget, like the profit plan, is an annually recurring process, it is advisable to begin its development in the latter stages of the fourth quarter of the preceding year. Mid-October, for those who have never developed an annual budget before, would not be too early to start the process. Starting early will allow sufficient time to thoroughly and methodically go through each step without the pressure of the coming year commencing before the budget is completed and can be approved. Annual Budget The annual budget, when properly developed, will include the chart of account num- bers and data from the profit plan. In its initial format, the annual budget will resemble an expanded version of the profit-loss statement (P-L). This expanded version (Tables 7.4-7.7) includes both fixed and variable expenses. This format allows for every known or anticipated expense to be included. This level of detail ensures a greater pos- sibility of capturing the expenditures for the coming year. Once this level of budget is as complete as possible, it would be reviewed by the appropriate firm leaders to make any final adjustments and to reach consensus on its approval. Once approved, the fixed and variable indirect expenses for the same major account numbers can then be combined in a "collapsed" version (Table 7.8) of the completed, expanded version. The major accounts shown in this collapsed version would then be used to develop the approved final annual budget version (Table 7.9). The approved final annual budget would also be

Chapter 16

CHAPTER 16 Risk Management 16.1 Risk Management Strategies Peter Gifford Longley, AIA, CSI CCS, LEED AP Being in the business of architecture means taking risks. But any good endeavor, like the privilege of practicing architecture, is worthy of some risk. The best approach is to know the risks, and then know how to manage them. HOW DOES THE ARCHITECT MANAGE RISK? The word "risk" derives from the archaic Italian word riscare, which means "run into danger," or to imperil, endanger, or jeopardize. All choices in life entail some risk; for example, play and risk injury, or pass and risk boredom. When a decision is made to risk one thing or another, security lies only in managing the risk. There are four classic strategies, all used by prudent firms to manage risk. These are manifested in the practice of architecture as shown in Table 16.1. Identifying Sources of Risk Some aspects of the practice of architecture are, by nature, more likely to create unmanageable risk—risk of claims that place a firm's reputation, even its existence, in jeopardy. Professional liability insurance companies track actual claims by category, frequency, and cost. These data are used to determine premiums—costly for customers servicing areas of greater risk, and less so for those where risks are low. TABLE 16.1 Strategies to Manage Risk Avoid Risk Transfer Risk Assume Risk Control Risk Marketing selects project types that fit with prior experience, working for clients with excellent reputations. Contracts transfer risk appropriately to the client, or downward to a consultant. Insurance transfers risk to a business financial partner. Accept appropriate work, but maintain enough cash to responsibly satisfy insurance deductibles. Adopt best practices, and educate staff. Seek good counsel to prevent or reduce losses when claims emerge. 40% 35% 30% 25% 20% 15% 10% 5% 0% Negotiation and Contracts Client Selection Project Team Capabilities Communication Top 4 Non-Technical Risk Drivers Percentage of Claims Affected 39% 2001 2012 23% 24% 25% 27% 13% 6% 16% 990 Risk Management Measured liability losses, organized by category, form a quantifiable basis for decoding areas of greatest risk. Professional liability insurance provider XLGroup identifies nine such categories in its Risk Drivers research: 1. Communication 2. Project team capabilities 3. Client selection 4. Negotiation and contracts 5. Budget control 6. Schedule control 7. Loss prevention issues 8. Construction phase services 9. Billing procedures XL Group's Risk Drivers research reveals that one or more of areas 1 through 4, shown in Figure 16.1, were present in 93 percent of all claims. Therefore, a focus on these four areas will address most causes of risk to architects—to determine best prac- tices to avoid, to transfer, or to control risk...reasoning, alternatively, which risk is reasonable to assume. The four greatest areas of risk that architects face are examined below, with poten- tially effective means to manage each of them also discussed. The order is to build to a key risk factor. NO. 4: NEGOTIATION AND CONTRACTS Claims almost always appear in a legal form, targeted directly at the failure of the architect to comply with some term of their design services agreement—the document that set forth the responsibilities now in dispute. (See Figure 16.2.) Not surprisingly, Risk Drivers data provided by The Design Professional unit of XL Group FIGURE 16.1 Chart Depicting the Four Greatest Areas of Claims PART 4: CONTRACTS AND AGREEMENTS Negotiation and Contract Issues No separate contingency fund set aside 5% Other 8% Lack of mediation clause 6% Unclear or inappropriate scope of services 38% Contruction phase services not in contract or not fulfiled 8% Did not formally evaluate project risks 16% Contract: - Not firms own -Not industry std. - Not reviewed by counsel 2% Contract not in place before work started 12% Deal breakers in contract 3% Field staff didn't have/understand contract 2% Client-generated agreement, not reviewed by senior mgmt. 1% Risk Drivers data provided by The Design Professional unit of XL FIGURE 16.2 Chart Depicting Negotiation and Contracts Claims by Type the contract is the first piece of paper consulted when a claim comes to light. Designers frantically examine it to learn if the claim has any basis in reality. Copies are requested by attorneys and insurance companies. Everyone scours it for the magic words that prove their perspective, supporting or refuting the claim. Long before the claim emerged, times were happier. At the beginning of the proj- ect everyone is excited about getting started. Still, the project is, after all, a business deal—a contract—a fee paid for services rendered. Central to both the client's and architect's mind are the large matters: the project description, the site, the program, the schedule, the budget. Next come the means to get there: the team, the consultants, the services needed, what's included, what's not, and the fees. Finally come the terms and conditions: all the legal fine print governing everything mentioned, and then some. The main characters typically lose interest at this point—the prime reason projects often begin without a contract in place. They turn over the business of sorting out the details to other people. These main characters are the same ones who frantically reach for the contact (if it was ever executed) once the claim notice arrives. They need to see what was previ- ously agreed. That day's conclusion will likely be determined by how well the agree- ment was negotiated. Deal Makers and Deal Breakers From the architect's perspective, the key issues in agreements are profitability and insurability. Simply put, if a profit can't be made with the deal as stated, the commission shouldn't be accepted. Likewise, agreeing to take on responsibilities excluded by a firm's professional liability insurance policy could leave the firm uninsured when a claim emerges. Either issue can put a firm out of business. Both present unmanageable risk. Both are deal breakers. Negotiation is the time to identify and remove deal breakers. If they can't be removed, some way must be found to offset the risk—something that would instead be a deal maker. Finding the deal makers are theoretically possible (e.g., a large enough fee can compensate for increased risk), but require willpower and skill to negotiate. Below are noteworthy deal makers and deal breakers. Working Without an Agreement Working without an agreement is an unmanageable risk. If a claim emerges before the contract is executed, there are no clear rules for settlement. The party due something may have to walk away without anything, perhaps even having to pay. In the case of the architect, that means real trouble. The effects of working without an agreement are many. Foremost concerns include: • Difficulty in getting paid, or getting paid all that the architect believes it is entitled to be paid • Claims of architect responsibility for any and all things not the firm's fault—such as the client's consultants' negligent services, the presence of hazardous waste on-site, inaccuracy of client's budget, changes in the code, bad construction safety, poor performance of the builder • Claims of architect responsibility for broader scope than may have been intended or understood by the architect • Claims of the architect causing delay due to a lack of written schedule, or definition of the schedule approval or amendment process Most architects would probably never work with just a handshake, wink, or nod. But exchanging draft agreements that never get signed has the same net effect—no written agreement. There are too many skilled attorneys and different-minded judges that would dismiss those unsigned pieces of paper, regardless of arguments about pay- ments made ("course of conduct"). Architects need to get the agreement negotiated and signed before issuing documents for use by the client or the builder. Once the work product is delivered, the architect loses the leverage necessary to get the client to the signing table. Heightened Standard of Care The standard of care is the basis against which architects are measured to determine whether they are performing to a level of legal competence. The standard of care does not require performing services perfectly. Rather, when errors and omissions occur, they are judged against a standard consistent with the work of other architects doing similar projects. Errors and omissions that fall short of this "norm" constitute a failure to meet the standard of care, amounting to legal negligence. The key to the concept is that there is a norm—and the norm is not perfection. The standard of care flows from a concept in English law that recognizes that pro- fessional services—from doctors, lawyers, architects, and engineers—are rendered based upon learned opinion. Such professional opinions are provided by gifted human beings who have plied their trade over time, developing varied pathways to success. There isn't always a single solution. To determine whether an architect has been negligent, performance will be mea- sured against what architects would typically have done in the same situation. The problem with nearly all client-developed agreements is that they seek to pre- scribe a standard for care that is higher than the norm. Problematic words abound that define the architect's enhanced performance level, including "best," "better," "high," and "higher." These words are red flags and should be stricken not only from agree- ments but also from marketing materials and proposals. What is the problem with being contractually required to perform at a higher standard of care? Professional liability insurance does not cover such a higher perfor- mance level. Architects are insured against acting negligently in performing their ser- vices. Beyond that, they are on their own. How does establishing a higher standard lead to claims? When architects are required to be near-perfect, the client will expect them to pay for every problem on the plans, everything missed, every mistake that the typical architect would be forgiven. Everything. PART 4: CONTRACTS AND AGREEMENTS THE LIABILITY BUCKET Sophisticated clients may try to come up with ways to quantify or measure the standard of care. One such attempt is to express the barrier in terms of construction change orders. For example, any amount of error and omission (E&O) change orders in excess of, say, 1.5 percent means that the standard of care has been breached. So each time an E&O change order is classified, it is dumped into a "liability bucket." When the amount in the bucket rises to the established rim, in this case 1.5 percent, the architect pays for the rest that spills over. The liability bucket is a noble idea. It has its basis in facts, as expert witnesses often quote normal change order percentages, such amounts varying by project size, complexity, new or renovated construction types, and the like. This seems like a fair and reasonable way to establish expectations of performance. Doesn't it? The problem is that there is no statutory or judicial percentage threshold for an across-the-board definition for the standard of care. None. The standard of care must be argued before the finder of fact (arbitrator, judge, or jury) and legally established for each element in every claim. Plaintiff's experts opine as to how bad the services in question were, how the mistakes were so egregious that, regardless of change order amount, "no other competent architect would have made that mistake." Then after hearing the charges, defendant's experts explain why everything that happened on the job was no different from any other project. In the end, the decision by the finder of fact will boil down to how convincing the arguments were, considering the credentials of the opposing experts—it's the proverbial "battle of the experts." The fact remains: There is no clear legal definition of a breach of the standard of care. Therefore, there is a problem in trying to establish a contractual measuring stick for the standard of care. Doing so removes the insurance company's ability to argue against claims that breach the contractual standard, but might arguably not have breached the standard of care. That is why underwriters specifically exclude "contractual breaches" from coverage. Check the firm's policy. The liability bucket may be uninsurable. Thankfully, most clients will accept pushback on this negotiation issue and will agree to take out the words "best" and "highest." As businesspeople, they understand the limits of insurance. They also recognize that if the policy does not cover their claim, the only other assets the architect has are used desks and computers—which don't amount to much. Indemnities Almost every client-furnished agreement comes with a professional services indemnity provision—most are hor- ribly written. The AIA has addressed client demands for such contractual indemnities in the major 2007 versions of the AIA's standard architectural services agreement forms. The AIA's language was reviewed by professional liability insurance carriers and determined to be insurable under typical professional liability insurance policies. The principle of the professional services indemnity is that the architect ought to reimburse the client for claims brought against them by a third party—claims arising from the architect's negligence. Indemnities of other types actually benefit the architect: • Client indemnity to the architect for claims arising from the presence of hazardous materials on the job site • Client indemnity to the architect for claims from the client's misuse of the architect's drawings • Mutual indemnities between the architect and consul- tants, making each party legally responsible for their own mistakes and not for the mistakes of the other Problems with professional services indemnities occur when they become too broad, holding the architect respon- sible for performance beyond professional liability insur- ance policy coverage. Common examples include: • Indemnifying persons or entities not a party to the agreement • Indemnifying the client from their own mistakes • Indemnifying for errors and omissions not rising to the level of legal negligence • Defending the client against third-party claims— providing legal defense—prior to legally establishing negligence Overbroad indemnities provide unmanageable risk. Therefore, read every proposed indemnity carefully. Use the AIA version (e.g., AIA Document B101TM-2007, section 8.4) as a good model. Always seek legal advice before agreeing to the client's version of an indemnity clause. Construction Means and Methods The architect designs the finished project. How it gets built, the "means and methods" to get there, are determined by the builder. Construction means and methods ought not, and generally are not, the responsibility of the architect. Means and methods claims examples include excavation cave-ins, scaffolding fail- ures, and crane collapses. Fortunately such claims are rare, but the result is almost ▶ The AIA Documents Program (17.5) details the range of AIA contract documents that capture and convey the expectations, relationships, responsibilities, and rules that bring parties together for the design and construction of buildings. always tragic, with property damage, personal injuries and death involving workers and members of the general public. These accidents turn into media events, with plaintiff awards that amount to tens of millions. AIA standard agreements have effectively managed this issue for decades, with carefully considered language in the architectural services agreements and the general conditions for the contract for construction. Take advantage of this language in AIA agreements—language tested in the courts. Guarantees and Certifications Architects are often asked to guarantee or certify the quality or completeness of their design. There is real danger here. The only guarantee that the law typically requires, and that professional liability insurance policies cover, is a guarantee to perform to the standard of care. Beyond this, guarantees and certifications are excluded from coverage. The words guarantee and warranty should either be stricken from the agreement, or at least used properly—for example, "Architect makes no guarantee of performance." Other terms take on the same meaning—"ensure," "assure," "insure," "confirm," "verify," "thorough," "any," all," and even "100% complete." Each may be placed in a context requiring that the architect perform at a level of perfection—to provide any and everything needed at the architect's expense. Certifications are far more common than guarantees, and cannot realistically be avoided. Building officials and jurisdictions require certifications stating that drawings have been prepared per code, or, after construction, that the project was completed per plans and specs. Other common certifications are requested by project financiers, banks, and lending institutions—all requesting the same thing: that architects promise that they didn't make any mistakes. There is a simple solution to any certification. Remember the standard of care— that the architect is a professional who exercises judgment. An architect should only certify "in my professional opinion" or "to the best of my knowledge, information, and belief." The contract should give the architect the ability to review and reasonably limit certifications before signing them. Do not certify perfect performance. Proper Scope Badly written scopes of services lead to claims and lost revenue. Unclear scopes can make architects responsible for the performance of someone not under their direct control. Overbroad scopes rob architects of the ability to invoice for extra services. Bad scopes can ruin a firm, damaging its relationship with the client. Good scopes of services set forth with precision the services the architect will provide, and exclude those they won't. Spend time getting it right. Review it with the client and other members of the team; include the junior staff that will work on the project. Getting the words right will clarify everyone's expectations and may eliminate later disputes. Administration of the Contract for Construction During the construction phase, the task for the architect is to "administer the contract for construction" between the owner and builder—various services that collectively are commonly referred to as "CA." These CA tasks include field observations, review of contractor's payment applications, answering contractors' questions about the drawings and specifications, review of contractors' submittals, review and approval of change orders, issuing revised documents for changes, and inspecting for substantial completion. Clients sometimes want to save on professional design fees by eliminating CA services. They reason that after the construction documents have been prepared, that the architect is done with design. But "design" is not done until the project is built. Changes occur during construc- tion, brought about by contractor substitutions, products and systems purchased off of ▶ Defining Project Services (15.1) further discusses the centrality of scope definition to effective agreements for professional design services. ▶ Construction Phase Services (10.9) covers the architect's evaluation and reporting of the progress and quality of the work and its conformance to the design intent expressed in the contract documents. PART 4: CONTRACTS AND AGREEMENTS 994 Risk Management performance specifications, unanticipated field conditions, modifications to accom- modate construction means and methods, owner changes, and errors and omissions. Plans are never perfect, nor are they "complete." With these change forces at work, the architect must continue to protect the cli- ent's core interest—the design. In protecting the design, architects also protect their own reputation and liability. Costs from fixing systems not properly integrated, not meeting code, or not functioning could become a basis for claims. Professional liability insurance providers recognize a rise in claims among firms that do not provide CA services—because the architect is not around to correct their documents or to defend them, to interpret and explain them, to preempt or minimize costly construction mistakes. Some underwriters will not insure firms that take on com- missions for construction that does not include CA services. Limitation of Liability Without a limitation of liability (LOL), there is "no limit" to an architect's liability. If a professional liability insurance policy has a per-claim limit of $10 million, a firm is not protected for any claim in excess of that limit. A $20 million claim, if enforced, could put a firm out of business. Uninsured loss is an unmanageable risk. A limitation of liability is an agreement not to seek damages in excess of a pre-established and agreed-upon amount. To be legal, the limit must provide fair payout in relation to the value of the services; unreasonably low LOLs have been struck down by courts. An enforceable LOL can be an effective way to manage risk. Most underwriters offer a break in premiums if all the insured's projects, or at least a significant percentage of them, have an LOL. What is a reasonable value for an LOL? Some advise that it should equal the compensation received on the proj- ect. But that can amount to a big number, exceeding policy limits. A reasonable target is to set the LOL at the "pro- ceeds of available insurance." Doing so will ensure that the firm never has to pay out of pocket, even if the annual policy limit (aggregate) has been eroded by claims on other projects. [Note: Savvy clients may require that eroded limits be replaced with the pur- chase of add-on coverage. Even so, that is a better deal than no LOL.] Significantly, LOLs should apply to the full sum of any and all claims on the proj- ect. Otherwise, the LOL may not do what it is supposed to do—set a limit on liability. Making Better Agreements Establish Standard In-House Practices There are firms with no standard approach to developing, executing, and maintaining design services agreements. Almost anyone can authorize work and sign contracts, committing the firm to situations of unmanageable risk. Consider these tips to address this risk: • Appoint a single person or, for larger firms, a team of individuals, to review and negotiate all contract terms and conditions. People who review contracts all the time know what to look for, acquiring the skills to effectively negotiate with difficult clients and attorneys. It takes years of training and experience to develop these skills. Consider hiring someone with a legal background or a licensed attorney to perform this role. Contracts legally obligate a firm and should be reviewed and approved by select firm members only. ▶ Insurance Coverage for Business and Professional Liability (16.2) covers the terminology and necessary considerations and alternatives when selecting insurance for one's firm. LIMITING THE LIABILITY OF A CONSULTANT Jay S. Gregory, Esq., founding partner of the Boston office of LeClairRyan, PC, tells the story of an architect he represented who had unwittingly agreed to certain fine print in the contract of a structural engineering consultant. When the structural design of the project turned out to be defective, resulting in repairs totaling several million dollars, his client turned to the engineer to make good. The engineer immediately produced the contract and turned to the fine print, which stated a limitation of liability in the amount of $100,000. The engineer freely admitted guilt—"Here, I'll get my checkbook and write you a check for one hundred thousand." The architect, holder of the prime agreement with the client, was responsible for the rest of the damages— damages arguably not his fault. • As part of the review process, the project manager (PM) should review their own contracts. They will manage the project and ought to play a role in shaping what the contract says. However, the PM should not be the only person reviewing the contract. • Provide access to signed agreements for review by the entire project team. • Save electronic copies of every agreement with the electronic project records. Also save a copy in a general office directory of the firm's contracts. When a problem emerges on a project, perhaps several years after the records have been archived, there will be a dash to find the contract. Make it readily available on that day. Get Professional Support If there is a claim, a firm will need support from an attorney, but attorneys can also help avoid a claim before it happens. Attorneys specialize in areas of legal expertise; contract law is one such specialty, and construction contracts a subset within it. There are attor- neys that work with owners, builders, or design firms. Finally, there are attorneys that specialize in developing agreement text, and others that are called in to resolve dis- putes. At times, help may be needed from both of these subspecialties. To find the right attorney, ask other architects in the area or a professional liability insurer for recommendations, or attend seminars in risk management conducted by attorneys to get a glimpse of what they know. Take time to make the right choice. Architects should select an attorney with relevant experience, clients, and references. A qualified attorney can help with the review of contracts, or perhaps just with dif- ficult agreement clauses. Some architects use outside counsel to negotiate contract terms—speaking attorney to attorney to the one representing the other party. While this is an extra expense, it could avoid a far more costly contract claim later that stems from improper review. In addition to paid attorney consultation, many insurance providers offer contract reviews. These reviews best address matters of insurance and insurability. Using both outside insurance and legal counsels will combine to make the contracts best suited to preserve the interests of the firm. Use Standard Agreement Forms Most professional liability insurance carriers offer discounts to their clients that use standard agreement forms, such as AIA documents. AIA forms have been tested by the courts. In addition, clients recognize and respect these forms, making the negotiation process with these as a starting point much easier. Standardized forms can be used "as is," but it is more typical that they be modified beyond project particulars and changes to common services, to include technical edits to the legal terms and conditions in response to the advice of legal and insurance advisers. One way to use outside legal and insurance counsel is in the development of a suite of standard agreement forms customized for use by the firm. These documents may seldom be adopted as is by the client, but they will be very useful as a reference to a firm's preferred language. There will be many times when client's counsel is pushing for certain text in the client's standard form. In that situation, an architect can transmit the firm's preferred paragraph for consideration—a good negotiation strategy. There are several key customized agreement forms to have on hand: • Full services agreements of the types most frequently used. • Small or limited-scope agreements: Short-form terms and conditions for projects where there is no construction involved, such as feasibility studies, programming, and planning services. • Notice to proceed: Brief letter agreement used to get a project going until the final agreement is executed. Such notices include limited items to agree on quickly: def- inition of limited scope and payment, intent to execute the final agreement, and rules to terminate or extend. • Consultant agreements: These should always be tied to the terms and conditions of the prime agreement between the architecture firm and the client. Never sign the consultant's proposal—and avoid attaching it to a consultant's agreement form— where its terms and conditions might conflict. • Common exhibits: Rate schedules, reimbursable expenses schedules, sample invoices, standard scopes of services for each type of consultant regularly hired, consultant standards. NO. 3: SELECTING THE CLIENT The third most frequent source of claims comes from client selection. (See Figure 16.3.) It is the client that most frequently sues the architect for failing to fulfill their duty. A client who is unsophisticated, or short on the cash needed to fund the project, or has a record of litigation, or is completely unknown to the architect, is one to avoid. Know the Firm's Expertise—Know the Market An architect that keeps designing the same thing, over and over again, necessarily develops an expertise in that one thing. The purest example of this is the prototype building. Examples include box stores and fast-food outlets. Each successful franchise solves a series of problems very effectively—established brand recognition, optimal layout for both customer service and product preparation, predictable construction cost and schedule, and significant reduction in errors and omissions. These prove a simple principle—if an architect were given the opportunity to design a project just like their last one, they would likely expect to do a better job. We see that specialization helps mitigate risk, while establishing a record of accomplishment. Sophisticated clients want to select firms that have successfully designed and com- pleted projects similar to theirs. Such is their means of managing risk. Know the Client Before beginning to work with a client, an architect should know them. Are they an experienced developer, having previously done projects like the one proposed? Can they afford the project? Do they have a reputation for negotiating fairly? Do they have a long list of architects they have hired—and if so, who? What is their track record for paying? Do they have a history of litigation? ONE GOOD LAWSUIT DESERVES ANOTHER A design firm completed a commission for a major institution and received popular recognition for a job well done. The client was happy. There was good publicity. Awards were given. But not everyone on the team was satisfied. Several years after the project was completed, three of the major trades filed suit over change orders that were long denied and never paid—three separate suits in three different jurisdictions. Whom did they sue? The architect. The subs each lost money on their contracts, primarily because there were unanticipated changes to the schedule that led to labor overruns. Despite these facts, the basis of the suits alleged that the plans were incomplete and uncoordinated, leading to their losses. This basis quickly faced an important legal obstacle: the architect, a third party to the construction contract, does not have a legal duty to save the builder's subcontractors from economic loss due to defective plans. Only the owner, through the general contractor, has this legal duty. But the builder did not want to sue his client to aid his subcontractors—the same client he wanted to work for again in the future. The subs didn't want to sue the builder for the same reason. At this point in the claim, summary judgment, with dismissal of the claims against the architect, seemed possible. Ensuing legal discovery exposed the faults of all team members—not surprisingly, no one had been perfect. Meanwhile, both the general contractor and owner, neither a defendant in the suits, watched with interest from the sidelines. Both suspected that at any time, they could get pulled into the fray. In the end, the owner and builder, the ones with legal agreements relevant to the claims, succumbed to pressure to do right by the subcontractors. Both volunteered to participate in mediation and settlement with the parties. The architect settled for six figures, about one-tenth of the stated claim value. The owner also kicked in seven figures. The parties agreed to settle, ending what could have been a much costlier trip to court, where anything could have happened. There is no justice in settlement—only conclusion. The lesson that the architect learned was this: People to whom you owe no legal "duty" can sue—and they may obtain something for their effort, even in claims lacking merit. ▶ Project Delivery Methods (9.1) provides an overview of the available models for project delivery. 998 Risk Management Hard bid is the so-called traditional method, or design-bid-build method (DBB). Under this option, the architect (design team) completes the plans and specifications (construction documents) and puts them out to bid. Regardless of the many options for selecting bidders, the bottom-line goal of the bidder is to get low and win. Hard Bid The more that is known about a potential new client, the better equipped a firm will be to make a proper deci- sion. Seeing the potential pitfalls and negotiating with these in mind helps avoid a bad client relationship. This information is often available in the community of archi- tects or from the firm's insurance agent. Condominium Projects Condominium projects begin with a client, the developer. But the moment that the developer sells the first unit, there is a new client—an owner of the design product. With each unit sold, the architect acquires another new client—one whom they didn't select and have no relation- ship with, and who might have unreasonable expectations. As a result, condo projects are notorious for claims. Professional liability insurance companies will charge sub- stantial premiums for covering this project type. Repeat Clients Are Like Gold Surveys of architectural firms across America indicate that most current clients are repeat clients. The repeat client rate can vary between 60 and 85 percent, and for a few firms, be even higher. There are two messages in these data: (1) It's very hard to break in with a new client who has previously worked with another architect, and (2) clients and their designers, after they've worked together, gener- ally like and trust each other. Respect is key to these rela- tionships. Where there is respect and clear expectations, there is a reduction in claims. Get the Right Builder A good builder can make a project a big success. Likewise, a bad builder—one that causes delays, can't follow the plans, or charges extra for everything—can make a project into a financial disaster, and not just for the owner. When a builder fails to perform well, everyone pays in one way or another. To the extent that architects have a voice in the decision, they should help their client choose a builder that is well organized, understands and respects the architect's role, and appreciates the value of all of the relationships involved. Impact of the Project Delivery Method How the project is contracted for construction is known as the delivery method. Some of the most common alterna- tives are explained below, with an eye toward identifying risk. PART 4: CONTRACTS AND AGREEMENTS On the surface, the hard-bid scenario sounds like it should be the best approach for reducing claims. The design process is linear, flowing uninterrupted from schematics, through design development, and then finishing with construction documents—sug- gesting no impediment to completing and coordinating the documents before they are put out to bid. The true difficulty is that no set of documents is ever fully complete or perfectly coordinated. This fact plays right into the hand of a skilled estimator—one that is looking for any advantage it can find over the competition. In the bid situation, the goal is to get low—quality in construction is not a priority for those that plan to win. Missing information in the bid documents affords opportunity to achieve the low bid. The real payday comes later, after award, when the seed of missing information yields a harvest in change orders. Mounting change orders—uncontrolled project costs—puts undue strain on the owner-architect relationship. Claims histories show that there are more claims by percentage of type of project delivery method on DBB projects than any of the other project delivery types. Negotiated Contracts Negotiated contracts are said to produce the best quality for the lowest price. In this option, the owner interviews and selects the builder independent of a bid pro- cess. Qualifications may include the cost of the builder's services, but more impor- tant drivers will be reputation for quality, on-time delivery, and effective cost management. Negotiated contracts come in a variety of forms. The builder might take on a purely advisory role (construction manager, adviser) with all of the "subs" under separate contracts direct with the owner; or the builder may build the project with their own forces and subcontractors. The cost model may be in the form of reim- bursement for all costs plus a fee, a fixed fee, or a guaranteed maximum price (GMP). Regardless of the many combined options, negotiating a contract with a good, qualified builder is most apt to bring the best results, and produce the lowest risk to all involved. Fast-Track Fast-track construction involves phasing of design activities to overlap the construction process—construction commences in one phase before design is complete for the next. Under this option, a series of "bid packages" are organized and scheduled. Throughout the fast-track process, the biggest (highest-cost) decisions are made first, the smallest (lowest-cost) decisions last. The risk in the process is that decisions are always made and implemented without complete information, and may later need to be changed at some expense. This risk is an outfall of the owner's decision to speed the construction process. The need for speed, over quality and first cost, is the owner's choice—and the owner ought to weigh the decision care- fully. Architects should attempt to highlight this point in the contract. At minimum there should be a record of discussion with the client regarding the increased risk of change orders. Managing this risk is mostly about clarifying expectations in advance. AIA Document B103TM-2007 contains good cautionary language for the fast-track method. Other Project Delivery Methods A number of other delivery methods are available, including contractor-led design- build (CLDB), architect-led design-build (ALDB), construction management (CM), and integrated project delivery (IPD). In each of these, the traditional roles of the architect, builder, and owner are modified to some degree, creating the potential for increased risk. In each case, understanding and clearly limiting the responsibilities of the architect, while maintaining insurability, is one way to keep the risk model from crumbling into disarray. Public vs. Private Clients There are many opportunities to compete for public design contracts. However, public contracts offer significant problems over private client relationships: • Terms and conditions are often one-sided against the architect, with little or no room for negotiation. • Profitmarginsaretight.Thepartiesthatfundtheprojecthavetoanswertotheir taxpaying constituents. • The press often has a field day with public projects, magnifying and misstating problems that leak out—sometimes without fact checking, and without understand- ing the construction or design trades. • Public officials owe more to their constituents than they owe to the design team. This can make it hard to establish a normal designer-client relationship. • Public officials come and go. After an election, an architect could be working for a person who previously opposed the project. Any of these issues can increase risk on public projects. Understand the risks and figure out how best to manage them. Establish a Reasonable Fee Examine a client's expectations and degree of sophistication and take into account the real level of risk inherent in the project. Then formulate the processes needed to pre- vent anticipated problems. After quantifying these processes, determine the real cost of taking the commission. Add profit to that figure to establish a fee. If the client con- sents to that sum, then, and only then, will it be known that the project constitutes a manageable risk. NO. 2: PROJECT TEAM CAPABILITIES The second most frequent source of claims comes from the risk category known as project team capabilities. (See Figure 16.4.) Dominating this category are claims aris- ing from the use of inexperienced staff. Coming in a close second and third are similar issues—inexperienced staff on site, and an inexperienced PM. To proactively help avoid 1000 Risk Management Risk Drivers data provided by The Design Professional unit of XL Group FIGURE 16.4 Chart Depicting Project Team Capability Claims by Type PART 4: CONTRACTS AND AGREEMENTS these kinds of claims, hire or train qualified staff and, as much as possible, have the most qualified people working on each project and each phase of the project. This includes a thoughtful division of labor, taking advantage of the lower billing rates of less- experienced staff for tasks that are appropriate to their skill level. A successful work plan requires enough senior level experience to balance the inexperience of youth. Managing this risk, while turning a profit, requires finding the right mixture of less- experienced interns and experienced architects. Use of Technology In the "old days," when drawings were prepared by hand, the plans were almost always drawn by the most senior staff. The plans required more depth of experience; more things had to be known to draw them properly—the program, the structural grid, the clearances for a toilet, what the walls are made of (how thick), the code, what's going on overhead, how to label, how to dimension. The details, on the other hand, were far more one-dimensional. With a small amount of coaching, and reference to prior proj- ects' working drawings as examples, an intern could in short order be equipped to become productive at drawing the details. Thus interns began their drawing careers with exciting tasks like door schedules and toilet room details. In the current day, drawings are prepared entirely on the computer—increasingly in 3D. The older experts are often less computer-savvy, becoming hands-off. The new generation, however, uses the computer with great familiarity, but lacks expertise in design and construction—they don't know what to draw. Neither can operate effec- tively entirely on their own. This can create a significant risk. Both generations need the skill that the other possesses. Below is a series of ways to manage the multigenerational approach: • Train senior level staff to draw again—on the computer, to become hands-on in the building information model being created in the computer. There are things in the model that cannot be seen on a print. Senior staff need to be able to see them. • Train junior level staff to know what they should draw, and why. • Manage the generational differences. Break down barriers between old and young so they can communicate effectively, respecting the different but needed value each brings to the team. • Foster mentoring. Senior staff possesses a wealth of experience to share with the next generation. Some will share, but only if asked. Effective mentoring happens when mentor and mentee both see the value. Both must be motivated to make it happen. • Hire and maintain a good mixture of staff at the various levels. Firms should invest in training staff of all ages in the proper use of technology. Staff Continuity on Projects People come and go for a variety of reasons. Whatever the cause, their departure cre- ates a void in the knowledge base of the project team—the perfect opportunity for unresolved issues to fall through the cracks. Take these steps whenever someone leaves: • Obtain a written "to do" list from the person leaving, documenting unfinished items and design decisions yet to be made. • Get commitments from remaining team members to pick up and close out the loose ends that result with the departure. • When appropriate, bring in the right replacement. If the position vacated was senior, the client may want to interview or review qualifications of the replacement; obtaining client approval might even be a contractual obligation. Regardless, make the client aware in a timely fashion of the change. Demonstrate intent to fulfill contractual commitments. Office Standards Standards exist for good reasons. They portray the signature of a firm, its image, its attitude. They establish a quick solution to a problem, avoid reinventing the wheel, and save money in the process. They also exist as a repository of firm knowledge, a refer- ence in how to avoid failures in quality. Standards are indeed great, but only when they are used. Firms can now host their quality plans online—available for reference by every employee as their home page. These online documents set forth the firm's policies and procedures for how to do almost everything—providing instant access to checklists, templates, and forms. They can provide handy links to resources, such as online build- ing codes, industry standards, an electronic library of past project drawings and speci- fications, image databases used for marketing, case studies, white papers, and lessons learned. Company intranets and online quality plans have become essential tools for today's architecture firms. These require significant investment of time and money, both to develop and then to maintain. But this investment is returned many times over by improving quality and reducing risk. NO. 1: COMMUNICATION The most frequently cited cause of claims is poor communication. (See Figure 16.5.) More than half of communication complaints arise out of a lack of procedures to iden- tify conflicts, errors, and omissions. Secondarily prevalent are the problems that hap- pen when people don't follow procedures that are in place. For the project to proceed without problems, people must communicate effectively. Peer Reviews: Quality Assurance/Quality Control (QA/QC) One sure way to prevent mistakes is to check the work—the benefit best characterized in the carpenters' saying, "measure twice, cut once." On any given project there are hundreds, even thousands of decisions that have to be communicated. Any decisions not made by the design team will be made by 1002 Risk Management Risk Drivers data provided by The Design Professional unit of XL Group FIGURE 16.5 Chart Depicting Communication Claims by Type PART 4: CONTRACTS AND AGREEMENTS someone else, and the architect may not like that decision or its impact on the project. This situation is less likely when a system is employed for managing or controlling quality. Here are several practical ways to manage quality: • Self-checking: Each team member must be responsible for the quality of their own work. They know their piece of the project better than anyone else. They can use checklists from the company standards, or a list developed by their immediate supervisor. Either way, expectations and communications need to be clear. • In-house third-party review: A "fresh set of eyes"—experienced eyes—can be a big help. Third-party reviews ought to occur at the conclusion of every major project phase, before deliverables are issued. Project leaders should see written proof that the reviews have occurred before they issue the documents. • Peer reviews: Some jurisdictions require independent, outside consultant "peer" reviews before they will issue a building permit—at least for some critical portions of the work. For projects with which a firm does not possess significant prior expe- rience, or when working with a new consultant, it might be prudent to have a peer review. Some institutional clients may even require it. Small firms can greatly ben- efit from a peer review. • Building information models: BIM can take advantage of electronic checking, employing clash-detection software. These software add-ons produce reports that still have to be reviewed by humans to determine which clashes are real and which are incidental. Nonetheless, the thoroughness of the reports is a remarkable benefit. Remember the simple goal of checking: to identify and correct a mistake before it becomes too expensive to fix. Checking, regardless of which tool or method is employed, helps members of a project team learn to communicate better—to provide better design. Know the Contract Nothing is as disappointing as a failure to meet expectations. Clients readily become dissatisfied because the architect didn't do things the way they had expected. Likewise, many project leaders become dissatisfied because the members of the team didn't complete tasks as they expected. Why does this happen? Bad communication. One simple way to address this concern is to review the services agreement—the written expectations—with everyone. Sit down with the client and go over the scope of work. Show examples of the deliverables that will be produced. Listen to the client. Their preferences might alter the standard approach. Likewise, review the agreement with the team at the beginning of the project. At appropriate times, pull out a copy of the agreement to confirm the written rules— expectations—for key deliverables. It is always better to discuss matters and review a change of strategy or approach in advance. The alternative, which is to make assumptions, often results in disappointment. Conduct Proper Meetings Meetings should never happen just because they're on the calendar. Meetings should be organized to complete a set of distinct decisions along the road to finishing the project. Each meeting deserves attention to the advanced development of an agenda, planning who should be there, and the topic of necessary decisions. The written outcome of meetings is the minutes. Minutes need not be lengthy. They just need to record date and location, attendees, a summary of each item dis- cussed, decisions made, and identification of action items, assigning who is responsible for each. The key in this record is decisions. ▶ The backgrounder on Project Documentation (5.1) discusses one of the most essential elements of communication in the construction industry. The architect is often the one responsible for preparing and issuing minutes during the design phase. Once construction commences, this responsibility often shifts to the builder. Regardless of formal responsibility, it is essential that the architect take written notes of some form at every meeting. Minutes issued by other parties should be reviewed promptly. If there is any disagreement, write and send a record of comments or correc- tions right away. In the ebb and flow of the project, often spanning several years, the minutes repre- sent a key record of who said what, what they knew, and when they knew it—docu- menting the involvement of people no longer around or available for comment. These become the means to affirm prior decisions, dissolve disagreements, or to resolve claims. Document Control Every paper document issued by the architect needs several points of identifying infor- mation: the author, who it is being issued to, the date issued, and, in the case of contract documents, a reference number. Documents that are revised and reissued, such as drawings, need a revision date. Last, copies of each document issued must be saved in the project record. In resolving disputes, the resolution hinges on who knew what and when they knew it. For example, change orders arise over information added or subtracted from the contract documents. Reference to copies of the documents of the two dates in question, before and after the change, will support or disprove the claim. Practice throughout the entire construction industry is moving toward a paperless exchange of information. E-mail is used to transmit documents of modest size. The courts now accept electronic records as a means of storing data for use in litigation. The benefit of this decision saves significant money on printing and delivery. In addi- tion, re-access to the data is improved, since many document storage systems are data- bases that can be electronically searched. Regardless of the system in place, access to important project records must be preserved long after the project has been completed—until the statute of limi- tations or repose (if any) precludes litigation. If project records are saved remotely during the life of the project, obtain a copy for safekeeping. If appropriate, convert the files into an electronic format that will still be recoverable by computer sys- tems toward the end of the potential litigation period—some 6, 10, or 15 years from now. Warning Signs of a Claim When someone has made a mistake, the human tendency is to hide. This is true in all relationships, including that between architect and client. Sooner or later mistakes will come out. Though difficult, it's always better to face one's own mistakes head-on—to tell the client about a problem before they hear about it from someone else. That, at least, gives the architect some measure of control. See It First Many claims begin with the architect being among the first to know of a problem. If they aren't among the first, it's likely because they're not listening or paying attention to what is going on. The discovery of an error often begins with denial. After this comes the realization that the problem needs to be fixed. Start with fact checking. Speak to the people involved with the situation; find out everything about it. Check out the timing on the issue; who knew or did what, and when. At the same time, formulate what has to change to resolve the matter. Is a change really needed? A partial change? What are the options? What is the cost? How would the schedule be impacted? ▶ Information Management and Services (5.12) further covers today's robust information management practices and technology-based information services. ▶ Dispute Management and Resolution (16.4) covers strategic and effective use of mediation, arbitration, and litigation. PART 4: CONTRACTS AND AGREEMENTS 1004 Risk Management Any serious mistake can damage the relationship with the client. If a claim could erupt, call in outside legal and insurance counsels for advice. Don't wait for the claim letter from the client's attorney. After the problem and its implications are understood, and good advice received from insurance providers or legal counsel, the next step is to tell the client. How to Preserve the Client Relationship It is important to be open with clients. At the same time, this is a business relationship, based on a contract. If the architect believes they are at fault, they should resist the first tendency to admit fault. First seek the advice of outside counsel, before taking respon- sibility for a repair. On examination, the facts could well prove the architect caused the problem. But that doesn't necessarily mean the architect has a legal obligation to fix it. Remember the standard of care. There may also be contractual or legal bases for excusing compli- ance with the standard of care (e.g., a force majeure clause). The law does not require the architect to be perfect, and hopefully the contract does not require perfection either. Do not offer to remedy the situation without approval from the insurer. Profes- sional liability insurance policies exclude from coverage situations in which they are not involved in authorizing a settlement. CONCLUSION The practice of architecture involves risk—risk that has the potential to strike directly at the ability of the professional to remain in business. Much risk can be avoided or transferred by simply being savvy, making good contracts, and getting good advice, then following through on it. The balance of the risk stems from being human, being fallible—architects do make mistakes. Architects need to man- age this risk. Errors and omissions are never planned, and many could have been avoided. Reducing human error requires nothing less than hard work, a commitment to excellence, and getting serious about improving the process by which services are rendered. A firm that is disinterested in risk management "processes" may feel invin- cible, but it is wise to beware. When risk isn't being carefully watched, claims will rear their ugly heads. BACKGROUNDER RISK IN DESIGN Mary Johnston, FAIA, and Ray Johnston, AIA Although it is difficult for architects to take creative risks, their embracing of innovation and experimentation can pro- vide answers to design challenges. Strategies for calculated risk-taking involve developing fresh attitudes toward pro- gram, materials, and collaboration and can allow archi- tects to make bold design moves while solving practical problems. Mary Johnston and Ray Johnston, AIA, founded Johnston Architects in 1991. For over 20 years they have designed projects that have received local and national recogni- tion. Mary and Ray Johnston hold master's degrees in architecture from the University of Washington College of Built Environments and continue their association with the college as frequent studio reviewers. It is difficult for architects to take creative risks. The exe- cution of the work is ever more complex, and the conse- quences of failure, whether material or functional or aesthetic, are severe. The added responsibility of not only using dwindling resources wisely but reversing degradation and depletion of the environment causes anxiety. But the embrace of risk and an experimental, even rebellious way of thinking about design can help resolve rather than inflame that anxiety. To take risks is to be optimistic, and optimism in design is exactly what is required in this era of doubt and instability. NO RISK MEANS STANDING STILL The forces working against risk-taking are both internal and external. The internal fears that designers have include the suspicion that risk and pragmatism are antithetical. Architects struggle between the desire to surprise and provoke and the desire to provide serviceable buildings. It takes a conceptual leap and some courage to believe that something untested and innovative can also be practical. Also, there is comfort in the known and it is tempting to think that what worked last time will surely work again. These internal apprehensions join with external forces of orthodoxy and constraint operating outside of the design pro- cess. With rare exceptions, clients prefer predictability. Pro- grams can be strict and inflexible, and the shadow cast by a tight budget is long. Codes, regulations, and design guide- lines encourage the status quo, and LEED checklists reward even the most mundane structures. Restraints, both self- imposed and imposed from the outside, are hard to resist, but if architects pay for taking risks, the penalty for standing still can be even greater. STRATEGIC RISK-TAKING It is clear that standing still is not an option, and that we can- not afford what Charles Moore, in his 1990 essay "Triple Threat Heritage," calls the "luxury of fixity." Moore says, "What our new architecture can't do is allow itself that luxury of immobility. It has always to be ready to move, to change, to be different from what it has been before." Although Moore was writing almost 20 years before Ste- ven Holl, in Holl's book Urbanisms: Working with Doubt he channels the same vision of design as a dynamic system. Holl writes, "Instead of simple and clear programs we engage contingent and diverse programs. Instead of precision and perfection we work with intermittent, crossbred systems, and combined methods." In other words, working with doubt is normal. The ideas of complexity and forward motion suggest some strategies for calculated risk-taking in design. One tac- tic is to turn oppositions into collaborations. Pragmatism becomes the ally of innovation when logic guides the search for solutions. It is brave to cast off assumptions and mine the logic of a problem, especially when the new logic seems to defy conventional logic. If architects don't work with simple and clear programs, as Holl says, how can they use "contin- gent and diverse programs" to produce thrilling new places? The Seattle Public Library designed by Rem Koolhaas and his firm OMA is an example of the application of fresh logic on a seemingly strict program. Koolhaas analyzed the trends in library circulation, the demographics of the city, and the bones of the Dewey decimal system to turn the traditional library program inside out. The result is an entirely new way of experiencing a library, and yet the design grew out of that exploration of data. The "architecture" is the consequence of the logic train. Another technique for subverting expectations is allow- ing and encouraging the transformation and manipulation of space by the user over time. Letting architecture be less of a spectator sport can produce spaces that delight and surprise. Although it takes some trust to design a building that can be easily altered by its users in practical as well as playful ways, the risk is offset by the likelihood that such spaces will be well-loved and cared for. The inventive and unexpected use of materials is part of the risk-takers toolbox as well. At the beginning of his career Frank Gehry used cheap and commonplace materials like chain-link fencing in unconventional applications to define and enliven his buildings. Samuel Mockbee and his students at the Rural Studio, out in front of the trend toward using recycled and repurposed materials, scavenged carpet tiles to make walls and old car windshields to make a surprisingly ethereal church roof. A last strategy for creative and calculated risk-taking is collaboration. Great architecture comes out of an open pro- cess that encourages an exchange of ideas that build on one another. It is a traditional and organic way of practicing and is sometimes overlooked as the powerful innovative tool that it is. THE NEXT GENERATION OF RISK-TAKERS A common complaint among instructors in design schools is that most students are risk averse. They produce with deriva- tive solutions for fear of ridicule or having a portfolio that will be frowned on by prospective employers. But if students can- not learn to be bold in school, they surely will not be bold in the real working world. It is up to instructors and practitioners who mentor and critique student work to encourage and reward original and even defiant thinking. This is where inno- vations will come from and this is how architecture will be not just relevant but essential. Students themselves can use all of the strategies mentioned in the studio context to strike out in new directions: logically critiquing the idea of program, loos- ening the hinges of design and opening schemes up to manipulation and unpredictable outcomes, rethinking materi- als, and working collaboratively with other designers. MOVING FORWARD If "working with doubt" is, as Steven Holl says, a given, then architects can learn to use doubt. To doubt that convention is the correct choice, to doubt that there are no new solu- tions, to doubt that asking different questions will not yield new answers is risky, but it is risk in the service of optimism. If in all other aspects of the profession architects must man- age and suppress risk, then it is in design that they can embrace it. PART 4: CONTRACTS AND AGREEMENTS 1006 Risk Management 16.2 Insurance Coverage for Business and Professional Liability Ann Casso and Fredric Schultz, CPCU, ARM There are many risks that can jeopardize the future of one's practice, one's firm, and one's own financial well-being. This article is intended to familiarize the architect with terminology and the necessary considerations and alternatives when selecting business and professional liability insurance for one's firm. RISKS FOR ARCHITECTS Architects face a wide range of risks every day. They must protect their firms against litigation alleging negligence, protect their offices against theft or destruction of prop- erty, protect against personal risks ranging from health and disability to life and retirement—and share similar concerns regarding their own employees. Newer and perhaps lesser-known but nonetheless virulent risks also exist—such as those inherent in unproven sustainable products and design, the changing standard of care, hidden electronic "metadata" in our offices, contracts that imply a fiduciary duty, and others. What are all of these risks that can jeopardize the future of one's practice, one's firm, and one's own financial well-being? And once aware of possible risks, what actions should one take? What are the major considerations—including the cost of mitigating those risks—or the cost of ignoring them? For architects, one of the most devastating professional and business risks is from litigation alleging negligence in performing professional services. These alleged neg- ligent acts, errors, or o

Chapter 17

CHAPTER 17 Agreements and AIA Document Program 17.1 Agreements with Owners Alan B. Stover, Esq., AIA The architect's agreement with the client should reflect the goals and expectations of both parties and establish the conditions under which services will be rendered. Other Handbook articles deal with defining the scope of a project and the pro- fessional services it will require, the compensation that is needed to support the needed level of services, and techniques for negotiating agreements. The importance of managing risk in an architecture practice is reviewed in Chapter 16, Risk Management. All of these concerns come together in the contract that the architect enters into with the client. The AIA has traditionally used the term "agreement" in the titles of its profes- sional services contracts and for the "front-end" document in a construction contract (the owner-contractor agreement form) that establishes the scope, time for comple- tion, and method of payment, separate from the general terms and conditions of the contract. However, there is no special legal significance to AIA's choice of terminology Alan Stover, an architect and practicing attorney, directed the AIA Contract Documents pro- gram during the 1970s and later served as the AIA's General Counsel. He is the principal author of The American Institute of Architects Official Guide to the 2007 AIA Contract Documents (Wiley, 2009). 1040 PART 4: CONTRACTS AND AGREEMENTS in the titles of its documents. An executed professional services agreement form is, in fact, a contract. PREREQUISITES FOR, AND BASIC TERMS OF, A LEGAL CONTRACT In order for a business relationship to be recognized as a contract enforceable by law, it must meet some basic tests, and the terms of the contract must be sufficiently clear that the performance required of the parties can be determined. Legal Prerequisites Mutual Agreement: A "Meeting of the Minds" There must be a mutual agreement between the parties as to the essential terms of the contract. This agreement is normally reached through the process of offer and accep- tance, and results in a "meeting of the minds." The negotiation process may involve many offers and counteroffers before the terms of the contract are settled on. Until both parties have agreed upon the identical terms, there is no agreement. Any terms raised during negotiations that have not been agreed upon do not become a part of the contract. Consideration A contract does not legally exist unless there is an exchange of values—what lawyers call "consideration." This is what distinguishes a contract from a gift. Each party must give something of legal value to the other: either a benefit conferred on the other, or a detriment incurred. Mutual promises are recognized as having legal value. In the nor- mal situation, the architect promises to provide services, and the client promises to pay the architect's compensation. Past consideration or a preexisting obligation does not qualify as consideration. An agreement made by a client that the client will pay the architect's past-due invoices in exchange for some additional services would "fail for lack of consideration"—even if the architect expressly agreed to the arrangement. Capacity Capacity is the legal ability of the parties to enter into a contract. While classic issues of age, mental incapacity, and incapacity due to the influence of drugs or alcohol rarely arise in contracts for architectural services, conviction of a felony may put someone under a disability, particularly in contracting with the federal, state, or local government. The Consolidated Appropriations Act of 2012 prohibits certain federal agencies from contracting with any corporation that has been convicted of a felony within the past 24 months. Companies can be debarred or suspended by government agencies for fraud, waste, mismanagement, or even for being delinquent in their tax payments. Legal Purpose If the underlying purpose of the contract is illegal, or if the contract requires the per- formance of an illegal act, the contract is void from the outset. This could come into play if the architect has agreed to provide services for a project in a state or jurisdiction in which the architect is not licensed. The courts will not facilitate the performance of an illegal act by enforcing the contract, and the unlicensed architect could be left with- out legal recourse to collect any unpaid fees. Contractual Intent The parties to a contract must have the mutual intent of entering into a binding legal agreement on the terms specified. This mutual intent may not be present because of a mutual mistake of fact, or where there has been the misrepresentation of a material ▶ Negotiating Agreement (15.3) discusses negotiation as a problem-solving skill that can be learned and mastered. fact or outright fraud, or because of the use of undue influence, or physical or eco- nomic duress. There is a difference between hard bargaining and economic duress. An architect may enter into an economically disadvantageous contract because the economy is bad and there are no other commissions to be had. The client who takes advantage of the architect's financial distress may be a sharp operator, but is not putting the architect under economic duress. Necessity for a Writing Only certain types of contracts are required to be in writing under what is called the Statute of Frauds, and this only affects the enforceability, not the underlying validity, of a contract. Examples include contracts for an interest in real estate (including the sale or lease of property), contracts that by their terms cannot be performed within a year, financial guarantees, and contracts between merchants under the Uniform Com- mercial Code for goods valued at $500 or more. Of particular interest to design profes- sionals, under the copyright laws any transfer of an interest in a copyright (such as the copyright in a set of drawings that the architect has prepared) must be in writing. Ownership of the drawings, even in an electronic form, is separate and distinct from the architect's ownership of the copyright that is embodied in them. Thus, a transfer of the drawings to another party such as the client does not result in a transfer of the copyright: That must be covered by a specific written agreement. Essential Terms, Express and Implied The terms of an agreement must be sufficiently definite in order for it to rise to the level of a contract. Essential terms include the subject matter of the contract such as the services to be performed, the time for performance, and the price to be paid for those services. In the absence of any of these terms, the contract may "fail for indefi- niteness," severely limiting the remedies that an architect might have. Services to Be Provided Is it enough for an architect to agree simply to design a client's house and still have an enforceable contract? Probably not, given the complexity of modern design and con- struction. In order to provide the necessary specificity, it will be important to describe the project, including such things as its location, building and construction type, approximate size or capacity, quality, and estimated cost. Services may be intangible in nature and abstract in their definition, and even when they are described in some detail, it is important to also define the deliverables that will result. In doing so, the architect should be careful to make it clear that the architect is providing and the client is pur- chasing services, not drawings. Since 1865, the AIA has taken care to define drawings as "instruments of service." Compensation Compensation is an essential term of any contract. Without it, the contract can "fail for indefiniteness." There are limited circumstances in which a court may supply a missing term of such importance. If the agreement is silent on the subject of compensation, a court may be able to sup- ply an implied term of "reasonable compensation." What is reasonable might be measured by the price that a client has previously paid the architect for similar services, or by what the architect normally charges for such services, or by what architects in the community normally charge or are paid for similar services. Obviously, it is better to have a specific agreement than to have to rely on others to determine what one deserves to be paid. Time of Performance The time of performance is an essential term of any agreement. If the time term is not specified, courts may sometimes find that there is an implied agreement that PART 4: CONTRACTS AND AGREEMENTS 1042 Agreements and AIA Document Program performance (such as when payments are due) will take place within a "reasonable time." The timing of architectural services often depends on external factors over which the architect has no control, particularly the time required for the periodic client approvals needed for the architect to proceed and building code review and approval of the construction documents. While it may not be practicable to include a schedule in the contract, a provision addressing the time for the performance and completion of the architect's services should be a part of every contract. The architect must be careful that any provisions on time of performance take into account delays caused by the cli- ent and external factors. Express Terms Express terms of a contract are those that have been specifically agreed upon, whether verbally or in writing. Courts generally require that certain undertakings be express, such as an agreement to indemnify another party. An architect may tell the client during negotiations that schematic design studies will be completed within 60 days. If the agreement is not in writing, the 60-day com- mitment is nevertheless an express term of the agreement. However, when and if the agreement is reduced to writing, it is important that all terms be included in the written contract, which generally supersedes any prior oral or written understand- ings or agreements. Most courts will not allow such "extrinsic" evidence to vary or add to the terms of a written agreement that appears to be complete and unambigu- ous on its face. The terms of the contract will be interpreted based on the reasonable meaning of the words that were used by the parties, or by common usage in their line of business, or by the conduct or course of dealing of the parties themselves. If the architect agrees to design a commercial retail space in a shopping center as a "vanilla shell" and agrees to produce a "permit-ready set" of drawings, these terms will have meanings that can be defined with fair certainty. Difficulties arise when commonly used words such as "estimate" and "inspection" have special meanings of which the client may not be aware. Implied Terms and the Architect's Standard of Care Implied terms in a contract are not specifically mentioned and have to be inferred. They include terms that are a necessary consequence of what the parties have under- taken to do. For example, under the professional standard of care, the architect has a duty under the building code to comply with the design requirements of that code, and it can be implied in a contract for architectural services that the architect will fulfill that duty. Whether the violation of a building code provision related to design is considered to be evidence of negligence in itself (negligence "per se") or merely as evidence of negligence varies among jurisdictions. While the architect's contract specifies what the architect will do, the manner in which the architect's services are performed is generally determined by the professional standard of care. Architectural agreements have historically been silent on the archi- tect's responsibility for code compliance and for the adequacy of its construction docu- ments. It went without saying that the architect was obligated to fulfill these responsibilities under the architect's professional standard of care. A few cases have held that architects impliedly warrant that their services have been performed in accor- dance with the professional standard of care. Since the 1970s, more sophisticated owners have insisted on including express terms in the architect's contract. Some of these terms have the effect of imposing a higher standard of care, and must be scrutinized carefully because they may go beyond what is covered under the architect's professional liability insurance. The current AIA agreement forms address clients' desire for more specificity by including a statement of a standard of care that is consistent with the law. ▶ Risk Management Strategies (16.1) further addresses standard-of-care issues and how to know and manage the risks inherent in architecture practice. TYPES OF AGREEMENT Agreements between architects and their clients can take many forms. Oral Agreements Oral or "handshake" agreements should be avoided except for the simplest, shortest, and least costly undertakings on behalf of a known and trusted client. While they may fulfill the legal necessities of a contract, oral agreements usually leave too many things unsaid: Movie mogul Samuel Goldwyn is reputed to have said that "verbal agreements aren't worth the paper they are written on." Some state laws—particularly consumer protection laws—require that certain types of agreement be in writing. This can extend to agreements for architectural design services. The biggest problem with verbal agreements is proving what terms were actually agreed upon. By the time a misunderstanding develops into a legal dispute, the parties may have vastly different recollections of what was agreed to—such as whether there was an understanding that the building would not exceed a certain cost. When the architect is put in the position of working under a verbal contract, even if it is based upon a detailed proposal or contract form that the client has neglected to sign and return, it will serve the architect to confirm the terms of any verbal agreement in writ- ing as soon as possible, and before beginning performance. Letter Agreements Letter agreements are sometimes used to confirm a prior informal verbal agreement, perhaps with the addition of a few terms not previously discussed. They may fulfill the legal necessities of a contract if they cover (1) the services to be provided, (2) the price to be paid, and (3) the time of performance, and provide for the client to return a signed copy confirming the client's acceptance. Like oral agreements, however, letter agreements often leave out too many things, and if the client does not coun- tersign with its acceptance, the letter may not prove the terms that were actually agreed upon. One variation on the letter agreement is the detailed proposal letter that an archi- tect may submit to a client. This approach is commonplace in all types and sizes of firms. Architects' proposal letters typically describe the project, the scope of services, and the proposed compensation, all in some detail, but all too often omit many of the "boilerplate" terms and conditions such as are found in the standard AIA agreement forms. To remedy that omission, a proposal should incorporate by reference or attach an AIA form or other terms and conditions document. If a client responds to the architect's proposal with any change in the terms, this is legally considered to be a rejection of the architect's proposal and a counteroffer. This exchange of offers and counteroffers may continue for several rounds before a final agreement is reached. The architect should take care to see that all of the terms of the agreement are restated in the final exchange. If a letter agreement is subsequently replaced with a formal written contract, the contract's "integration clause" should note that it specifically supersedes the prior letter agreement. This will avoid having two potentially inconsistent contracts operating simultaneously. What if a client responds to a proposal by asking the architect to proceed with the services as outlined, but without making a firm commitment to the price or other terms or returning a countersigned copy? If the proposal (or an attached AIA agreement form) is never signed by the client, the oral authorization to proceed may be the only contract there is, and it will be subject to all of the same difficulties encountered with oral agreements. The written proposal or AIA form will only be evidence of what the agreement is, not definitive proof. One way to address the possibility that a client may not countersign and return the written proposal is to provide in the proposal for the manner in which it may be accepted by the client: in effect, by creating a "self-executing" proposal. The architect could do so (with the assistance of an attorney) by including a statement in the proposal that the terms of the proposal (and/or the attached AIA agreement form) can be accepted by the client's giving authorization for the architect to proceed with the ser- vices described in the proposal. AIA's Owner-Architect Agreement for a Residential or Small Commercial Project, AIA Document B105TM-2007, has been designed as a substitute for a simple letter agreement on smaller projects. Formal Written Contracts Formal written contracts identify the parties to the contract, describe the scope of the project and services to be provided, the architect's compensation, and the time of per- formance, and indicate the parties' acceptance by their written signatures. They often include additional terms and conditions. Contracting parties should take pains to see that their written contract is a com- plete expression of their agreement. Any conditions or contingencies should be spelled out in the written contract. When a contract is in writing and appears to be complete and unambiguous on its face, the courts are reluctant to look beyond the written words. Standard AIA Contracts Standard AIA forms of agreement for architectural services were first introduced in 1917. Today, the AIA publishes many different forms of owner-architect agreement. Although these "B-series" documents share many of the same provisions, each addresses a particular range of circumstances. The various architectural services agreement forms are found in coordinated families of documents. AIA's standard forms of agreement are based on general principles of law prevailing in the United States. However, variations in state and local laws may affect the form and substance of agreements, particularly consumer protection laws that may affect contracts with residential clients. The architect should be aware of the laws in every jurisdiction in which the architect practices. Variation in both statutory and case law among jurisdictions is one reason why architects should consult an attorney about using, completing, or modifying a standard form. There are many advantages of using AIA standard forms, for both parties: • The forms describe the services typically provided by the architect in some detail, and in terms that have been widely used in the industry; they also describe the cli- ent's responsibilities. • AIA forms cover the situations, conditions, and contingencies that are most fre- quently encountered, such as the need for additional services, what happens when the building as designed will cost more than was originally anticipated, and the client's rights to use the work product of the architect. • They describe not only the extent, but many of the limitations of the architect's services, responsibilities, and authority, so as to avoid major misunderstandings. • AIA agreement forms are carefully coordinated with other contracts and forms that will be used on the project. • Great care is taken to see that the forms are objectively reasonable and fair, and that they will be legally enforceable by all parties. The documents have a long history of acceptance by the courts. Some clients may express a reluctance to use a standard printed form for fear that it may be one-sided in favor of the architect. The best way to overcome such a fear will be to engage the prospective client in a review of the specific terms of the agreement to identify any provisions that are of particular concern. ▶ The AIA Documents Program (17.5) discusses the range of standard form agreements included in the AIA Contract Documents. SPECIAL CONSIDERATIONS Any agreement for architectural services will need to take into account some special considerations, including the following. Nature of the Owner, Their Capabilities, and Successors Individual Clients Individual clients building for themselves or a small business (as opposed to business entities or institutional clients with building programs) rarely have much experience with architects or building construction, and so may have expectations that differ from normal industry practice. For instance, a client may need to understand that an archi- tect expects to be paid for its services whether or not the client decides to proceed with construction. It is extremely important that an agreement be reached regarding any construction cost limitations. "Design creep" can easily take the construction cost of a project beyond what the client expected to spend, and the architect must be prepared to keep rein on the client's expectations. Likewise, the client will need to understand that "schedule creep" must be controlled, as it can delay a project beyond the antici- pated construction commencement or completion date. Individuals sometimes mix their business and personal affairs. If there is a business use involved, the individual may own the business outright or be part of a business entity such as a partnership. It is important to determine whether the client is the individual or the business entity. Care must also be taken when dealing with married couples or partners in civil unions. A client's spouse or domestic partner may not be bound by an agreement entered into solely by the client. Most projects involve improvements to real property. In order for the architect to secure its lien rights (if available), the architect should check to see that the client is in fact the sole legal owner of the property. Individual clients building for their own use may fall under the protection of cer- tain state and local consumer protection, new-home, or home-improvement laws and regulations. AIA Document B105TM-2007 is a form of agreement that may be appropriate for small residential projects. Small Businesses Small businesses may take many different forms, from individual proprietorships to partnerships, limited liability corporations, and business corporations. A business may be "trading as" or "doing business as" using another name. Some of these forms of business will give the individual limited liability for the debts and obligations of the business. It is important for the architect to know exactly who the client is, and to determine the client's fiscal responsibility. The architect should also check the state corporations or franchise tax office to determine that the business has a legal existence and is in good standing with the state. AIA Document B104TM-2007 is a form of agreement that may be appropriate for small to midsize projects that are of limited scope and complexity. Corporate Clients Corporations, limited partnerships, limited liability companies, and other business enti- ties such as real estate investment trusts operate through individuals, but not all corporate or entity employees have the authority to make binding commitments. It is important to know the capacity of the individual(s) with whom one is dealing. Unless that individual is the corporate president or CEO with clear authority to commit the organization, the architect should determine just what the individual's authority is. It is not uncommon for the owner's project manager, to whom the architect reports, to be employed by an entity different from that with which the architect has contracted (making the individual an agent of the client). It is far better for the architect to be able to rely on actual authority, stated in the contract, than on the apparent authority of an agent of the client. In addition, the architect should also determine what relationship the client corpora- tion has to the real property that is to be improved. The actual owner of the property may be a "shell" corporation with no unencumbered assets; it could be a wholly owned subsidiary; or a separate corporation controlled by or under common control by the cli- ent. The client may want the contract to be with one entity, but have the architect report to people in another company. These corporate interrelationships need to be sorted out. Most corporate projects are constructed for the company's own use and occupancy for an indefinite time into the future. Thus, the company may be more interested in sustainable design, the comfort and convenience of its employees, higher quality of construction, increased energy efficiency, and longer-term savings in operating costs than in a lower initial cost of construction. A corporate client may also offer the archi- tect an opportunity to provide extensive additional services, such as interior design. AIA Documents B101TM-2007 and B103TM-2007 are forms of agreement that may be appropriate for larger and more complex projects. Nonprofit Organizations and Institutional Clients Nonprofit organizations and institutional clients such as educational and health care institutions usually have a corporate organizational structure; however, they differ from business corporations in their outlook. Because these organizations are less oriented to making a profit than providing a service, the construction of a building may not be viewed as an investment that must have a measurable return. These organizations may be much more receptive to making expenditures for sustainable design and measures that require an extended amortization period. Many nonprofit organizations work on extremely tight budgets. They may expect their professional service providers to contribute part of their services or work at reduced rates. AIA Document B101TM-2007 may be an appropriate contract to use for typical institutional building projects. AIA Document B106TM-2010 has been developed for those situations in which an architect is performing services on a pro bono basis. A version of B101TM-2007 for use on sustainable projects, B101TM-2007 SP, is also avail- able, complementing other newly published AIA documents for sustainable projects. Public Sector Clients and Publicly Funded Clients Contracting with a public sector client differs in many respects from the private sector. Architects seeking to work for the public sector should first be aware of the selection procedures utilized by an agency. One paramount principle of government contracting is that an agency generally cannot legally contract for services without a specific legislative and/or budgetary authorization. Only certain designated officials have the authority to enter into con- tracts; contracts are invariably written, but often on an inflexible, non-negotiable gov- ernment form that may or may not be up to date or appropriate for architectural services. There are many rules and regulations that may be incorporated into a con- tract or that will apply independent of the contract, such as accounting rules that may affect the architect's entire practice. The architect is obligated to be aware of and comply with these regulations whether or not they have been brought to the archi- tect's attention. Government contracts can be extremely difficult to modify, such as to authorize the performance of or pay for additional services that may have been required of the archi- tect. Some public sector forms of contract have borrowed liberally from prior editions of AIA Contract Documents. Some AIA components have worked with public sector entities to develop adaptations of the AIA forms that meet their specific contracting requirements but remain consistent with current architectural practices, services, and expectations. ▶ See Owner-Generated Agreements (17.3) for further information about how to evaluate terms in such agreements. Contracts with clients whose funds are provided by public sources such as grants or loans will also involve restrictions and regulations with which the architect must be familiar. Users may consider the specialized scope of service forms in the B200 series of documents for defining the scope of services to be provided in a public sector contract. AIA Document B108TM-2010 has been designed for use on certain federally funded or federally insured building projects. Developers Contracting with a real estate developer is different in many respects from the average business client who is building on its own behalf. Professional developers are usually very familiar with the market for design services and construction. They often have a very definite idea of the services that they want, and how much they are willing to pay for them. While some developers have begun to see the value in having a LEED-cer- tified building, many speculative builders may still be driven by the desire for a project that has the lowest possible initial cost—and this includes their architectural services. Developers are among the client types who prefer to use their own form of contract, and the terms they seek to impose on the architect can be very one-sided. Many develop- ers and their attorneys now use the AIA Contract Documents software as a starting point for their agreements, so some of the language in a developer's agreement form may be familiar to the architect. However, the presence of familiar language may be deceptive, as the language changes may be subtle and the modifications (particularly deletions) may be extensive, substantially changing a document's legal effects. Engaging a knowledge- able attorney may be necessary in order to negotiate a contract with acceptable risks. Typically the owner of the property to be developed is a single-purpose entity that only exists on paper and has no other assets other than the property, which is already fully encumbered by a development or construction loan. It is important for the archi- tect to ascertain just what the relationship is between the developer and the client who signs the contract. Because the project may be highly leveraged and offer no source of financial recov- ery for the architect, it is important that during the course of the project, the architect keeps current with its billings and keeps the client current on its payments. Services that have not been billed or fees that are in arrears may be very difficult to collect if the developer or the project encounters financial problems. One consideration that should be kept in mind is that the project may be one such as a condominium apartment building that the client will be turning over to one or more new owners after it is completed. This may expose the architect to potential claims from many subsequent purchasers for alleged deficiencies in design and construction. AIA Documents B107TM-2010 and B109TM-2010 are forms of agreement that may be appropriate for use with developers of single-family residential projects and larger, mixed-use developments, respectively. In addition, AIA Document B509TM-2010 pro- vides supplementary conditions that may be used to modify B109 for use in residential condominium construction projects. Design-Build Companies Another class of client that the architect finds far different from others is the design- builder. In this situation, the architect no longer has a direct relationship with the ultimate client, and the architect may be working under a detailed set of design criteria developed by the owner or its bridging consultant. The architect's design decisions may be subject to a higher level of scrutiny for their impact on overall building costs. Deci- sions on finishes, materials, and equipment selection may be made by the design- builder rather than the architect. Finally, the architect may have a much diminished role in construction administration, perhaps limited to reviewing subcontractors' shop drawings, responding to requests for information (RFIs), and providing other services only on an as-needed basis. ▶ Contractor-Led Design-Build (9.4) further discusses arrangements in which the contractor holds the prime contract with the owner. PART 4: CONTRACTS AND AGREEMENTS 1048 Agreements and AIA Document Program Since the emergence of design-build in the 1980s, the AIA has promoted measures that help ensure that the architect will continue to have a meaningful and ethically proper role in the design-build process, even when serving as a consultant to a design- builder. AIA Document B143TM-2004 is a contract specifically designed for use between the design-builder and the architect. If the design-builder is not using AIA forms for its agreement with the owner, B143TM-2004 can be used as a reference to evaluate the form of agreement that the design-builder proposes that the architect use. Nature and Extent of the Architect's Undertaking The Baseline: "Full" Traditional Services A client that has a definite need, knows its requirements, and has a budget and the means to pay for a project is in a good position to enter into a contract such as AIA Documents B101TM-2007, B103TM-2007, or B109TM-2010, each of which will provide for a "full" scope of services that includes the traditional "Basic Services" plus "Addi- tional Services" that may range from programming and site selection through postoc- cupancy evaluation. The architect may be able to assemble a project team for the duration of the project and provide the services more efficiently than on a piecemeal basis. The higher degree of certainty in such a project may allow the architect to struc- ture a definitive compensation package. Feasibility and Design Studies A contract for preliminary services such as feasibility and conceptual design studies will be most appropriate when the client is not entirely sure of its needs, its desires, or its finances. These types of services may be more open-ended, and it may be most appropri- ate to charge for them on an hourly or similar basis. It may be appropriate to contract for such services under the terms and conditions of AIA Document B102TM-2007, with the scope of services found in B203TM-2007, the scope of services document for Site Evalua- tion and Planning. Another example is AIA Document B142TM-2004, the agreement form under which an architect will define the scope of a design-build project for the owner. Procurement and Construction Phase Services The architect who has an involvement in the bidding and negotiation phase is more likely to see that a construction contract incorporating AIA Document A201TM-2007 is used. The AIA general conditions includes provisions affecting the architect's inter- ests, such as notice of perceived errors or inconsistencies in the contract documents, insurance, indemnity, and waiver of subrogation provisions. Without any involvement during bidding, the architect will have no influence over the documentation that is used for the construction contract. The construction phase services of A201 are incorpo- rated by reference into AIA owner/architect agreements. If A201 is not used, the archi- tect's construction phase services written there establish a reasonable basis for the architect's compensation during the construction phase. Some owners, particularly those with ongoing building programs, have the knowl- edge, experience, and personnel to manage the bidding and construction process and to take on much of the contract administration by themselves. Other owners will have hired construction managers to manage construction procurement and administration. In such cases, the architect's role during procurement may be limited to advising on the acceptance of various alternates, and during construction, to reviewing and approv- ing submittals and making recommendations for (as opposed to certifying) payments to the contractor. See AIA Document B132TM-2009, the agreement form that has been designed for use on construction management projects. Unfortunately, there are also owners who lack construction procurement or admin- istration capabilities, but do not appreciate the value of an architect's services during construction. Architects who contract to provide design services only should consider obtaining legal advice to protect their interests, which may be affected by what may happen during the course of construction. The Architect as Subconsultant Architects are not always the lead on a project with a direct contract with the owner. When the architect is in a subsidiary position, such as a subconsultant to an engineer- ing firm on a project that has a high engineering component, the architect may not have a choice of which form of agreement to use. Because the architect will be assum- ing part of the prime consultant's responsibilities, and usually is subject to a "flow- down" of rights and responsibilities, it is important that the architect is provided with a copy of the prime consultant's agreement. Of particular importance will be any unusual allocations of risk in the prime agreement such as indemnity clauses, dispute resolution, and provisions requiring redesign in case of cost overruns. As a subconsultant, the architect will need to know who is responsible for coordi- nating the work of the architect with that of the prime consultant, with other subcon- sultants, and with other prime consultants working for the owner. As a subconsultant, the payment provisions of the contract need to be examined carefully. Will the architect be paid promptly for its services when billed? Will payment be made within a reasonable time after the owner has paid the prime consultant ("pay when paid")? Or will the architect be expected to bear the risk of nonpayment by the client ("pay if paid")? The Architect as a Team Member "Teaming" is a popular term in marketing but is extremely vague in describing legal responsibilities. In some forms of project delivery, such as design-build and integrated project delivery (IPD), the architect may be assuming legal obligations that extend not only to the ultimate client or project owner, but also to other team members. For instance, as a partner in a joint venture, the architect may have fiduciary responsibilities to its partners that go beyond the duties one would have to a client or consultant. The Delivery Method The various construction delivery methods (i.e., conventional design-bid-build, cost- plus work, contracting with separate primes, fast-tracking or phased construction, con- struction management with a CM-adviser or CM-constructor, design-build, and integrated project delivery) will affect the design documentation that will be provided by the architect, as well as the scope and extent of the architect's construction phase services. If the client has determined what the delivery method will be at the time the owner-architect agreement is negotiated, that should be set forth in the written agree- ment, and appropriate modifications may need to be made in the architect's services and construction phase responsibilities. The architect's design and construction phase services, as described in AIA Docu- ment B101TM-2007, anticipates that the project will be procured and constructed in a conventional manner—a fixed-price contract with a single general contractor. This should be regarded not as a commitment by the client that it will use that process, but as the basis on which the architect prices its construction administration services. Review of alternative methods of delivery is a service that the architect provides under the standard AIA forms. If the owner determines that something other than a conven- tional delivery approach will be used, the architect will need to initiate a change in the agreement to reflect the approach chosen. For instance, if the owner intends to contract on a cost-plus basis, the architect may have substantially more construction administration work to do, particularly in reviewing the contractor's documentation of expenditures and calculating allowable overhead and profit. Similarly, if construction will proceed on the basis of a third- party professional construction manager managing multiple separate prime construc- tion contracts, the architect may be required to create multiple bid packages of construction documents for different trades. This may require substantially more effort than a single set of construction documents intended for a general contractor. PART 4: CONTRACTS AND AGREEMENTS 1050 Agreements and AIA Document Program In such a case the architect may also have more limited construction phase responsi- bilities. The terms of the owner-architect and owner-CM agreement will need to be coordinated closely. If the use of a cost-plus or multiple separate contracts can be anticipated at the time the contract for architectural services is entered into, or if the owner has preselected a contractor or construction manager with whom the architect will be working, these factors should be included in the agreement and appropriate forms selected and mod- ifications made. If it is known that the owner wants to include the services of a con- struction manager as adviser, the architect may want to start with the AIA's Construction Manager as Advisor forms. LEGAL AND RISK MANAGEMENT CONSIDERATIONS Risk Management and Allocation The professional services agreement is the primary vehicle for allocating risks between the client and architect. Some of the ways that this can be done are as follows. Architect's Disclaimers of Responsibility and Liability Sometimes it may be easy for a person to read too much into an undertaking described in a contract. Disclaimers are used in contracts to secure a mutual understanding of the limitations of the architect's authority and responsibility. For instance, the preparation of cost estimates by the architect is fundamentally different from a contractor's under- taking in pricing a project for bidding purposes, and yet the contractor may use the same term—"estimate." Perhaps the single most frequent cause of disputes between architects and their clients over the past 150 years (if not over centuries) arises when bids are received that far exceed the architect's estimates. The client may feel that the architect's services have been of no value, and refuses to make payment for the services rendered, especially when the project has to be abandoned or radically reduced in scope. In order to avoid misunderstandings, it is important that architects make it clear that they are not guaranteeing the cost of construction or warranting that costs will not exceed the architect's estimate. Beyond that, the agreement should address what hap- pens if bids exceed the client's budget or the architect's estimate. Clients and members of the public may have unrealistic expectations as to the extent of the architect's control over the contractor during the construction process, and the extent of the architect's responsibility for the acts or failures to act of the con- tractor and its subordinates. The architect's review of shop drawings and other submit- tals has a limited purpose. Likewise, the architect's certifications of a contractor's applications for payment may be misconstrued. These undertakings by the architect are limited by carefully worded disclaimers in the AIA owner-architect agreements and construction contract forms in order to distinguish between the responsibility of the actor (contractor) and the reviewer (architect). Limitations of Liability One method of risk allocation that has become increasingly common over the last 40 years is the contractual limitation of liability. Such a provision may be an agreement by the client to limit any claim against the architect to an amount not to exceed the archi- tect's fee or some other sum, or the amount of available insurance coverage. The pur- pose of such a limitation is to make it clear how much potential risk the architect is prepared to shoulder for the fee it is to receive. Such provisions are often upheld, particularly when it is demonstrated that the limitation is part of an overall risk man- agement agreement that the parties have reached. Because limitations of liability alter the normal legal consequences, courts scrutinize them carefully, and they may be sub- ject to state law requirements. Architects are well advised to seek legal assistance in drafting such a provision. ▶ Risk Management Strategies (16.1) addresses the range of risks that architects encounter— and the strategies to manage them. The AIA has not elected to include limitation of liability clauses in its standard form agreements, but sample language can be found in AIA Document B503TM-2007, Guide for Amendments to AIA Owner-Architect Agreements. Insurance Insurance is an essential element of any risk management strategy. Some clients insist that their architects carry certain types and limits of coverage. Inclusion of such provi- sions can reinforce an overall risk management strategy; however, it is important that the coverage and limits specified are reasonable and available. Consultation with one's insurance adviser is critical. It is also important that the architect understand what coverage and limits are car- ried by the client. AIA professional services agreements and construction contract forms contain waivers of subrogation that assume that the owner carries property insurance. Some owners do not carry such insurance, and are self-insured. Legal assis- tance will be needed to redraft these waivers so that their intent is preserved when the client self-insures. A key element of the insurance plan is a universal waiver of subrogation that extends to all the project participants—owner, architect, consultants, contractor, and subcontractors. The effect of the waiver is to make the owner's property insurance the source of recovery for an insured loss, and to prevent the insurer from bringing suits against project participants in order to recover the amounts it has paid out. Such a waiver can only be implemented in a written contract, and all of the AIA professional services agreements and construction contract and subcontract forms include a univer- sal waiver of subrogation for losses covered by the owner's required property insurance. Indemnification (Hold-Harmless) Provisions Indemnification is an important part of the overall risk management strategy embodied in the AIA contract documents. It is found in the provisions of the construction con- tract, whereby the contractor is obligated to indemnify the owner and architect against damages or injuries suffered as a result of the contractor's negligence. It has become common for sophisticated owners to demand indemnification from the architect, as well. Such clauses may extend far beyond the architect's normal legal liability for its errors and omissions and may be uninsurable—for instance, the clause may require the architect not only to indemnify but also to defend the owner against claims, which takes the clause outside of the coverage of the architect's normal profes- sional liability insurance. Because of the legal complexities of such a provision, an architect should consult its attorney upon encountering such a provision. An example of an indemnification provision that can be used (with appropriate legal guidance) is found in AIA Document B103TM-2007, the owner-architect agree- ment form for large or complex projects; and in AIA Document B503TM-2007, Guide for Amendments to AIA Owner-Architect Agreements. Responsibility for Consequential Damages Consequential damages are the indirect costs that result from a breach of a contractual undertaking. A primary example would be lost income, productivity, rents, and profits resulting from a construction defect (the direct damages would be the cost of correction of the defective work). Such damages can amount to huge sums, and far exceed the reason- able expectations of the person against whom they are claimed. In a well-considered risk management plan, an owner would purchase loss of use insurance to cover such conse- quential damages, and there would be a waiver of subrogation so that the owner's insurer could not turn around and sue the contractor or architect in the name of the owner. The AIA professional services agreements and construction contract and subcon- tract forms all include a universal mutual waiver of consequential damages. Like the waiver of subrogation, it is important that this be included in every participant's con- tract in order to be fully effective. ▶ See Owner-Generated Agreements (17.3) for guidance on how to systematically approach terms in agreements provided by owners. PART 4: CONTRACTS AND AGREEMENTS 1052 Agreements and AIA Document Program Other Contract Issues There are more contract issues that should be addressed in a typical professional ser- vices agreement. Among the most important are the following. Intellectual Property The architect performs professional services, which are represented in tangible form by the drawings, specifications, and other documents that the architect prepares. They are not tangible goods that the architect sells to the client. Nevertheless, some clients take the position that since they are paying for their creation, the documents prepared by the architect (and all rights therein) are owned by the client. The AIA has consis- tently maintained the position embodied in the U.S. copyright laws that the documents prepared by the architect are the intellectual property of the architect, as their author and creator. AIA contracts go to a great extent to delineate the rights and responsibili- ties of the owner, architect, and contractors in the documents prepared by the architect. With the emergence of electronic technology, the architect's work product has taken a more intangible form. The AIA has developed a family of digital practice doc- uments that contain protocols that can be agreed upon by the parties who are transmit- ting and receiving these documents. Additional Services Additional services have long been a source of friction between clients and their architects. Clients are prone to ask for changes in the architect's design, or for extra services that the architect did not anticipate providing. The architects for the original Library of Congress building won the initial design competition with an Italian Renaissance design in 1873, and over the next 15 years were asked to develop designs in Gothic, French Renaissance, Romanesque, and German Renaissance styles, ultimately returning to an Italian Renais- sance scheme. A less-than-satisfactory award on their claim for services rendered was finally confirmed by the Supreme Court in 1893, some 20 years after their work began. The need for additional services also arises out of events that occur over which neither party has any control, such as a change in the building code. AIA owner-archi- tect agreements distinguish between additional services that the architect will perform only when requested to do so by the client, and the additional services that the architect will provide unless the client determines that they should not be provided—which will typically result in a reassessment of how to deal with the contingency that has arisen. When preparing an AIA agreement form, the parties should carefully review the document and determine which of the listed services are applicable, and make their own determinations as to the services that should be included in the architect's basic compensation, those services that will not be required, and those that may be required and should be considered as "additional services." COMPLETING AND MODIFYING THE STANDARD AIA AGREEMENT FORMS Every architectural commission is different. The standard AIA owner-architect agree- ment forms provide a lot of flexibility in how they are completed, and the AIA Contract Documents software provides the ability to modify them at will, while keeping track of changes made from the original. A dozen different forms of agreement, and the many additional possibilities provided by the B200 scope of services series of documents, cover a large range of situations. Nevertheless, users should understand when and how to adapt the documents for their own purposes. Assumptions on Which the Contract Will Be Based The services described in AIA Document B101TM-2007, the prototypical AIA owner- architect agreement, generally apply where the owner will be constructing a new ▶ The AIA Documents Program (17.5) covers the range of standard forms included in the AIA Contract Documents. building for its own use on an undeveloped site. Since 1997, AIA owner-architect agreements have included room for a detailed description of the initial information or assumptions on which the agreement is based, including the project's description and its parameters. Users are encouraged to complete optional Exhibit A to AIA Document B101TM-2007, which will include information on the project's physical characteristics, program, budget, delivery schedule, and construction delivery method—all critical information, which could require substantial modifications if it changes from the initial assumptions on which the agreement is based. During the initial client interviews and a site visit, the architect should determine if there are other major factors to account for. The client may in fact be looking to renovate, modify, or add to an existing structure, which will trigger the need for addi- tional services to document existing conditions. An existing building may remain par- tially occupied during renovations. There may be significant historic preservation aspects to the project. The site may have existing improvements on it that may need to be demolished, but even if the site has been cleared, there may have been a prior use of the site (in days before environmental regulations) that will require investigation. Services Provided by Architect's and Owner's Consultants The standard B101TM-2007 form anticipates that the architect's services include the "usual and customary" structural, mechanical, and electrical engineering services required for the project. These services are typically provided by the architect's consul- tants, who many owners insist on having listed in the agreement. Users should note that civil engineering, a site-related service, is not included. Under the agreement, the owner is responsible for site investigations—the rationale is that, after all, it is the owner's property, and there can be serious consequences if there is an error in the sur- vey or subsurface investigation reports. That is a risk that the architect is not normally prepared to undertake. If the site investigations are not a service that the architect typically provides, civil and geotechnical engineering services are likely not covered under the architect's professional liability insurance. To avoid any confusion over "who does what," an agreement should specify the ser- vices that are to be provided by the architect, the owner, and the consultants of either party. The responsibility for coordination of these consultants' services must also be addressed. Owner's Role AIA contracts have historically anticipated that the owner will have a limited role in the project, primarily in providing necessary information and approvals, providing insurance, and making payments. Many owners prefer to have a more active role in both design and construction of the facility. In the latter case, the owner may maintain its own construction administration staff, and the architect's authority may be limited to an advisory role. Any such change in the balance of responsibilities should be reflected in the agreement. One major change in the owner's responsibilities that has been anticipated in some AIA professional services agreements is the provision by the owner of cost estimating services. These provisions, which will also affect the architect's responsibilities for rede- sign to meet budgetary requirements, can be found in AIA Documents B103TM-2007 (for large, complex projects), B105TM-2007 (for small projects), and B109TM-2010 (for large, multifamily residential and multiuse development projects). B108TM-2010, used on federally funded projects, provides an option for either the architect or owner to provide the cost estimates. Modifying the AIA Forms AIA Document B503TM-2007, Guide for Amendments to AIA Owner-Architect Agree- ments, includes sample language for many modifications that a user might wish to make. Most agreement forms have a provision such as Article 12 of AIA Document B101TM-2007, where additional terms and conditions can be added, or where reference can be made to an Exhibit or Attachment to the agreement form. For descriptions of various types of services, users should consult the special-purpose forms described in this section and the B200-series scope of services documents that are used in conjunc- tion with B102TM-2007.