“Is it more appropriate to apply the percentage-of-completion method or the completed-contract method for recognizing revenue of long-term construction contracts?”
Draft Paper for DFST3341
Financial AccountingBachelor of Applied Business Administration – Accounting
February 4, 2014
Many businesses are concerned with how to record their revenues and expenses in order to maximizing their benefits while minimizing their taxes legally. The question relating to taxes is often asked by many small businesses’ owners. However, another equally important issue that small business owners might often forgot is their accounting income which can be equally important. Many small businesses might be constantly looking for the additional loans to fund their on-going projects. Therefore, financial institutions and prospected investors might be wondering if the business can handle extra loans or take on the new proposed projects.
For the purpose of this paper, we will be examining small home builders who have been recording their contracted projects by using the completed method to determine if it is more appropriate to use the percentage of the completed method.
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The immediate impact of the different methods of revenue recognition will have direct impact on the financial statements. Therefore, we will be using the example from John-of-all-trades building corporation to base our findings if the company should be choosing one method over the other.
We may find that depending on the various needs of the business, one method might be more appropriate than the other depending on the desired numbers that a business owner wants to have on the financial statement that will be satisfying the unique needs of a company.
The Percentage of completion method versus the Completed contract method
A comparison of the two different accounting methods will enable us to have a better understanding of the advantages and disadvantages in term of financial and non-financial factors.
The percentage of completion method
The percentage-of-completion method recognizes income as work on a contract (or a group of closely related contracts) progresses. The recognition of revenues and profits is generally related to costs incurred in providing the services required under the contract.
Under this method, work-in-progress (WIP) is accumulated in the accounting records. At any point in time if the cumulative billings to date under the contract exceed the amount of the WIP plus the portion of the contract’s estimated gross profit attributable to that WIP, then the contractor recognizes a current liability captioned “billing in excess of costs and estimated earnings”. The liability recognizes the remaining obligation of the contractor to complete additional work prior to recognizing the excess billing as revenue.
If the reverse is true, that is, the accumulated WIP and gross profit earned exceed billings to date, then the contractor recognizes a current assets captioned “cost and estimated earnings in excess of billings.” This asset represents the portion of the contractor’s revenues under the contract that have been earned but not yet billed under the contract provisions.
The percentage-of-completion method recognizes the revenue over time as construction progresses to capture the ‘earned’ revenue and match it with the incurred expense. The contractor has the obligation to perform the work and the buyer has the obligation to pay the contractor throughout different completed stages of the project.
According to the article Overview of the Percentage of Completion method, this method works best when it is reasonably possible to estimate the stages of project completion and the remaining costs. This method will not be favourable when there are too much uncertainties about the percentage of completion and the contractor is unable to estimate the minimum total revenue and maximum total cost to arrive at the contract bid.
The advantages for the contractor would be a decrease in bad debt, revenue received sooner which improves the cash flow for the business which could lead to a potential reduction in interest expense, and an increase in motivation to complete the project according to the projected time frame.
The disadvantage for the contractor would be an increase in administering cost to issue estimates of completed stages of the project, an increase in labour for issuing invoices and collecting revenues.
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The disadvantage for the buyer would be an increase in cash out flow than the completed accounting method.
The completed-contract method
The completed-contract method recognizes incomes only when the contract is complete, or substantially complete. Under this method, contract costs and related billings are accumulated in the accounting records and reported as deferrals items on the statement of financial position until the project is complete or substantially complete. A contract is regarded as substantially complete if remaining costs of completion are immaterial. When the accumulated costs (WIP) exceed the related billings, the excess is presented as a current asset (inventory account). If billings exceed related costs, the difference is presented by current liability. The determination is also made on a project-by-project basis with the accumulated assets and liabilities being separately stated on the statement of financial position. An excess of accumulated billings over related costs is presented in most cases as a current liability.
The completed contract method is a deferral method of recognizing the ‘earned’ revenue and ‘realized’ expenses. The completed contract method will recognize the WIP as a current asset item while the excess of billing will be categorized as current liability.
The disadvantages for the contractor would be a decrease in cash flow due to final payment will be received once the whole project is completed. Therefore, an increase in interest expense would be realized due to the limited of cash inflows.
Is it more appropriate to apply the percentage of completion than the completed contract method?
These following factors that should be considered before selecting the accounting method for recognizing the revenue of the construction projects:
- The possibility of uncertainties that associated with the remaining costs of the projects
- Are there possible conditions that might prevent the enforcement of a project due to related properties being expropriated?
- When contracts are short-term in nature that the results reported differ between the two methods are immaterial.
- The delaying in recognizing revenues will allow a business to defer the recognition of related income taxes.
- There is a need for obtaining additional funding as working capital for expansion in the next few years
- There is an expectation of loss before the project is completed
According to the article of Overview of the Completed Contract method and the Percentage of completion method, the author identifies the appropriate situations that will encourage the selection of one method over the other. By going through each factor, a company can determine the needs of the presentation of the financial statements to reflect the revenue recognized.
Because of the different treatment of the earned revenue, one company may choose the percentage of completion because of the needs in more frequent cash flows to cover expenses that the company does not have enough cash to cover. Also, another key factor that will encourages a business to choose the percentage of completion is the ability to foresee the instability in the economy; therefore, enabling the estimates of final costs for the project prior to the company’s competitors.
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8)Brady, R., & Triplett, L. (2011, October). Revenue recognition: comment letters help shape future guidance. Financial Executive, 27(8), 30+. Retrieved from http://go.galegroup.com.libezproxy.nait.ca/ps/i.do?id=GALE|A270733460&v=2.1&u=naitl_main&it=r&p=AONE&sw=w&asid=c3da09f0219b502c098e26ad463dce28
10)Wiley GAAP 2012 pages 359