Percentage of Completion Accounting
We previously noted that the majority of sales are reported under very strict guidelines. For a bookstore it is easy to tell when a customer has taken possession of the merchandise, thus qualifying the transaction as a sale. However, consider long-term projects such as large construction projects. Is it right to wait until the last brick is laid before recognizing the sale? Remember, according to the matching principle revenues and their associated expenses should be recognized in the same accounting period. The contractor has expenses throughout the course of the project. Should these expenses be held off the books until the project is completed as well?
For such projects, the matching principle is essentially turned around and the expenses are used to estimate the associated revenues. This process is called the percentage of completion (PoC) method. Prior to the project’s start the contractor estimates the costs at each stage of the project. As time passes and the stages are completed, the contractor recognizes an estimate of the revenue that has been earned based on the percentage of the estimated costs that have already been incurred.
There are two potential issues for investors in companies that use the percentage of completion method. Both arise from the fact that the contractor is recognizing revenue on the basis of estimated expenses. Of course, actual expenses may be higher or lower than the estimate, even if the contractor is as scrupulous as possible.
If expenses turn out to be higher than estimated, the past expenses recognized will be too low. As soon as the contractor realizes there is a cost overrun he must recognize all of the understated past expense in the current reporting period. This can cause significant earnings shortfalls relative to expectations. It is very difficult for investors to anticipate such events, so instead many investors simply discount the price they are willing to pay for a company that extensively uses the PoC method.
Then there is the possibility that the contractor is not entirely scrupulous. In addition to the difficulty in estimating costs at the project’s outset, at any stage along the way it can be difficult to determine exactly how much of the project is complete. If the contractor wants to boost revenue in the current accounting period he could make an aggressive estimate as to how much of the work is complete, shifting revenue that should be recognized later into the current period. Investors may be able to spot this type of activity by monitoring the unbilled receivables account for sudden spikes.
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