Author: Paul Muldoon
Six questions – and answers – to help you better evaluate your borrowers’ performance
According to Generally Accepted Accounting Principles, “GAAP”, any revenue from projects that span more than a calendar year are typically recorded under the “percentage of completion method” for long-term contracts. Here’s what you need to know to help you better evaluate your borrowers’ performance.
Q: What do I need to know about the percentage of completion method?
A: If a borrower enters into a long-term contract, the percentage of completion method will affect its financial statements, and the subjective use of estimates might put you at risk for financial misstatement. It’s critical that you understand the basics of percentage of completion accounting so you can make more informed, prudent lending decisions.
Q: What types of lenders typically use the method?
A: Any company entering into a long term contract. For example, homebuilders, architects, commercial developers, creative agencies or engineering firms, use this method. There are several ways to report long-term contracts, according to the AICPA’s Accounting Research Bulletin (ARB) No. 45, Long-Term, Construction-Type Contracts, and Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts.
The first method is known as the “completed contract.” With this method, revenues and expenses are recorded once the contractor fulfills the terms of the contract. The “percentage of completion method,” on the other hand, ties revenue recognition to the incurrence of any job costs (or estimates of an annual completion factor). SOP 81-1 establishes a strong choice for the percentage of completion method, so long as businesses can make estimates that are “sufficiently dependable.” Many contractors use the method for income tax purposes.
Q: How does the method differ from the revenue recognition principle?
A: GAAP requires that all borrowers report revenues as earned, regardless of when the cash is received. Typically, revenues are considered as “earned” when a business delivers the products or services to the customer. The percentage of completion method deviates from the revenue recognition principle by identifying income before a job’s completion.
This method matches any revenues to costs incurred, including materials, direct labor, and overhead. Normally, borrowers use the cost comparison method in order to estimate percentage complete. And sometimes, contractors will estimate the percentage complete with an annual completion factor. Keep in mind that the IRS requires detailed documentation or certification from an engineer or architect to support annual completion factors.
Q: How does percentage of completion work?
A: This is how percentage of completion affects financial statements: Let’s look at a $1 million job that’s expected to span two years and cost somewhere around $800,000. In the first year, the contractor incurs some $400,000 in costs and then sends an invoice of $450,000 to the client.
At the end of Year 1, the percentage complete is 50% — that is, $400,000 in actual costs divided by $800,000 in expected total costs. Thus, the contractor would record some $500,000 in revenues (calculated as $1 million times 50%) to match the $400,000 in costs. So, the contractor’s net gross profit is $100,000 in Year 1.
Next, the contractor reports billings in excess (a liability) or costs in excess (an asset) on the balance sheet. Here, the borrower has billed $450,000 but has recorded $500,000 in revenues. The $50,000 difference will show up as costs in excess, a current asset account that reflects the under billings in Year 1.
Many companies run several jobs simultaneously. GAAP doesn’t allow contractors to offset (or net) assets against liabilities. So it’s possible that a contractor will report both costs and billings in excess on its balance sheet.
As you can see, percentage of completion accounting requires subjective estimates about expected costs. Further complicated by job cost allocation policies, changes in estimates and orders, and differences between book and tax accounting methods.
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