As opposed to the other alternative costing method called variable costing, every expense is allocated to products manufactured whether or not they are sold.
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.
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 clearly specifies a preference for the percentage-of-completion method for the accounting of construction contracts.
Moreover, SOP does not excuse the unsophisticated contractor from being required to employ its methodolgy for the recognition of revenue on long-term construction contracts. 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 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.
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.
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.
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: 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.
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:As stated in ARB No.
45, SOP , and the AICPA Audit and Accounting Guide: Construction Contractors, generally accepted accounting principles is fairly clear, straightforward, and unambiguous regarding the accounting of revenue recognition of long-term construction contracts, prescribing the use of the percentage-of-completion method of accounting, except in very rare .
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