Percentage-of-completion vs. completed contract

%-of-completion is a better predictor of trends in earning power.

Under Percentage-of-completion
Contruction-in-progress (CIP)

• considered as current asset and only affect current asset but not LT asset.
  
  CIP = Cumulative cost incurred + cumulative pro-rata share of gross profit
  Where:
  Cumulative pro-rata share of gross profit = (Cost incurred/ Total cost )x estimate total profit

Advance billing:

• cumulative over the project life

Construction-in-progress and advance billing are netted in balance sheet. The amount of cumulative construciton-in-progress minus advance billing is posted to financial statements.

• If +ve, construciton-in-progress in asset side;
• If –ve, advance billing in liability side.

Under completed contract method

• Contruction-in-progress does not include cumulative gross profit recognition but netting of contruction-in-progress & advance billing still occurs. Due to non-recognition of gross profit, liability is likely be greater under completed contract method.

Impact of the use of percentage-of-completion in compared to use of completed contract in the years before the completion of the contract:

• Cash flows - No impact Cash flow schedule specified in contract
• Assets – Higher (due to greater construciton-in-progress)
• Liabilities – Lower
• Equity - Higher (due to higher income)
• Revenues – Higher (Revenue in completed contract = 0)
• COGS – Higher (COGS in completed contract = 0)
• Net Income – Higher (Higher revenues outweigh higher COGS)
• Volatility of income - Lower (Income smoothened out)
• Profitability (ROE, ROA) – Higher (Higher NI outweighs higher equity)
• Leverage (Debt/Equity) - Lower (due to higher equity)
• Shareholder’s equity- greater
• Current ratio- higher (due to higher construction-in-progress)
• A/c receivable turnover- higher (due to higher revenue w/ same a/c receivable)

Note:

• LT asset is not affected by selection of %-of completion or completed contract methods.