The
Percentage-of-Completion Method of Accounting for Long-Term
Construction Contracts
According to ARB No. 45 and SOP 81-1
by William Brighenti, Certified Public Accountant, Certified QuickBooks
ProAdvisor
Although
there was never an individual FASB
(Financial Accounting Standards Board’s Statement) or APB (Accounting
Principles Board’s Opinion) on the accounting for construction
contractors, for decades three publications issued by the AICPA
(American Institute of Certified Public Accountants) have constituted
GAAP (Generally Accepted Accounting Principles) for construction
accounting:
- ARB (Accounting Research Bulletin) No. 45:
Long-Term Construction-Type Contracts (1955);
- SOP (Statement of Position) 81-1: Accounting
for Performance of
Construction-Type and Certain Production-Type Contracts (1981);
- AICPA
Audit and Accounting Guide, Construction Contractors.
These pronouncements permitted the use of two different accounting
methods for the treatment of construction contracts:
- Completed Contract;
- Percentage of Completion.
The completed-contract method recognizes revenue upon completion of the
contract; the percentage-of-completion method recognizes revenue over
the life of the contract.
The two methods should not be used for the same circumstances as
acceptable alternatives from which contractors are free to choose as
suits them. The percentage-of-completion method ordinarily is to
be used for the accounting of long-term construction
contracts except in two situations:
- Where reasonably reliable estimates cannot be
made; or
- Where the results of using the completed-contract
method do not differ materially from those obtained by using the
percentage-of-completion method.
It is ordinarily presumed that virtually all contractors are capable of
making reasonably reliable estimates, otherwise their companies would
not be going concerns. SOP 81-1 states:
For entities engaged on a
continuing basis in the production and
delivery of goods or services under contractual arrangements and for
whom
contracting represents a significant part of their operations, the
presumption
is that they have the ability to make estimates that are sufficiently
dependable
to justify the use of the percentage-of-completion method of accounting.
Persuasive evidence to the contrary is necessary to overcome that
presumption.
The ability to produce reasonably dependable estimates is an essential
element
of the contracting business. Accordingly, entities with significant
contracting
operations generally have the ability to produce reasonably dependable
estimates
and for such entities the percentage-of-completion method of accounting
is
preferable in most circumstances.
Consequently, the burden of proof rests upon the contractor to justify
its use of the completed-contract method for long-term construction
contracts, since SOP 81-1 clearly specifies a preference for the
percentage-of-completion method for the accounting
of construction contracts. Moreover, SOP 81-1 does not excuse the
unsophisticated contractor from being required to employ its
methodolgy for the recognition of revenue on long-term construction
contracts. Contractors who have
“informal estimating procedures” resulting in “poorly documented
estimates and marginal quality field reporting and job costing
systems”—and who are, therefore, unable to estimate given
levels of total contract revenue and total contract costs—would be
required then to produce “ranges” of amounts of estimated revenues and
costs and therein select the most conservative,
if not the most likely, value. If they are still unable to
estimate total contract costs, then the contractor would be required to
estimate total contract costs equivalent in value to total
contract revenues, yielding a zero estimate of profit, until results
can be more precisely estimated, at which time a change in accounting
estimate would be disclosed.
In essence, SOP 81-1 concludes that if the contractor’s estimates are
sufficient to justify one’s bids on contracts, then they “should be
regarded as reasonably dependable” enough to justify the use of the
percentage-of-completion method of accounting. In
other words, meeting the exception for not using the
percentage-of-completion method based on an inability to make
reasonably reliable estimates would be extremely rare.
On the other hand, attempts to meet the second exception in order to
avoid using the percentage-of-completion method of accounting for
long-term construction contracts would be absurd, if not a waste of
time. In order to substantiate that the results of
using the completed-contract method would not differ materially from
those obtained by using the percentage-of-completion method, by
implication a contractor would have to compute the results
under both methods, or pay one’s auditor to do so, and then compare the
results. Of course, the question is if the results did not differ
materially, why on earth would one incur this
additional expense of time and money just to employ the
completed-contract method for financial statement purposes.
Unless the contracts were unenforceable, pending litigation, or
involved properties subject to condemnation or expropriation, it would
be advisable to save money and headaches and use the
percentage-of-completion method. Otherwise, “specific, persuasive
evidence” to the contrary would be required to justify the use of the
completed-contract method, while the probability of providing such
evidence would be rare given the nature of circumstances
required to substantiate its use. Moreover, even though both
methods would be required to recognize a loss on a contract in the
period in which it became anticipated, the
percentage-of-completion method would more than likely enhance a
contractor’s financial picture rather than impair it, since it
ordinarily offers the prospect of income recognition over the periods
of
construction.
For most contractors, the real problem with using the
percentage-of-completion method is that it is not an easy method to
implement and maintain on the books. Even the most sophisticated
and expensive construction accounting software will necessitate
considerable judgment and some adjusting journal entries—if not a
complete export of a report into Excel—in order to produce accurate
financial reports based on its methodology.
Contributing to the problem of reporting revenue in accordance with the
percentage-of-completion method of accounting is the fact that the
contractor’s books typically are kept and maintained on a basis of
accounting facilitating the preparation of its tax
returns and not the percentage-of-completion method of
accounting. For many small contractors, that often means the
books—particularly in QuickBooks—are kept on the cash basis of
accounting, recognizing revenues when payments are received and
expenses when bills are paid. Of course, the cash basis of
accounting may have little relevance to the actual revenues
earned and the corresponding expenses incurred. Other contractors
possessing a little more accounting savvy sometimes will use the
accrual method of accounting on their books even
though their tax returns are prepared on the cash basis of accounting,
recording revenue when invoices or AIA requisitions are submitted and
expenses when bills are received.
Although the percentage-of-completion method of accounting is not cash
basis accounting, it is also not accrual accounting as most users know
it and as most contractors customarily maintain their accounting
records: that is, it is not simply
recognizing revenue when an invoice is submitted, and recognizing
expense when a bill is received. Contractors are notorious for
“frontloading” requisitions in order to assist in the financing of
construction. Similarly, invoices from subcontractors and vendors
for work or products provided may not strictly apply to the period in
question, since such may have been paid for, purchased or
invoiced but not yet performed or installed. As a result, in the
everyday books of contractors, revenues and the corresponding expenses
of generating those revenues rarely reflect the
actual percentage of work accomplished during the accounting period in
question, unless, of course, billings are strictly based on the actual
work completed and expenses reflect
precisely all of the actual work undertaken and installed to-date.
In short, whether contractors employ cash or accrual basis accounting
in their normal day-to-day accounting activities, they ordinarily will
have to adjust their records at year-end to reflect the actual work
completed during the year in order to comply with the
requirements of the percentage-of-completion method of long-term
construction contracts.
First, the contractor would need to
ensure that all expenses had been accrued for all work undertaken
prior to the end of the period. Failure to do so would impair the
results obtained from implementing the percentage-of-completion method
since the cost-to-cost method of the
percentage-of-completion method—the most widely used method of
determining the percentage of completion of contractual work—determines
the percentage of completion by dividing
the total costs to-date of work undertaken on a contract by the total
estimated costs of the contract. This percentage is then applied
to the contract’s value or expected gross profit to
arrive at the requisite adjustment to revenues. Thus, if all
costs were not included, the percentage of completion would understate
completion and result in less income being recognized.
Second, and equally as important, the contractor would need to ensure
that all relevant direct and indirect costs and expenses of
construction have been appropriately applied to construction
contracts. The omission of this step could have serious
ramifications on the revenues recognized under the
percentage-of-completion method of accounting for construction
contracts for the same reason as mentioned above. In addition to
direct materials,
direct labor, subcontract, and other direct costs, generally accepted
accounting principles require the inclusion of indirect overhead
expenses in contract costs. But determining which
indirect costs and the amount to apply to contract costs is not as
straightforward as applying materials, direct labor, subcontract, and
other direct costs since considerable judgment may be involved.
For the sake of simplicity and expediency, it is often recommended that
contractors, where permitted, capitalize the same indirect costs in the
same amounts on financial statements as reported on tax returns.
For the most part, there are only a few
indirect costs that would necessitate different treatment for
capitalizing contract costs on tax returns as opposed to financial
statements:
- Of course, tax depreciation would be reported on
tax returns and book depreciation on financials; hence, relevant book
depreciation would be capitalized in preparation of the application of
the percentage-of-completion method.
- Although contract-related research and development
expenses would require capitalization on tax returns, GAAP would not
permit such treatment on financial statements.
- Except for the above two mentioned expenses,
virtually all of the other contract-related expenses would be eligible
for similar treatment on the tax returns as on the financial
statements, including the following, which many contractors might
overlook:
- Contract administrative expense
- Officer salaries
- Administrative support departments
- Pensions and profit sharing
- Rework, scrap, and spoilage
- Successful bidding expense
- Engineering and design
- Storage, handling, purchasing, and
related costs
- Of course, the following indirect costs would
also
be capitalized on tax returns and financial statements:
- Rent of construction equipment and
facilities
- Repairs of construction equipment and
facilities
- Maintenance
- Utilities
- Tools
- Supplies
- Inspection, quality control
- Indirect labor salaries and wages
- Payroll taxes
- Fringe benefits
- Workers’ compensation insurance
- Liability insurance
- Certain taxes
By doing such, the amount of work involved in the conversion of
financial records to tax return information would be minimized, and the
methodology of allocating these indirect costs to individual contracts
would be more systematic and rational, objectives
which FASB has traditionally endorsed for all accounting methodology.
Third, any mixed indirect overhead costs would need to be first
decomposed into that amount representing construction work and that
representing strictly selling and general administrative work. Of
course, strictly selling and general and administrative
expenses would not be applied to contract costs. Amounts
representing construction activity would be allocated to the
construction contracts based on an appropriate driver, such as direct
labor and/or equipment hours, direct labor costs, direct material
costs, etc., in a systematic and rational manner.
Fourth, after all expenses had been recorded and accrued, and all
direct and indirect costs had been applied to contracts, it is time
review and update total estimated costs for all open contracts.
Total estimated costs, or more precisely, total
estimated costs to complete, is a significant variable in the process
of determining income earned and is thus a significant factor in
accounting for contracts. Ideally, this process should involve
all members of the construction team, including the controller, project
accountants, engineers, project managers, superintendents, foremen, et
al. Because conditions change daily
and change orders modify total estimated costs, this critical step
should be undertaken on a frequent basis: if not weekly, then
monthly. Again, failure to do so will distort operating
results, since total estimated costs to complete may often be
understated, in turn leading to an overstatement of revenues from the
application of the cost-to-cost measure of the percentage of completion.
After all of the above steps are completed, it is now time to compute
the percentage of completion. As previously mentioned, the degree
of completion of construction is typically estimated by dividing the
total construction costs incurred to-date by the total
estimated costs of the contract, or job. However, other rational
and systematic measures of progress toward completion may be employed
if appropriate and justifiable, “having due regard to the
work performed”. For example, physical measures of output
completed, material quantities, labor dollars, hours of labor,
equipment, and/or subcontractors, etc., may be appropriate as long as
the measures reasonably reflect the degree of completion in the given
circumstances.
Once the particular measure of completion is determined, then the
percentage of completion can be calculated:
Percent complete =
Total
measure to-date / Total estimated measure
Using the cost-to-cost measure, the percentage of completion is
calculated as follows:
Percent complete =
Total
construction cost to-date / Total estimated
costs of contract
Then total estimated revenues or gross profit is then multiplied by
this percentage of completion to derive the total revenues or gross
profit that have been earned to date:
Gross profit to date =
Percent complete X Total estimated gross profit
An example of the computation and the respective journal entries can be
found in a companion article on the subject: The
Percentage-of-Completion Method by William Brighenti, Certified
Public Accountant. As one can see, the percentage-of-completion
method is presently the
preferred accounting method of revenue recognition of long-term
construction contracts. Only under rare circumstances would the
completed-contract method be employed.
Although conceptually the percentage-of-completion method is not
difficult to understand, care must be exercised in its
implementation. Contractors are often careless in accruing all
construction costs, including indirect overhead expenses, to contracts,
and of failing to update total estimated construction costs, which are
subject to constant change and revision given the
difficulty of foreseeing all future conditions and including all
relevant variables. With the involvement of all members of the
construction team and particularly of a trained accountant in
construction accounting, the degree of difficulty in its implementation
should be significantly reduced.
This article is provided for informational purposes and is
not intended to be construed as legal, accounting, or other
professional advice. For further information, please consult
appropriate professional advice from your attorney and certified public
accountant.
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