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.

Expense recognition – matching principle

Under accrual accounting, expenses recognition is based on the matching principle.

Matching principle

• If the expenses are tied directly to generating the revenue, recognize them in the same period as the revenue
• If the expenses are NOT tied directly to generating the revenue, recognize them in the period they incurred, e.g. administrative costs.
• For long-lived assets, the cost must be matched with revenue in form of depreciation or amortization expenses.
• For goods on credit or warranty, required to estimate bad-debt expense / warranty expenses.

Implication:

• delay expenses recognition increase net income and is more aggressive.

Revenue Recognition Methods and Implications

Sales-basis Method

• Revenue is recognized at the time of sale, i.e. the moment when the title of the goods or services is transferred to the buyer.

Implication:

• the most common and accurate form of revenue recognition.

Percentage-of-completion method

• Logistically extended by sales basis method
• Recognize revenues and expenses in proportion to work completed.
• Used by contractors and service firms for long-term projects.
• Use this method if two conditions are met: (1) a long-term legally enforceable contract (2)
• can estimate the percentage of the project that is complete, its revenues and its costs.
• Two conditions to estimate the %: (1) engineering estimation or physical milestone 2) ratio of incurred cost to the total estimated cost even if the total estimated cost has changed.
  
  Revenue = (cost incurred / total cost) x (total revenue)
  Income = Revenue - cost incurred

Implication:

• can overstate revenues and gross profits if expenditures are recognized before they contribute to completed work.

Completed-contract method

• Recognize revenues and expenses upon the full completion of contract
• Used if the two basic conditions needed to use the percentage-of-completion method are not met
• More conversative than and revenue lag behind %-of completion method
• Cannot guage profitability from income statement & must analyse through cash flows

Implication:

• can understate revenues and gross profit within an accounting period because the contract is not accounted for until it is completed.

Installment sales method

• Recognize gross profit in proportion to cash collected.
• Used in case customer collections are unreliable but the cost of goods & services are available.
• Similar to %-of completion and revenue lag behind sales basis. Should analyse cash flow.
  
  Cost =(cash collected / total revenue) x (total cost)
  Income = cash collected – cost.

Implication:

• can overstate gross profits if the last payment is not received.

Cost-recoverability method

• No profit is recognized until all of the expenses incurred to complete the project have been recouped.
• Used when cost are not known
• Conservative form of installment sales method.

Implication:

• can understate gross profits initially and overstate profits in future years.

Notes:

• Under IFRS, if the firm cannot reliably measure the outcome of the project, revenue is recognized to the extend of contract costs, costs are expensed when incurred, and prodit is recoginized at completion
• %-of-completion is a more aggressive method than completed contract as the revenue is reported earlier. Cash flows are same under both methods.

Barter transaction

• Two parties exchange goods or services without any cash payment.
• According to US GAAP, recognize revenue at fair value only if the firm has historically received cash payments and can use this experience to determine the fair value.
• According to IFRS, revenue must be measured based on the fair value from similar non-barter transaction with unrelated parties.

Revenue-Recognition Principles and SECs additional Guidance

Revenue-Recognition Principles
Two conditions must be met for revenue recognition to take place:

• Completion of the Earnings Process (accrual concept)
• Assurance of Payment

SEC’s additional guidance on determining whether revenue should be recognized:

• evidence of arrangement between buyer and seller
• product/services has been delivered/rendered
• determinable price
• reasonable assurance of collecting the money by seller