Financial Management and Accounting for the Construction Industry
Reproduced with permission. Originally appeared in Financial Management and Accounting for the Construction Industry. © 2015 LexisNexis Matthew Bender.
Costs in Excess and Billings in Excess
The accounts for costs in excess and billings in excess are probably the most confusing and misunderstood accounts that are shown on the balance sheets of contractors. The following discussion is intended to help those without detailed knowledge of construction accounting to better understand these accounts that are unique to contractors.
Costs in excess and billings in excess are sometimes referred to by accountants as “unbalanced items,” because they are what it takes to balance the entries when accrual basis records are converted to the percentage-of-completion or the completed-contract method. These unbalanced items may also be referred to as “deferred revenues,” “deferred costs,” or other terms. Sometimes the term “construction-in-progress” is used; however, since this term can add to the confusion, it is not recommended. This section discusses unbalanced items and attempts to answer the following questions:
(1) What are unbalanced items?
(2) How do they originate and what do they represent?
(3) What do they mean to the user of the financial statements?
Because unbalanced items are unique to construction accounting, an example of the application of the two basic generally accepted methods of accounting for long-term contracts will provide a basis for understanding unbalanced items. Assume the following:
(1) Company A entered into a contract to build a warehouse for a total contract sum of $100,000.
(2) At the end of the fiscal year, Company A had completed 50 percent of the project at a cost of $40,000.
(3) Company A completed the project in the following fiscal year at a total cost of $78,000.
(4) Company A incurred general and administrative expenses of $5,000 in each fiscal year.
If Company A accounted for its long-term contracts by the completed-contract method, assuming that this contract was the only one in process during the two years, the income statements for the two fiscal years would appear as follows:
If Company A accounted for long-term contracts by the percentage-of-completion method, the income statements for the two fiscal years would appear as follows:
Recognition of Unbalanced Items
Unbalanced items result from the conversion of the contractor’s day-to-day accounting records related to long-term contracts to the percentage-of-completion basis. When accrual basis revenues and costs are adjusted to percentage-of-completion revenues and costs, either costs in excess or billings in excess, herein referred to as unbalanced items, result. A common practice for many contractors is to maintain day-to-day accounting records (books) on a “modified accrual basis.” Under this method, contract revenues are recorded when billings are made to the owner, and costs are recorded when incurred. Still other contractors maintain day-to-day accounting records on a “cash basis,” under which revenues are recorded when cash is received, and costs are recorded when cash is expended.
When the conversion from the day-to-day accounting records takes place, two types of unbalanced items may be generated. One type of unbalanced item, presented in the balance sheet as a current asset, is generally described as “costs and estimated earnings in excess of billings on uncompleted contracts” (costs in excess). The other type of unbalanced item is presented in the balance sheet as a current liability and is generally described as “billings in excess of costs and estimated earnings on uncompleted contracts” (billings in excess).
Computation of Percentage of Completion
In computing the percentage of completion for a project, a commonly used industry practice is to compute the percentage by dividing the total costs incurred to date that have contributed to contract completion by the total estimated contract costs. This method is referred to as the “cost-to-cost” method for measuring the percentage of completion. The computed percentage (costs incurred to date divided by total estimated costs) is multiplied by the contract amount to obtain the total revenue to be recognized. When the revenue is recognized, the costs incurred to date that have contributed to contract completion are deducted to arrive at the gross profit to date for the project. To illustrate, assume the following:
(1) Builder Company has a contract for $500,000 to construct a bridge.
(2) Builder Company has incurred costs to date of $300,000, and company engineers estimate that additional costs of $100,000 will be incurred to complete the project.
The percentage of completion is 75 percent, arrived at by dividing the total costs incurred to date ($300,000) by the total estimated contract costs ($400,000). Therefore, the revenue recognized to date is $375,000, which is the contract amount multiplied by the percentage completed ($500,000 × 75 percent). Gross profit to date on this contract is $75,000 ($375,000 − $300,000). Note that the gross profit to date is also equal to 75 percent of the total anticipated profit ($500,000 − $400,000 = $100,000 × 75 percent = $75,000). An alternative approach to this method is referred to as Alternative B. In this case, Alternative A and Alternative B would produce the same results. In other cases, the two alternatives can produce the same amount of gross profit but different amounts of revenues and costs recognized in particular years.
Another method of determining the percentage of completion of a project is known as the physical completion method. Under this method, the percentage of completion of a project at any point is determined by project engineers based on their assessment of work completed and total estimated work to be performed. This method should not produce results that deviate significantly from the cost-to-cost percentage-of-completion method, since both are predicated on work performed productively as a basis for determining the percentage of work completed.
Costs and Estimated Earnings in Excess of Billings on Uncompleted Contracts
Accounting literature recognizes that when the cost-to-cost percentage-of-completion method is applied, certain costs should be omitted from the costs incurred to date in computing the percentage of completion. This takes into account that all costs do not reflect work performed. To illustrate this point with an extreme case, assume that Builder Company had incurred the $300,000 of costs by simply purchasing materials although it had not yet begun work on the bridge. Obviously, it would not be appropriate for Builder Company to recognize 75 percent of the job profit before any work was performed. Accordingly, materials stored at the jobsite and not yet consumed or put in place generally should be omitted from the cost-to-cost percentage-of-completion computation. Another example of costs incurred that may not accurately represent work performed is that of advances paid to subcontractors by the general contractor.
Costs omitted in computing the percentage of completion should not be included as costs in the income statement, but should be deferred as costs in excess, or netted against billings in excess on the balance sheet, until the period in which they will be recovered through contract revenues.
To illustrate a computation of percentage of completion that results in costs in excess, assume the same facts in the Builder Company example plus these additional facts:
(1) Materials stored at the jobsite cost $50,000.
(2) Total billings to the owner amounted to $275,000.
The computation of percentage-of-completion by the cost-to-cost method would be:
The unbalanced item results from the conversion of the contractor’s day-to-day accounting records, which reflect actual billings and costs incurred, to percentage-of-completion accounting. Therefore, the costs in excess should simply be the difference between the two methods. This is shown by comparing the contractor’s “book profit or loss” with the percentage-of-completion profit.
The unbalanced item of $87,500 consists of stored materials of $50,000, which are excluded from contract costs under the cost-to-cost percentage-of-completion method, and $37,500 of revenues earned but not yet billed ($312,500 − $275,000 = $37,500).
The percentage-of-completion method of accounting for long-term contracts depends on the contractor’s ability to estimate reliably both the percentage of completion and the total costs to complete the project. Errors in these estimates can cause incorrect revenue recognition, reported profits, and financial position. In some cases, unexplained costs in excess might serve as a warning to company management that the estimating process is not functioning properly and that related contract profits could be misstated, since billings are not keeping up with work performed.
Further, general contractors often prepare bids with an unbalanced schedule of values. That is, a contractor may allocate a larger portion of the total bid profit to bid items that will be completed and billed early in the job. This allows the contractor to effectively balance risk and improve cash flow of the project in its early stages when materials are purchased and other major contract costs are incurred. Contractors who bid projects in this manner must keep in mind that, in many cases, certain bid items to be completed in the later stages of the project may contain a relatively small profit margin.
This practice generally causes excess billings to the owner in the early stages of a project and is represented by the contract billings being in excess of the percentage-of-completion basis revenue. Given this practice, it is reasonable to infer that if a contractor has costs in excess on a lump-sum or fixed-price contract in the early stages of construction, instead of billings in excess that would be expected, the reasons for the situation should be carefully evaluated and understood. Costs in excess or low billings in excess amounts in this situation may indicate that unit costs are greater than the bid amounts or that unexpected costs have been incurred.
The costs in excess of billings may be a result of the contractor using funds to purchase necessary materials, a poor billing cycle causing an under billing to the owner, or even an error in the total estimated costs to complete the project. The last cause is the most dangerous, because it has a direct effect on the job profits and financial position. If the estimated costs to complete a project are significantly understated, the result is an overstatement of total job profits, which results in an overstatement of percentage-of-completion job profits and assets (costs in excess). Significant costs in excess could also indicate delays in billing due to disagreements or other problems with the owner.
To avoid immediate and often unwarranted skepticism, costs and estimated earnings in excess of billings on uncompleted contracts are not always red flags. For example, a small amount of costs in excess on a fixed-price lump-sum contract that is ninety percent complete may represent materials stored at the jobsite that are needed to complete the project instead of significant cost overruns or errors in estimating the costs to complete. Likewise, a reasonable amount of costs in excess on cost-plus-fee contracts does not automatically indicate a problem. The costs in excess may merely represent costs that the contractor has incurred, but that are still in the process of being billed to the owner.
Billings in Excess of Costs and Estimated Earnings on Uncompleted Contracts
The second type of unbalanced item is generally described as “billings in excess of costs and estimated earnings on uncompleted contracts” (billings in excess), and is classified as a current liability on the balance sheet. Billings in excess result from contract billings being greater than recognized revenues under the percentage-of-completion method. To illustrate, assume the following:
(1) DD Construction Company has a contract to build an office building for $1,000,000.
(2) DD Construction Company has billed the owner $750,000 during the first year of construction.
(3) The project is 60-percent complete, based on a cost-to-cost percentage-of-completion computation, and the total estimated job profit is $100,000.
The unbalanced item can be shown by comparing the contractor’s “book profit” with the percentage-of-completion profit.
In this example, the $150,000 billings in excess results simply from $750,000 being billed while only $600,000 has been “earned.”
In some cases, the owner may make an advance payment to the contractor before commencement of the project. Although this type of transaction results in the receipt of monies that may represent a large portion of the total contract profit by the contractor, it is sometimes classified as payable to the owner in the financial statements and is not included in billings in excess.
In the above examples of unbalanced items normally found in a contractor’s balance sheet, each project has had only one unbalanced item. In practice, an individual contract may have characteristics of both types. Many long-term contracts in the early stages of completion might have both substantial over billings, which would normally result in billings in excess, and a large inventory of materials stored at the jobsite, which would normally result in deferred costs or costs in excess. In these situations, only one net unbalanced item for each contract is presented in the financial statements.
For example, if the conversion of a contract from the contractor’s day-to-day accounting method to the percentage-of-completion basis results in (1) costs in excess represented by stored materials of $10,000, and (2) billings in excess represented by front-end loaded pay items of $25,000, the contractor’s balance sheet should present a net billings in excess of $15,000 for that contract. However, this right of offset exists only for unbalanced items on the same contract. It is not proper to offset an unbalanced item (that is, costs in excess) on one contract with an unbalanced item (that is, billings in excess) on another contract.
In addition to the separate disclosure of costs in excess and billings in excess on the balance sheet, many contractors present a contract billing status footnote. Such a footnote presents, for uncompleted contracts, the aggregate contract costs incurred to date and the estimated gross profits earned to date on those contracts and compares that sum to actual billings to date. The result is the net excess of billings over revenues earned or the excess of revenues earned over billings to date.
A typical footnote then goes on to identify the components of this net amount, which includes costs in excess, billings in excess, and, sometimes, unbilled work. No specific recommendation exists in the Guide requiring this disclosure; however, similar disclosure appeared in both the 1965 AICPA Industry Audit Guide, “Audits of Construction Contractors,” and the current Guide’s example financial statements. Another disclosure that is sometimes included in this footnote is the amount of anticipated future losses on uncompleted contracts, which is shown in the example.
For contractors using the completed-contract method, the disclosure is much simpler and involves just a comparison of billings to date with contract costs incurred to date. Alternatively, contractors using the completed-contract method may show an expanded caption on the face of the balance sheet that (1) identifies the aggregate costs incurred on contracts that have net billings in excess, and (2) discloses the aggregate billings to date on contracts that have net costs in excess.
Balance Sheet Classification
A debate has existed for many years regarding the classification of billings in excess. Some believe that the profit component of billings in excess, that is, the amount that is ultimately expected to become a part of equity instead of being paid out as future costs that are incurred, should be classified as a non-current liability. In particular, some people argue that a contractor using the completed-contract method should be allowed to classify the profit component of billings in excess as non-current on the basis that this amount is unrecognized only because of the company’s election to use the completed-contract method. This argument is somewhat inconsistent with the notion that the completed-contract method is used because of skepticism regarding the ability to estimate profits.
This issue was considered extensively when the Guide was written, and a paragraph in the Guide summarizes the conclusion as follows:
Billings in excess of costs and estimated earnings should generally be classified as a current liability. However, to the extent that billings exceed total estimated costs at completion of the contract plus contract profits earned to date, such an excess should be classified as deferred income. Although there have been inconsistencies in practice, billings in excess of costs and estimated earnings should be regarded as obligations for work to be performed and classified as current liabilities, except in those circumstances in which billings exceed total estimated costs at completion of the contract plus contract profits earned to date, in which case such an excess should be classified as deferred income.**AICPA Audit and Accounting Guide, Construction Contractors, § 6.16.
This conclusion appears to allow classification of a component of billings in excess only in an extreme situation. Such a situation exists if a contractor is able to bill enough ahead so that billings exceed not only the total estimated costs at completion, but also profits recognized to date. As an example, consider the following facts:
In this situation, the Guide would allow reclassification of $2,000 of the billings in excess as a non-current liability, because the billings ($98,000) exceed the total estimated costs at completion ($80,000) plus contract profits earned to date ($16,000). As shown in this example, the Guide has recommended a severe restriction on reclassification of billings in excess as a non-current liability.
Provisions for Anticipated Losses on Contracts
FASB ASC 605-35-25-46 addresses loss contracts and states the following basic principle:
when the current estimates of total contract revenue and contract cost indicate a loss, a provision for the entire loss on the contract should be made. Provisions for losses should be made in the period in which they become evident under either the percentage-of-completion method or the completed-contract method.
In accounting for losses, it is recommended that provisions for losses be recorded as additional costs instead of reduced revenue. It is not typical to separately categorize provisions for losses in the income statement; however, anticipated future losses on contracts-in-process or uncompleted contracts are sometimes disclosed in the contract billing status footnote, as shown in note (4) to Example Percentage Construction Inc.
It is also recommended that provisions for losses on contracts be shown separately as liabilities on the balance sheet, if significant, except in circumstances in which related costs are accumulated on the balance sheet, in which case the provisions may be deducted from the related accumulated costs. A separate liability account is included in the current liabilities section of the balance sheet for Example Completed Contract Co. The title, “estimated liability to complete contracts,” is a typical title used if such a liability is identified separately on the balance sheet.
Deferred Income Taxes
This section is intended as a brief overview of issues related to accounting for income taxes by contractors. This section also provides examples of deferred tax accounting for the benefit of those without detailed knowledge of such accounting.
Although issues and requirements for contractors are not different from those for other companies, the effects on contractors are sometimes more significant because of the volatility of profits in the industry and the differences between financial statement and tax methods. One of the most highly debated issues is the classification of deferred income taxes that result from the difference between percentage-of-completion accounting for financial statements and completed-contract (or hybrid completed-contract/percentage-of-completion) accounting for tax purposes.
Concept of Deferred Income Taxes and Typical Application for a Contractor
This discussion is primarily intended for the non-accountant who is attempting to understand deferred income taxes presented in the financial statements of contractors. A contractor, like any potential taxpayer, would prefer to appropriately defer the payment of income taxes to the greatest extent possible.
Contractors have historically used several different methods for reporting taxable income. These methods include the percentage-of-completion method, the completed-contract method, the accrual method (generally excluding retention receivables), and the cash method. Although the Tax Reform Act of 1986 and subsequent amendments have significantly modified the alternatives available and their related benefits, deferral opportunities generally will still exist, but benefits will be reduced.
Note that for a contractor organized as a pass-through entity (e.g., an S Corporation or an LLC), the entity’s taxable results are included in the income tax returns of the stockholders or members. As a result, for these entities, there may be little or no income taxes included in the contractor’s financial statements.
Deferred Income Taxes Under FASB ASC 740
Under the asset and liability method of FASB ASC 740, the calculation of deferred income taxes focuses on the balance sheet rather than on the income statement. Deferred tax assets and liabilities are calculated based on temporary differences—differences between the financial statement carrying amounts and tax bases of assets and liabilities that will result in future taxable or deductible amounts. Deferred tax expense or benefit is based on the change in the sum of the deferred tax asset, valuation allowance, and deferred tax liability during the year.
The objective of the asset and liability method is to recognize a liability or an asset for the expected future tax consequences of events that have been recognized in the financial statements or tax returns. This objective is achieved by recognizing a deferred tax liability for taxable temporary differences, recognizing a deferred tax asset for deductible temporary differences and operating loss and tax credit carryforwards and, if necessary, reducing the deferred tax asset by a valuation allowance if it is more likely than not that all or some portion of that deferred tax asset will not be realized.
A deferred tax liability is recognized for virtually all taxable temporary differences. A deferred tax asset initially is recognized for all deductible temporary differences and operating loss and tax credit carryforwards. The likelihood of realizing the tax benefits related to a potential deferred tax asset is then evaluated, and a valuation allowance is recognized to reduce that deferred tax asset if it is more likely than not that all or some portion of the deferred tax asset will not be realized. The remaining deferred tax asset, net of valuation allowance, represents the portion of the deferred tax benefits that more likely than not will be realized. More likely than not is intended to mean a level of likelihood that is more than 50 percent.
The amount of the valuation allowance for deferred tax assets may range from zero to the full amount of the potential deferred tax asset, not just the net deferred tax asset (net of deferred tax liabilities). Realizing tax benefits of deductible temporary differences and operating loss or tax credit carryforwards depends on sufficient taxable income of an appropriate character within the carryback and carryforward periods. Sources of taxable income that may allow for realizing those tax benefits include:
(1) Taxable income in the current year or prior years that is available through carryback (potential recovery of taxes paid for current or prior years);
(2) Future taxable income that will result from reversing existing taxable temporary differences (potential offset of deferred tax liabilities); and
(3) Future taxable income, excluding the reversal of existing temporary differences.
FASB ASC 740 requires separate disclosure of the gross deferred tax asset and the amount of any valuation allowance recognized to reduce the gross deferred tax asset. Therefore, the gross deferred tax asset must be determined even when it is known that the asset will be offset by a valuation allowance.
Total income tax expense is the sum of the results of separate calculations of current tax expense and deferred tax expense. Current tax expense is generally calculated in the same manner as amounts reported on the company’s current year income tax returns. Deferred tax assets and liabilities are calculated as of the end of each period, and deferred tax expense is the change between the net deferred tax asset or liability at the beginning and the end of the period.
A separate deferred tax calculation will have to be made for each taxing jurisdiction (national, state, local, and foreign) and alternative tax systems. This is necessary because the deferred tax liability of one taxing authority cannot be offset against the deferred tax liability of another authority unless such a right of offset exists in the law.
Temporary differences arise when the tax bases of assets and liabilities and their financial reporting amounts differ and will result in future tax consequences when the assets are recovered or the liabilities are settled.
To account for deferred income taxes, contractors should prepare a tax basis balance sheet and maintain records of their temporary differences. These records should include not only the temporary differences at the balance sheet date (required to calculate the deferred tax liability), but also a year-by-year schedule of reversal of temporary differences.
Temporary differences commonly affecting contractors include:
(1) Contract income on a percentage-of-completion basis for financial statements and completed-contract basis for tax return;
(2) Different depreciation methods for book and tax purposes;
(3) Use of different methods of revenue recognition for construction joint ventures for both book and tax purposes; (Note, timing differences may also arise because of differences in accounting periods between the joint venture and the entities of the joint venture);
(4) Different indirect cost allocation methods for book and tax purposes;
(5) Amortization for tax purposes of an adjustment to income caused by a change of accounting method;
(6) Lack of achievement of a designated minimum level of completion for recording profits for book purposes if the percentage-of-completion method is used for both book and tax purposes;
(7) Recognition, for book purposes, of the entire estimated losses on uncompleted contracts, which is not appropriate for tax purposes; and
(8) Differences caused by net operating loss, investment tax credit, and contribution carryovers being used for tax purposes.
Additional categories of temporary differences also include:
(1) Basis differences arising in a business combination;
(2) Reduction in the tax basis of depreciable assets for tax credits;
(3) Investment tax credits accounted for by the deferral method; and
(4) Differences arising through the re-measurement of the assets and liabilities of a contractor’s foreign operations if the functional currency is the reporting currency.
Illustration of Deferred Income Taxes Under FASB ASC 740
The following example illustrates the application of the procedures discussed above to the computation of current and deferred tax liabilities.
(1) Facts: Contractor A had pretax financial reporting income of $250,000 in 20X1, the contractor’s first year of operations. Contractor A is subject to federal income taxes, but is not subject to state or local income taxes and does not operate in any foreign tax jurisdictions. Taxable income for 20X1 was $220,000.
Contractor A has these temporary differences:
The reconciliation between pretax accounting income for financial reporting purposes and taxable income is:
(2) Temporary differences: Temporary differences are estimated to result in future taxable or deductible amounts as follows:
(a) The warranty liability is expected to be settled in 20X2, resulting in a tax deduction of $15,000.
(b) Depreciation for financial reporting and tax purposes in each future year is assumed to be as follows:
(c) Percentage of completion is used for financial reporting and completed contract for tax purposes. The schedule of contract differences for 20X1 is assumed to be as follows:
(d) Deferred compensation is expected to be paid in 20X3.
(e) The equity income in less than a majority-owned subsidiary will be recognized as income for tax purposes when Contractor A actually receives a dividend in 20X5.
(3) Tax Rates: The enacted tax rate for future years is 34 percent in 20X1, 20X2, and 20X3, 38 percent in 20X4, and 40 percent in 20X5.
Current income tax expense for 20X1 and income tax payable as of December 31, 20X1 (Contractor A did not make estimated payments during 20X1) would be calculated as follows:
The deferred tax liability as of December 31, 20X1 and deferred tax expense for 20X1 would be calculated as follows:
The deferred tax liability as of December 31, 20X1, is the sum of the amounts payable in each future year aggregating $24,350 ($7,140 plus $1,020 plus $3,990 plus $12,200). Since 20X1 is Contractor A’s first year of operations, the deferred tax expense for 20X1 equals the deferred tax liability at the end of the year less the deferred tax asset of $11,900, or $12,450.
For this example, assume that there will be sufficient future income to support the realization of the deferred tax asset.
The financial statement presentation would reflect the following (without considering the classification of the deferred tax liability and asset) as of December 31, 20X1:
Balance Sheet Classification of Deferred Taxes
Deferred tax assets and liabilities are classified as current or non-current based on the classification of the related asset or liability for financial reporting. In a classified balance sheet, the net deferred tax asset or liability for each tax-paying component of an enterprise should not be offset in the classification process.
The current portion of deferred tax assets and liabilities represents the tax effect of temporary differences related to current assets and current liabilities. Deferred taxes that are created by temporary differences related to non-current assets and non-current liabilities are reflected as non-current deferred tax assets and liabilities. Certain temporary differences and carryforwards are not related to an identifiable asset and liability for financial reporting purposes.
For instance, organizational costs that are capitalized for tax reporting purposes but expensed for financial reporting purposes create a temporary difference for which there is no identifiable asset for financial reporting purposes. Deferred tax assets and liabilities resulting from temporary differences that are not related to an identifiable asset or liability for financial reporting purposes should be classified according to the expected reversal date of the temporary difference. Deferred tax assets related to carryforwards should be classified based on the year that the carryforward is expected to be used in the tax return to reduce taxes payable.
For contractors with operating cycles that are longer than one year, it is commonplace to classify all contract-related assets and liabilities as current. In this case, the balance sheet classification of deferred tax assets and liabilities is more complicated. The current portion of deferred taxes also will include (1) the tax effect of temporary differences related to assets and liabilities that are classified as current because the operating cycle is longer than one year, and (2) the tax effect of temporary differences that are not related to identifiable assets or liabilities for financial reporting purposes, but “other” related assets and liabilities are classified as current, because the operating cycle is longer than one year.
For example, temporary differences related to long-term contracts that are accounted for by the percentage-of-completion method for financial reporting purposes and by the completed-contract method (or modified percentage-of-completion method) for tax purposes, cannot be identified with a particular asset or liability in the financial statements. Since those temporary differences are related to “other” assets or liabilities for financial reporting purposes that are classified as current because the operating cycle is longer than one year, the tax effect of those temporary differences also should be classified as current.
A valuation allowance recognized for deferred tax assets must be allocated between current and non-current deferred tax assets for that particular tax jurisdiction on a pro rata basis. This is required even if it is known that the valuation allowance relates specifically to deferred tax assets that are classified as non-current.
For many years, there has been a debate regarding what to include in construction contract revenues. The issue was dealt with in the literature as far back as 1953, when Accounting Research Bulletin (ARB) No. 43, “Restatement and Revision of Accounting Research Bulletins,” Chapter 11A, “Cost-Plus-Fixed-Fee Contracts,” discussed the subject in response to the question, “What amounts are to be included in sales or revenue accounts?”10
10ARB No 43, Ch 11 Government Contracts § A 19–20 (FASB ASC 912-605-25-17 through 19) state the following:
This problem is whether sales or revenue as reported in the income statement should include reimbursable costs and the fee, or the fee alone. The answer to this question depends upon the terms of the contract and upon judgment as to which method gives the more useful information.
Some CPFF [Cost-Plus-Fixed-Fee] contracts are service contracts under which the contractor acts solely in an agency capacity, whether in the erection of facilities or the management of operations. These appear to call for inclusion in the income statement of the fee alone. In the case of supply contracts, however, the contractor is more than an agent. For instance, if the contractor is responsible to creditors for materials and services purchased; employees for salaries and wages; facilities in carrying out agreement; the contractor’s position in many respects is that of an ordinary principal. In view of these facts, and the desirability of indicating the volume of the contractor’s activities, it appears desirable to include reimbursable costs, as well as fees, in sales or revenues.
This issue came even more into focus as construction management contracts began to be used more often. From an accounting perspective, the basic question is whether the contractor has the risks and rewards associated with the costs that are incurred to construct a project. In some cases, a contractor approves invoices, supervises vendors and subcontractors, and prepares checks in payment for the related costs incurred; however, those checks are written directly on the project owner’s bank account. The contractor may never have a legal liability, and the cash transactions may never run through the contractor’s general ledger.
However, is this any different from a situation in which the contractor pays these costs out of contractor’s own bank account and immediately asks for and receives reimbursement from the project owner? Some argue that it is no different. Others argue that it is different because of a difference in the element of risk to the contractor, for example, if the owner unexpectedly runs out of cash, if an employee of the contractor makes a mistake and orders the wrong materials, etc.
Some contractors who have many contracts falling into this gray area have developed objective ways to differentiate between management contracts and construction contracts. For example, a contractor might conclude that if the contract relationship requires the contractor to sign payroll tax returns, purchase orders, and subcontracts, those costs are accounted for in the books and reported as revenues in the financial statements of the contractor.
SOP 81–1 at 58–59 (FASB ASC 605-35-25-20 through 21) addresses the issue as follows:
One problem peculiar to cost-type contracts involves the determination of the amounts of reimbursable costs that should be reflected as revenue. Under some contracts, particularly service-type contracts, a contractor acts solely in the capacity of an agent (construction manager) and has no risks associated with costs managed. This relationship may arise, for example, if the owner awards a construction management contract to one entity and a construction contract to another. If the contractor, serving as the construction manager, acts solely as an agent, the revenue should include only the fee and should exclude subcontracts negotiated or managed on behalf of the owner and materials purchased on behalf of the owner. In other circumstances, a contractor acts as an ordinary principal under a cost-type contract. For example, the contractor may be responsible to employees for salaries and wages and to subcontractors and other creditors for materials and services, and may have the discretionary responsibility to procure and manage the resources in performing the contract. The contractor should include in revenue all reimbursable costs for which is at risk or on which the fee was based at the time of bid or negotiation. In addition, revenue from overhead percentage recoveries and the earned fee should be included in revenue.
On the other hand, if a cost-plus-fee contract requires the contractor to account for everything, but the owner actually signs subcontracts, purchase orders, and payroll tax returns—thereby taking responsibility for those commitments after advice and consultation from the contractor who functions as the owner’s agent—then only the fee would be reflected as revenue in the financial statements. This example of an objective, although not necessarily a pure approach, is just an indication that often a somewhat arbitrary decision has to be made as to what is considered revenue and what is not. Further, many accountants would argue that it is not crucial for the theoretical basis of the policy to be perfect. It is more important that the policy be applied consistently to the same types of contracts and to the same circumstances from year to year.
Taking the issue of what to include in revenue to the next step, some would argue that not only should the contractor include reimbursable costs that were paid on behalf of the owner, but the contractor should also include in revenue any materials furnished directly by the customer for inclusion in the project.11
Again, the discussion has theoretical merit, but it is extremely difficult to apply the “associated risk” criteria objectively and consistently. In practice, relatively few contractors include materials acquired directly by owners as revenues. Many contractors consider owner-furnished materials to be very different from reimbursable costs on the typical cost-plus-fee contract for which a contractor has some accountability for those costs.
However, some contractors do disclose amounts described as total work in place, value of construction completed, volume managed, or some other type of measurement of total activity. Contractors might provide this disclosure in a separate cover letter if the company is private, in the management’s discussion and analysis, the president’s letter, or perhaps in some graphic
11SOP 81–1 at ¶ 60 (FASB ASC 605-35–25-22 through 24) addresses this issue as follows:
Another concern associated with measuring revenue relates to materials furnished by a customer or purchased by the contractor as an agent for the customer. Often, particularly for large, complex projects, customers may be more capable of carrying out the procurement function or may have more leverage with suppliers than the contractor. In those circumstances, the contractor generally informs the customer of the nature, type, and characteristics or specifications of the materials required and may even purchase the required materials and pay for them, using customer purchase orders and checks drawn against the customer’s bank account. If the contractor is responsible for the nature, type, characteristics, or specifications of material that the customer furnishes or that the contractor purchases as an agent of the customer, or if the contractor is responsible for the ultimate acceptability of performance of the project based on such material, the value of those items should be included as contract price and reflected as revenue and costs in periodic reporting of operations. As a general rule, revenues and costs should include all items for which the contractor has an associated risk, including items on which the contractual fee was based.
display if the company is public or for some other reason is producing a glossy annual report.
There are a few examples in which this type of information is included in the income statement with further elaboration in the footnotes. For example, a contractor might include a line like the following at the top of the income statement:
(Remainder of the income statement would be a normal presentation of operating expenses, general and administrative expenses, and so on.)
A note like the following would then explain what “volume of construction completed” means:
The volume of construction completed reflects a measurement of the Company’s construction activity. A summary of this activity follows:
This type of presentation actually provides significant information to users of financial statements; however, practical problems have limited the number of contractors that have tried this unusual presentation. One of the basic practical problems is that the contractor does not always know what the costs are of owner-furnished materials. Many believe that requiring or encouraging this type of presentation would create more inconsistency in the income statements of contractors than currently exists.
In note (1)(b) of Example Percentage Construction Inc., it is disclosed that:
for management contracts (substantially all costs are the responsibility of the owner) and specific cost-type contracts (certain costs are the responsibility of the Company and other costs are the responsibility of the owner) revenues are recognized under the percentage-of-completion method based only on those costs for which the Company is responsible.
This reference is an indication to the reader of the financial statements that the company manages projects that have values (that is, the value of the total project) in excess of the amounts included as revenues in the financial statements. However, this example does not take the next step described above, which would be to disclose the amount of work performed. In fact, as also mentioned above, the contractor may not even know the total dollar values of all the projects being managed.
Incentive and Penalty Provisions
Another area that affects what is included in contract revenue is contract provisions that are contingent upon performance. Many contracts contain provisions for upward or downward incentive adjustments that are based on costs or other performance by the contractor in relation to targets established by the contract. In order to account for contract incentives, the substance of the incentive provisions must be understood, and performance must be evaluated in relation to the targets.
Several general parameters have developed in practice for recording of upward or downward incentive provisions. The effects of upward incentive provisions are normally recorded if performance in relation to established targets is reasonably predictable. The effect of incentives that are predicated upon superior performance should be recorded only if basic contract performance is assured and if there is adequate evidence that the amounts are realizable. The effect of certain incentives predicated upon superior performance should be recorded only if the buyer agrees that they have been earned. In other words, bonuses to be paid based on outstanding performance do not receive accounting recognition until it is clear that they have been earned and can be realized. On the other hand, downward incentives are normally reflected at the earliest indication of failure to meet the contract requirements.
Provisions for upward incentive adjustments are frequently predicated upon performance, in meeting either cost reduction targets or specified completion dates, that is superior to that which can be reasonably estimated or expected at the time of entering into the contract. Compensation for superior performance is outside the basic contract in the sense that the contractor is not obligated to attain the standards that trigger the incentives. If the contractor meets the tests of superior performance, the contractor is rewarded; if not, only the revenue contemplated in the basic contract is received.
It is possible to reasonably predict the realization of some upward incentive revenues only if the buyer agrees that they have been earned, because performance cannot be reasonably predicted in advance. For example, situations when performance may not be reasonably predictable may involve either a single opportunity to accomplish a test or a demonstration in accordance with established performance criteria or award fees that may be both determined solely by the government and subject to retroactive adjustment after evaluation of the contractor’s performance.
In addition, some incentive formulas are so complex or subjective that any incentive revenues ultimately received are matters of future negotiation. Accordingly, such an incentive should be recorded only at the time that the buyer agrees that the incentive amount has been earned.
A frequently encountered downward incentive is a penalty for late performance. If this incentive exists, estimates of the date of completion must be carefully and continuously evaluated to determine whether adjustments of contract revenue under the percentage-of-completion method or provision for loss under either long-term contract method are required. Recognition of this downward incentive should be made as soon as the contractor’s ability to meet the completion date can no longer be reasonably predicted.
If adjustments are made for upward or downward incentives, most accountants believe that adjustments should theoretically be made to contract revenue instead of contract costs. However, in practice, it is not unusual to see provisions for liquidating damages (penalties for late completion) included as contract costs as part of the estimated costs to complete. In most cases, this would have an immaterial effect on the overall revenues and costs in the income statement and, therefore, would not be a major consideration.
Basic questions related to contract costs are (1) when should contract costs be recognized and (2) what should be included in contract costs. The financial statements of a contractor can be affected by the determination of whether costs are (1) classified as general and administrative costs and expensed in the current period, or (2) considered to be contract costs and recognized as costs when revenues are earned by percentage-of-completion contractors or deferred until contract completion by completed-contract companies. Obviously, this distinction has a much larger impact in the latter (completed-contract) than in the first (percentage-of-completion) case.
Allocation of Indirect Costs
Practices vary significantly for the accounting treatment of indirect costs. The question often focuses on what to do with general and administrative costs. However, calling these costs general and administrative would indicate that they are already considered to be period costs rather than costs allocable to contracts. Therefore, these costs are referred to in this section as indirect costs. In some cases, all of these costs are treated as period costs and, in other cases, substantially all of these costs are deferred through inclusion in contract costs. FASB ASC 605-35-25-99 acknowledges that:
When the completed-contract method is used, it may be appropriate to allocate general and administrative expenses to contract costs rather than to periodic income. This may result in a better matching of costs and revenues than would result from treating such expenses as period costs, particularly in years when no contracts were completed. It is not so important, however, when the contractor is engaged in numerous projects, and in such circumstances it may be preferable to charge those expenses as incurred to periodic income. In any case there should be no excessive deferring of overhead costs, such as might occur if total overhead were assigned to abnormally few or abnormally small contracts in process.
Based on this language, some believe that all expenses incurred by a contractor using the completed-contract method are allocable to contracts. Further, FASB ASC 605-35-25-37c states that:
general and administrative costs ordinarily should be charged to expense as incurred but may be accounted for as contract costs under the completed-contract method of accounting …
Authoritative literature, however, indicates that the key consideration in determining the propriety of allocating these costs to contracts is whether the costs can reasonably be associated with a specific contract or with contracting activities. FASB ASC 330-10-30-8 states that:
general and administrative expenses should be included as period charges, except for the portion of such expenses that may be clearly related to production and thus constitute a part of inventory costs (product charges).
Deferring costs on a basis other than their association with contracting activities is also not in accordance with the principle of systematic and rational allocation. Therefore, it would appear that a cost whose association with contracting activities could not be demonstrated should be expensed and not deferred to a future period.
If indirect costs are to be deferred as contract costs, one of the following conditions should be met:
(1) The costs relate directly to performance under a specific contract-in-process, or
(2) The costs relate directly to the contractor’s contracting activities.
If these costs are to be deferred, the association tests should be met, irrespective of whether the completed-contract or the percentage-of-completion method is being employed, even though the effect may not be as dramatic.
The use of the percentage-of-completion method does not always preclude the deferral of inventory costs to future periods. This deferral can exist under this method if the percentage of completion is determined on a basis other than the cost-to-cost method (for example, labor hours, labor costs, machine hours, or architectural estimates), if indirect costs are not incurred ratably as costs directly associated with a contract are incurred, or both. Consider the following example for a $1 million contract for which the cost-to-cost method is used to determine percentage of completion.
In this extreme example, the earnings are the same in both cases over the two-year life of the contract, but are very different in the individual years. If the indirect costs are contract-related, the contractor should not have to report a loss in the first year to be made up the next year. If the costs are not contract-related, the contractor really had a loss in the first year. If the direct and indirect costs are incurred ratably, approximately the same amount would be charged against earnings whether as contract costs or as general and administrative expenses; therefore, the question of allocation would only affect classification instead of the net result.
Imprecision is inherent in the determination of what constitutes general and administrative expenses and, therefore, which costs are associated with contracting activities. However, it is not the nature of the costs, such as salaries or rent, that is the important consideration from the viewpoint of contract accounting. Instead, the determining factor is whether the employee’s services or the rented space or property contributes to the contracting activities. Some types of costs may relate to both contracting activity and general corporate activity. The salary of an officer whose duties serve both activities or the costs to operate an accounting department that handles all accounting functions are examples of such costs. If a portion of these costs can be identified as contracting activity, it may be appropriate to allocate that portion among contracts-in-process on a rational and systematic basis.
Although there is no single generally accepted method for determining the appropriate allocation of overhead to contracts, the decision to allocate a particular cost or pool of costs to contracts should be based on whether the activity generating the cost contributes to completing the contract. Finally, if the determination has been made that certain indirect costs are to be deferred, because they are identified with contracting activities, those costs must be included in estimates of the cost to complete the contract as shown in the previous example.
This inclusion is necessary, irrespective of which of the two methods of recognizing revenue is being used. Under the completed-contract method, the policy used for allocation of overhead is relevant to the determination of recoverability of contract inventory costs and to the determination of whether a loss will be suffered on the contract. Under the percentage-of-completion method, the overhead allocation policy affects the calculation of the percentage of completion under the cost-to-cost method.
Notes to Financial Statements
Other Significant Accounting Policy Disclosures
This section discusses some of the general disclosures in note (1) to the examples of financial statements in §§ 3.20 and 3.21, which have not already been mentioned in preceding sections.
Nature of Business
Although not an accounting policy, contractors should include general disclosure about principal markets and locations, the types of construction projects undertaken, and the types of contracts normally entered into. This is usually described as a nature of business, organization, or business activity type of note. As the examples show, if a company is involved from time to time in joint ventures, this note is a logical place to introduce that aspect of the company.
Basic Method of Accounting
The most important disclosure, which users of a contractor’s financial statements look for first, is whether the company uses the percentage-of-completion method or the completed-contract method. The following paragraphs describe the details that sometimes are included with disclosure of the basic accounting method.
Method of Determining Percentage of Completion. Percentage-of-completion accounting “recognizes as revenue that portion of total estimated revenue that incurred costs to date bear to total estimated costs, except on certain contracts as described below.” This disclosure describes what is commonly referred to as the cost-to-cost method. The reference to a discussion below refers to the disclosure in the next paragraph that for management contracts, only the costs that are the responsibility of the company are used in this measurement.
How Construction Costs Are Recorded. “Construction costs are recorded as incurred.” This statement may seem like a superfluous and obvious disclosure, but it indicates to a knowledgeable reader that construction costs generally reflect accrual-basis costs, while revenues are recognized based on a cost-to-cost percentage-of-completion calculation—as opposed to, for example, recognizing construction costs based on engineers’ estimates of the percentage of completion multiplied by the total estimated contract costs, with a related accrual of costs not yet incurred, or a deferral of costs incurred but not yet contributing to contract completion.
Disclosure of Base Percentage. “No gross profit is recognized until a contract has reached a stage of completion sufficient to reasonably determine, in the opinion of management, the ultimate realizable profit. Base percentages, which range from one percent to twenty-five percent, depending upon the type of contract, are generally used to determine when a sufficient stage of completion has been reached.” Although many contractors use the percentage-of-completion method for contract revenue recognition, they may defer recognition of any profit until a specified percentage-of-contract performance is complete (for example, 25 percent, 15 percent, and so on). Those contractors who defer profit recognition until a specified level of performance is reached take the position that, although they generally meet all the criteria for the application of the percentage-of-completion method at the outset of the contract, completion to the specified level further ensures the dependability of the estimating process.
Although the Guide does not discuss this practice, deferring profit recognition until a specified contract performance level is reached is generally considered acceptable if:
(1) The specified performance level is reasonable in the circumstances,
(2) The practice is applied consistently to all similar contracts, and
(3) Disclosure of the method is made in the financial statements.
It is not uncommon for a contractor to have different base percentages for different types of contracts. For example, profit might be recognized at 1 percent for cost-plus contracts, at 10 percent for cost-plus contracts with a guaranteed maximum, and at 25 percent for lump-sum contracts. Some would argue that a differentiation based on size is appropriate, because more effort is put into updating cost estimates earlier for a large job. Another differentiation might be based on the relative risk deemed to be associated with different types of construction, for example, a tunnel versus a parking lot.
The latter two examples (size and risk) would be more difficult to apply consistently. If a base percentage is used, it is normal practice to recognize equal amounts of revenues and costs until the base percent is reached when the full unrecognized profit is reflected. Some accountants who disagree with this approach would argue that it makes more sense to handle the first portion by the completed-contract method and recognize no revenues or costs until the base percentage of completion is reached.
Some would then go on to argue that the recognition should not occur at one point, but should be spread over the remainder of the contract. For example, if 25 percent is the base, then 100 percent would be recognized over the last 75 percent of the contract. In theory, an across-the-board base percentage approach is not supportable; however, most accountants would probably agree that it is really just an added layer of conservatism and would accept it as long as the policy is consistently applied and disclosed.
Estimated Losses Are Recognized When Known. “Provision is made for the entire amount of future estimated losses on uncompleted contracts.”
Policy for Claims Recognition. “Claims for additional contract compensation due the Company are not recognized until the year in which such claims are allowed, except where contract terms specifically provide for certain claims in the event of certain occurrences that have taken place and the Company has determined that it is probable that such claims will be realized.”
How Changes in Estimates Are Handled. “As to contracts that extend over more than one year, revisions in cost and revenue estimates during the course of the work are reflected in the year in which the facts that require the revision become known.” This reflects application of the required cumulative catch-up method. Further, FASB ASC 605-35-50-9 states that:
although estimating is a continuous and normal process for contractors, paragraph 250-10-50-4 requires disclosure of the effect of revisions if the effect is material.
Even though this guidance appears to be stating that contractors have to figure out a way to desegregate the effects of various forces that routinely require changes in estimates of contract costs, contract revenue, and the extent of progress towards completion, it is often impractical and sometimes impossible to do so. For example, the effect of labor strikes, unexpected weather conditions, or transportation delays usually cannot be quantified. Most either have not interpreted this paragraph as recommending more extensive disclosure than is necessary to comply with FASB ASC 250, “Accounting Changes and Error Corrections,” or, at least, have not complied with it.
Most accountants would probably concur, however, with the suggestion that FASB ASC 250 requires disclosures for estimates that change because of significant errors as opposed to estimates that change because of circumstances and events that affect estimating or because of normal modifications that occur due to the nature of the contractor’s estimating process. Note (13) of Example Percentage Construction Inc. shows a type of change in estimate that could have been seen earlier, but was not anticipated. It is somewhat debatable whether even this type of disclosure is absolutely necessary under FASB ASC 250. Apparently, few contractors disclose changes in estimates related to contracts-in-process.
Accounting Method Used for Income Tax Purposes. “For federal and state income tax purposes, the Company recognizes revenues and costs on construction contracts, including joint venture contracts, under the completed-contract method.” The note in Example Percentage Construction Inc. goes on to disclose the tax accounting method used for foreign contracts, which had become a fairly widespread disclosure for many contractors during the 1970s when foreign contracts were numerous.
When a Contract Is Considered Complete Under the Completed-Contract Method. “Revenue should be recognized under the completed-contract method when the contract is complete or substantially complete. This occurs if the risks of contract performance have been eliminated, and only minor costs remain to be incurred. As a general rule, the contractor’s risk of performance is eliminated when the goods or services provided under the contract are delivered to the purchaser, and either the purchaser has accepted the goods or services or acceptance is perfunctory (for example, a building contractor has notified the developer that a building has been completed, and all inspections required under the contract have been made and approved).
As long as the contractor has satisfactorily discharged its obligations under the contract, performance risks have been eliminated. For example, a contract for the manufacture and installation of specialized equipment, which must perform to specifications that have not been previously met by the contractor, should not be considered complete until the equipment has been installed at the buyer’s location and has performed in accordance with those specifications. In certain contract situations, the agreement may provide for future warranties or maintenance agreements. As long as these obligations can qualify for accrual under FASB ASC 450, “Contingencies,” they should not preclude the conclusion that the earning process has been completed.
As a practical matter, most contractors using the completed-contract method select a percentage typically determined by a cost-to-cost calculation and apply this percentage to all contracts or groups of similar types of contracts. Some contractors use percentages as low as ninety-five percent, while some contractors do not recognize revenue until the job has been accepted by the owner, which is consistent with the “finally completed and accepted” criteria used for tax purposes. Again, consistency and disclosure are very important.
Disclosure of Backlog
Since the Guide was issued in 1981, it has become more common for backlog information to be disclosed in financial statements of contractors.13 Disclosures sometimes appear in footnotes to financial statements.
13AICPA Audit and Accounting Guide, Construction Contractors § 6.28 discusses backlog disclosure as follows:
In the construction industry, one of the most important indexes is the amount of backlog on uncompleted contracts at the end of the current year as compared with the backlog at the end of the prior year. Contractors are encouraged to present backlog information for signed contracts on hand whose cancellation is not anticipated. Backlog can be reported by industry or type of facility and by location (domestic or foreign). Additional disclosures that a company may want to make include backlog on letters of intent and a schedule showing backlog at the beginning of the year, new contract awards, revenue recognized for the year, and backlog at the end of the year. The presentation of backlog information is desirable only if a reasonably dependable determination of total revenue and a reasonably dependable estimate of total cost under signed contracts or letters of intent can be made. Information on signed contracts should be segregated from information on letters of intent if both types of information are presented.