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.
Generally accepted accounting principles (GAAP) must be followed to present fairly the financial position of a business entity. The construction industry has two distinct alternatives for financial accounting and reporting that conform with GAAP, the completed-contract method and the more widely used percentage-of-completion method. This section reviews some of the authoritative literature on construction accounting and provides a brief synopsis and comparison of the two accounting methods.
Authoritative literature on construction accounting is limited. The American Institute of Certified Public Accountants (AICPA) issued no authoritative literature on proper accounting for the construction industry until 1955.
The Committee on Accounting Procedure (CAP) of the AICPA was the first body created to establish standards of financial accounting and reporting. The CAP issued 51 Accounting Research Bulletins. Accounting Research Bulletin (ARB) No. 43, “Restatement and Revision of Accounting Research Bulletins,” which was issued in 1953, restated, revised, and codified prior ARBs. Chapter 11 of ARB No. 43, “Government Contracts,” dealt with the issues of cost-plus-fixed-fee contracts, accounting for government contracts subject to renegotiations, and accounting for terminated war and defense contracts. Clearly, those issues were not important to the majority of construction contractors. In 1955, the CAP issued ARB No. 45, “Long-Term Construction-Type Contracts.” This was the first pronouncement issued by the accounting profession dealing with the special characteristics of contractor accounting. It has not been amended or revised.
In 1959, the AICPA issued an audit guide and an accounting guide for contractors. In 1965, the AICPA issued “Audits of Construction Contractors,” an audit and accounting guide that combined the two previous guides.
In response to the 1974 request to update the 1965 audit guide, the AICPA formed the Construction Contractors Guide Committee in 1975. The Committee was to present recommendations on specialized accounting and reporting principles and practices for the construction industry.
After more than five years of deliberation and study, the AICPA, in 1981, issued a new Audit and Accounting Guide, “Construction Contractors.” Simultaneously, the AICPA issued Statement of Position 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” The Guide and Statement of Position 81-1 (SOP 81-1, now known as Accounting Codification 605-35) significantly improved the quality of authoritative literature on construction accounting. Financial reporting improved in the construction industry, and all interested users of financial statements, such as stockholders, sureties, and bankers, benefitted from the improved quality of the financial information.
In 1973, the Financial Accounting Standards Board (FASB) assumed the responsibility of establishing and promulgating reporting practices. That responsibility had previously been the AICPA’s. Therefore, when the Guide and SOP 81-1 were issued, the AICPA did not have the authority to establish GAAP. The FASB in 1985 put the Guide and SOP 81-1 on its agenda for review. However, due to a backlog in late 1985, the FASB removed the Guide and SOP 81-1 from its agenda. FASB does not know when the issues of construction accounting will be addressed and the present GAAP revised.
On June 24, 2010, the Financial Accounting Standards Board (FASB) issued an Exposure Draft entitled, “Revenue from Contracts with Customers.” The purpose of this exposure draft is to develop one set of standards for revenue recognition applicable to all industries to replace the 100+ revenue pronouncements currently existing in GAAP and to bring GAAP and IFRS (International Financial Reporting Standards) into convergence. The large number of comments received on the Exposure Draft resulted in the FASB deciding to reissue another Exposure Draft in late 2011. The intention was to end up with a new GAAP pronouncement covering Revenue Recognition that applies to all industries issued in 2011 or shortly thereafter; it now looks like the target date for issuance of that new standard will have taken place the first quarter of 2014. The effective date should be no sooner than January 1, 2017.
Acceptable Income Recognition Methods
ARB No. 45 continues to provide the accounting requirements of income recognition for the construction industry and allows either the percentage-of-completion method or the completed-contract method. The construction industry, however, is strongly influenced by the Guide, SOP 81-1 (now known as Accounting Codification 605-35), and FASB Statement No. 56, “Designation of AICPA Guide and Statement of Position 81-1 on Contractor Accounting and SOP 81-1 Accounting for Performance of Construction-Type and Certain Production-Type Contracts as Preferable for Purposes of Applying APB Opinion 20.”
Under the percentage-of-completion method, revenue, costs, and gross profit are recognized in all accounting periods throughout the duration of the contract. A method of measuring the extent of progress toward completion is selected, such as the cost-to-cost method, efforts-expended method, or units-of-work-performed method.
To use the percentage-of-completion method, a contractor must be able to provide reasonably dependable estimates of revenue, costs, and progress toward completion. For entities that are engaged in construction contracts on a continuing basis, there is a presumption that they have the skills to make such estimates and that this capability is essential to maintaining profitable operations. In addition, most users of financial statements, especially sureties and bankers, expect the use of the percentage-of-completion method.
Under the completed-contract method of accounting, revenue, costs, and gross profit are not recognized until the contract has been finally completed and accepted. Although ARB No. 45 indicates that the completed-contract method is acceptable for purposes of GAAP, the AICPA prefers the percentage-of-completion method because, for contracts whose performance extends beyond one accounting period, the completed-contract method does not report revenues and expenses in the periods when economic performance takes place. Normally, the completed-contract method is only used when inherent risks associated with the contract preclude the contractor’s ability to reasonably estimate contract revenues, costs or gross profit.
The completed-contract method of accounting is considered acceptable when the contractor has many short-term contracts. This method does not present a material distortion of the financial statements from one accounting period to the next when the level of uncompleted work at the end of both periods is similar.
Unacceptable Income Recognition Methods
Income is sometimes recognized using the cash basis, accrual (billing) basis, or some other hybrid basis. None of these are acceptable for financial statements prepared in accordance with GAAP because they do not yield a proper matching of revenue and expenses. The cash basis does not provide a meaningful determination of gross profit at any point in time, because a contractor can distort performance by accelerating or delaying the collection of cash receipts and the payment of cash disbursements. The accrual method can also produce a distorted gross profit figure, because billings do not present a reliable indicator for measuring progress toward completion. Furthermore, significant overbillings or underbillings on a project will cause an unrealistic timing of revenue recognition.
These methods may be used for income tax reporting even though they are not acceptable for financial reporting in conformity with GAAP. Contractors frequently use different methods for reporting income for financial statements and income for tax reporting.
Illustration of Income Recognition Methods
The following illustrates how reportable gross income varies according to the income recognition method used. Table 4-1 compares the computation of revenue, contract costs, and gross profits for each period using the income recognition method.
The income recognition methods are:
(2) Accrual, including retention;
(3) Accrual, excluding retention;
(4) Percentage-of-completion; and
(5) Completed contract.
The financial information is as follows:
Note that the gross profits vary among the methods. In the first period, for example, the gross profit varies from zero under the completed-contract method to $750,000 under the accrual method including retention. The accrual method including retention in the first period would report $250,000 in additional gross profit than the total gross profit of $500,000 on the job—creating a distortion in the form of overbilling.
The percentage-of-completion and the completed-contract methods, which are the only methods acceptable under GAAP, do not allow the determination of income to be recognized due to billing, cash collection, or cash disbursements made at year-end. Of these two methods, only the percentage-of-completion method allows a realistic assessment of the financial position and periodic reporting of revenues and costs of the company during the course of the contract.
Calculation of Income Using the Percentage-of-Completion Method
Given the complex nature of long-term construction contracts, the calculation of income, which should realistically measure performance, requires experienced judgment. The variables that change over time can affect contract income significantly. In theory, the calculation should be quite simple. Expected contract revenue less expected contract costs equals contract gross profit. The components of income—revenue, costs, and gross profit—should be systematically allocated to accounting periods over the term of the contract.
Note the following variables and consider their effect:
(1) Material shortages or labor strikes;
(2) Design changes and change orders;
(3) Environmental factors such as weather or unanticipated geological problems;
(4) Nonperformance by subcontractors;
(5) Jobsite accidents; and
(6) Ripple effect of late completion of critical sub-projects.
Any one of these variables can significantly influence the results of a contract. If the unexpected increases cost, it will affect contract income unless there is a proportionate change in contract revenue or recoveries, such as claims, that would be available from third parties such as subcontractors.
In order to calculate contract revenue, costs, and gross profit, a system must be established to measure performance. For example, assume that there is a contract to build 100 miles of highway. Standards considered appropriate for measuring performance could include costs incurred, labor hours incurred, or completed miles of highway. These are the most commonly used standards and are generally referred to as the “cost-to-cost method,” the “efforts method,” and the “output method,” respectively. Depending on the standard of measurement selected, the calculated income at a point in time may be different. However, the final income earned at completion will always be the same.
To illustrate, assume 100 miles of highway are to be constructed over a two-year period as follows:
Using these facts, the percentage of completion (year one standards and year two standards divided by the total for both years) by year is as follows:
As illustrated, each method results in a different percentage of completion. Therefore, the amount of income recognized in each of the two years also differs.
Selection of a method to measure performance requires evaluation of the type of project, information available from accounting and management information systems, and the accuracy of the information. The method selected must be applied consistently to all projects, year after year. Projects with unusual characteristics may require the selection of a different method that is just for that unique project.
The construction industry primarily uses the cost-to-cost method. Since most contractors do not inventory significant amounts of materials, the expenditure of labor and material dollars closely approximates the physical construction process. However, there is an inherent risk in using the cost-to-cost method. If the estimated total cost changes significantly upward (which is the denominator in computing the percentage of completion), the percentage of completion will be overstated in the earlier periods of the contract. For example, in the illustration at § 4.02, the original cost estimate was $9,500,000. At the end of the first year, the costs incurred were $4,250,000, and the percentage of completion was 44.75 percent. If the total cost estimate was understated by $500,000, the total cost would have been $10,000,000, and the percentage of completion would have been 42.5 percent.
In using the cost-to-cost method, a more precise estimate of the total cost results in a more precise measurement of the percentage of completion. Cost accounting systems must be able to capture costs on a timely basis and classify them in the appropriate categories of material, labor, overhead, and components of the construction project.
Incurred labor hours is the most commonly used measurement of the efforts method. Since construction is a labor-oriented business, labor hours can be an appropriate measurement unit. If there are periods when the project is labor intensive, using labor hours recognizes the effort as it is incurred.
If measurement units related to effort are used, the completion amount of effort or the amount of effort incurred to date should be calculated. The computation of both labor hours incurred to date and total expected labor hours should include direct and indirect labor hours as well as labor hours from subcontractors. If subcontractors are unable to provide labor hour information, the efforts method may be inappropriate.
Generally, the output method is used if there is uniformity of output. Each unit is identical, and the cost per unit is fairly standardized. Examples are cubic yards of concrete poured, feet of pipe laid, or number of units installed (windows, partitions, cabinets, etc.). The standardization of the product and the repetitive installation processes generally indicate that the material and labor cost for the first unit produced is the same as for the last unit produced.
On the other hand, it would be inappropriate to use a mile output measurement if a railroad track that was being constructed across relatively flat land and also passed through mountains where a tunnel had to be constructed. Obviously, much more effort is expended through the mountains than over flat land. In addition, even if the terrain is the same, there may be increased efficiency as the effort is repeated.
Frequently, contracts provide a number of pay items or a schedule of values used to facilitate periodic payments. Because these items are not similar and may, or may not, have uniform mark-ups, they are not appropriate units for the use of the output method of revenue recognition.
Measurement of Completion
The various performance standards of measurement are defined as cost-to-cost, efforts, and output. These concepts were originally stated in ARB No. 45, paragraph 4, in which the committee believed that:
“the recognized income [under the percentage-of-completion method] be that percentage of estimated total income, either:
(a) that incurred costs to date bear to estimated total costs after giving effect to estimates of cost to complete based upon most recent information, or
“(b) that may be indicated by such other measure of progress towards completion as may be appropriate having due regard to work performed.”
These measurement approaches can be grouped into two categories: (1) input and (2) output. Input measures the effort put into a project such as costs, labor hours, and materials used. Output measures the results accomplished in terms of units.
Each measurement category has advantages and disadvantages. Input measures are good indicators of the efforts incurred, but may not be representative of major tasks accomplished or of obligations discharged. If output can be measured, tangible evidence exists that progress has been made and the contractor has discharged the contractual obligation, assuming that the product meets the contract specification.
Regardless of the measure selected, consideration should also be given to efficiency. Measurement of performance can be overstated or understated at different times during the construction process. Learning curves, construction delays, and other factors that alter the measurement results must also be considered.
After the performance measurement standard has been selected, the contract revenue earned, costs incurred, and gross profit can be computed. Two alternative methods can be used. In SOP 81-1, these methods are referred to as “Alternative A” and “Alternative B.” Although the two methods are different, their objective is the same. Both methods attempt to determine the portion of contract revenue, cost, and gross profit to be recognized in a particular period that will reflect in monetary terms the progress completed in that period.
“Alternative A,” sometimes referred to as the “Revenue-Cost Approach,” measures contract revenue and related costs proportionate to the percentage of completion using the selected performance measurement standard. This method is most commonly used when the percentage of completion is determined by inputs other than total costs (direct labor hours, labor costs, etc.), outputs, or other estimations of physical completion.
In contrast, “Alternative B,” sometimes referred to as the “Gross-Profit Approach,” measures the portion of gross profit to be recognized proportionate to the costs incurred to date. Revenue under the “Alternative B” method is calculated as the sum of the cost incurred to date plus the calculated gross profit earned to date. Both methods are acceptable; however, “Alternative B,” based on contract costs which are recorded and reported on a regular basis, is more widely used.
If the percentage of completion is determined using the cost-to-cost measurement standard, the gross profit will be the same under both calculations. Differences arise primarily if the percentage of completion computed dividing current costs incurred by total costs (cost-to-cost method) is different from the percentage of completion calculated by either the efforts method or output method.
Alternative A’s theoretical support is based on the matching concept. In theory, once progress has been determined, the estimated contract revenue and costs would be multiplied by the percentage completed. This matches the same proportion of revenue against costs. The difference between the recognized revenue and costs is earned gross profit. If there are no changes in the estimated total contract revenue and cost, this method provides a constant gross margin percentage for all accounting periods within a contract period. In practice, however, this is seldom the case, since most contract estimates require revision during the contract period.
Alternative A requires that all computations for any period be calculated by multiplying the percentage of completion by contract revenues and costs, adjusted for revisions in estimates when they become known. The following steps are taken to calculate contract revenues earned, costs incurred and gross profits using the revenue-cost approach:
Step 1: Compute percentage of completion to date using the selected performance measurement standard.
Step 2: Multiply the percentage of completion by the total contract revenues.
Step 3: Multiply the percentage of completion by the estimated total contract costs.
Step 4: Subtract the contract costs from the contract revenue to derive gross profit.
Step 5: Subtract revenues for previous periods and costs recognized from previous periods to compute the amounts to be recognized for the current period.
To illustrate, assume the following:
The amounts to be recognized are computed as follows:
In this example for both Period 1 and Period 2, the same percentage of revenue and costs has been recognized, resulting in a constant gross profit percentage of 10 percent in each period.
Assume the same facts as above except that construction delays of $40,000 in Period 2 increase the estimated total costs to $940,000. Furthermore, there is no increase in the contract price. The computation for Period 1 would be the same, since the cost increase was not anticipated. The calculation for Periods 2 and 3 is as follows:
Step 1: Recompute the percentage of completion by using the revised total cost estimate.
Step 2: Compute the earned contract revenue by multiplying the percentage of completion by the total contract price and subtract any revenue previously recognized to determine the earned revenue for the current period.
Step 3: Compute the recognized contract cost by multiplying the percentage of completion by the total estimated contract cost and subtract any cost previously recognized to determine the costs to be recognized in the current period.
Step 4: Compute the recognized gross profit by subtracting the cost recognized from the revenue earned for each period.
A summary of the example is as follows:
Note that in Period 1, the gross margin percentage is 10 percent, since the cost increase was not anticipated. The gross profit margin in Period 2 is influenced by two factors. First, a reduction in the expected gross profit margin from 10 percent to 6 percent reduced the gross profit by $22,400 ($560,000 ×.04). Second, Period 2 absorbs the reduced gross profit margin from the previously recognized revenue. This results in a reduced gross profit margin in Period 2 of $16,000 ($400,000 ×.04). A reconciliation of the original expected gross profit percentage to the actual gross profit percentage for Period 2 is as follows:
Using Alternative A may cause the calculated costs to be greater or less than actual costs incurred. In this case, the difference is carried in the balance sheet as an asset (costs incurred in excess of costs recognized) or as a liability (cost recognized in excess of costs incurred).
Alternative B” or the “gross-profit” approach suggests that the measurement of contract progress be reflected in the gross profit. Proponents of Alternative B believe that the amount of gross profit earned, based on progress, has more significance than the attempt to evenly match contract revenue and costs throughout the contract period. They recognize that gross margin percentages will change as contract revenue and costs are revised throughout the contract period. They point out, however, that the gross profit percentage generally changes using Alternative A, since the final contract revenue and costs seldom remain in the same proportion from the original estimate to final completion.
The following steps are taken to calculate contract revenue earned, costs incurred, and gross profit using the gross-profit approach.
Step 1: Compute the percentage of completion using the selected performance measurement standard.
Step 2: Estimate the contract gross profit using total estimated contract revenue and costs.
Step 3: Multiply the percentage of completion by the estimated gross profit.
Step 4: Subtract any gross profit previously recognized to determine the gross profit to be recognized in the period.
Step 5: Add the gross profit for the period to the costs incurred for the period to determine the contract revenue to be recognized.
To illustrate the application of Alternative B, assume the same facts used in the Alternative A illustration:
The amounts to be recognized are computed as follows:
In this example, the earned revenue amounts for each period are the same as the amounts calculated using Alternative A. This will always be the case with the cost-to-cost standard of measurement if the estimated contract costs do not require revision. The significant difference lies in the standard performance measurement method used in computing the percentage of completion for Alternative B. Regardless of the percentage of completion, the costs recognized in the period will always be equal to the costs incurred excluding costs incurred for standard materials purchased but not yet installed. The gross profit is always a calculated amount using the current estimate of progress and the estimated final gross profit. Revenue is always equal to the sum of the gross profit recognized and the costs incurred to date. To determine the portion to be recognized in subsequent periods, the previously recognized amounts must be subtracted from the cumulative year-to-date amounts.
The following example illustrates the effect of cost revisions on estimated gross profit for Periods 2 and 3. Using the same contract amounts as in the Alternative A revision, assume the following:
(1) Period 2 estimated total contract costs increase to $940,000, and
(2) Period 3 additional $40,000 of costs incurred.
Step 1: Recompute the percentage of completion using the revised total cost estimate (same as Alternative A).
Step 2: Compute the earned gross profit by multiplying the percentage of completion by the revised estimate of gross profit, and subtract any gross profit previously recognized to determine the earned gross profit for the period.
Step 3: Compute the earned revenue by adding the earned gross profit, as calculated to the actual costs incurred during each period, and subtract any revenue previously recognized to determine the earned revenue in the period.
Comparison of Methods
To understand the difference between Alternative A and Alternative B, the percentage of completion, based on the performance measurement standard must be different from the percentage calculated using the cost-to-cost method. To illustrate, assume the same facts in the illustration in § 4.02[a], but use the output method for the performance standard of measurement.
The following summarizes costs by period and the percentage of completion assuming an output measurement standard:
The total contract price is $1,000,000 and $40,000 of additional costs are incurred in Period 3.
Table 4-2 compares the two alternatives, A and B, using the above facts.
The following illustrates gross profit and gross profit percentages under Alternative A and Alternative B:
Regardless of the alternative selected, the final contract revenues, costs, and gross profit are the same. Using Alternative A may cause the calculated costs to be greater or less than actual costs incurred. In this case, the difference is carried in the balance sheet as an asset (costs incurred in excess of costs recognized) or as a liability (cost recognized in excess of costs incurred). Alternative A limits the recognition of costs and revenue to the percentage of completion, whereas Alternative B allows costs to be recognized as they are incurred.
Requirements for Using the Percentage-of-Completion Method
Probably the most unusual aspects of accounting in the construction industry are that the product to be sold does not exist at the time the contract is signed, no title transfer of the product sold triggers revenue recognition, and that the final cost of the product is unknown. From a financial reporting viewpoint, the percentage-of-completion method is preferred over the completed-contract method, since it more closely follows principles of accrual basis accounting (the matching principle and the reporting of economic activity). Throughout the contract period, the contractor is performing under a contractual obligation and is receiving the rewards as progress billings are collected. Proponents of the percentage-of-completion method of accounting believe that the periodic measurement of the company’s transactions more fairly present the economic substance of the entity. The inherent risk in measuring periodic performance is the probability of error within any period of the contract term. Accordingly, certain conditions should be present if the percentage-of-completion method is selected for contract accounting. These conditions are as follows and are discussed in detail in the sections below:
(1) Ability to make reasonably reliable estimates and to make revisions to those estimates as progress occurs;
(2) Terms and conditions of performance that are clearly specified in a legal contract;
(3) Reasonable expectations for performance:
(a) Contractor can perform under the term of the contract, and
(b) Purchaser can satisfy contractual obligations; and
(4) Risks should not exceed those encountered in the ordinary course of business.
Percentage of completion assumes that revisions to measurement of progress, total costs, and revenue can be made reliably. After the initial estimates have been made, it is important to periodically update the estimates as progress occurs and actual results replace estimates. Obviously, the closer a project is to completion, the more accurate the estimate for the remaining work becomes.
Reliable estimates are important from an accounting standpoint only if the percentage-of-completion method is used. In the completed-contract method, the final costs and revenue are reported only at the conclusion of the contract. Under both methods, the final results are the same.
Financial statements prepared according to the percentage-of-completion method are often used to evaluate the contractor’s financial performance in deciding whether to extend financing, to supply a bid or performance bond, or to enter into a contractual relationship. Therefore, reporting reasonably accurate estimates of earnings can aid in establishing the contractor’s credibility. There is little or no value to financial statements that report overstated gross profits throughout the contract term and then a loss when the contract is completed. The overriding objective is to present fairly the proportion of gross profit earned in relation to progress completed.
Changes in estimates can have a significant effect on the related computations of revenue, costs, and gross profits. The more precise an estimate is, the more accurate the periodic measurement. In order to make reliable estimates and related revisions throughout the contract term, certain elements must exist. Two important elements are experienced personnel and accurate accounting systems and easy access to information.
Personnel must have the experience necessary to perform their respective tasks. The gathering of information and subsequent evaluation may involve cost estimators, cost accountants, project managers, architects, engineers, and the owners of the construction entity. Since the sum of their work will be translated into a cost estimate or measure of progress, the final compilation will have value only if participants were reasonably reliable.
A contractor cannot realistically prepare an intelligent contract bid if a reliable cost estimate cannot be determined. This does not mean that construction personnel are incapable merely because a contractor cannot estimate a contract. Instead, specifications may not be clearly defined or new construction technology may be involved. The skills and experience of the personnel must be commensurate with the degree of complexity of the project.
Accounting Systems and Access to Information
Personnel responsible for the estimating process must have access to financial information. Financial results from previous contracts often provide a basis for estimating similar projects. Furthermore, costs of material, labor, equipment, etc., can change. If the available information is current, the cost estimate should be more precise.
In today’s environment, it is essential that total costs be broken down into specific tasks. In most instances, the more discrete the segment is, the smaller the margin of error. The use of budgets detailed by task also helps monitor progress and provides an “early warning system” for problems.
Construction contracts legally bind the purchaser and contractor to specific terms and conditions. In order to calculate the estimated cost of performing a task, the nature of the task must be clearly defined. Specification of materials, structural design, compliance with regulatory requirements or building codes, and performance dates all have a bearing on estimating the cost of performance. In addition, contracts generally provide for rights and remedies for nonperformance or requests for changes to the contract specifications. The more vague the contract is, the more difficult it is to estimate the cost of performance.
If a contractor enters into a fixed price contract, it is critically important to know the precise contract requirements. Without these specifics, it is impossible to determine if a request for performance falls outside the parameters of the contract and the estimated cost of performance.
If no contracts exist, it may be inappropriate to use the percentage-of-completion method unless the agreement provides for consideration of the cost of time and material. Still, the absence of a contract may raise concerns about collection of the consideration, and careful thought should be given to determining the requirements of performance.
The percentage-of-completion method assumes that both parties have the ability and intend to perform under the terms of the contract. Since periodic measurements indicate the progress completed, presumably the contractor has completed a sufficient amount of work to satisfy a portion of the contract requirements. In practice, the results of the contractor’s efforts have been transferred to the purchaser. The contractor’s rights to collection of consideration for the work completed rest with the contract and the lien laws. As long as the contractor demonstrates performance and the intent to complete the work in accordance with the contract terms, the use of percentage of completion is appropriate.
If, for any reason, the purchaser’s intent or capacity to fulfill the reciprocal terms of the contract is questionable, it may be inappropriate to use the percentage-of-completion method. Progress payments made during the contract term based on the contractor’s performance are generally considered proof of the purchaser’s intent and capacity.
Any business entity is susceptible to risks in the ordinary course of business. There are normal operating risks, such as collection of receivables, timely completion of commitments, or loss of a major customer, and there are infrequent risks such as natural catastrophes or fires that can disrupt normal business operations. These risks should not preclude the use of the percentage-of-completion method of accounting. The presence of risk directly related to the terms of the contract, conditions for performance, or the ability to determine reliable estimates may be a basis for precluding the use of the percentage-of-completion method. These risks include the following:
(1) Unrealistic contract terms;
(2) Ill or non-defined contract terms;
(3) Unreliable parties to the contract; and
(4) Shortages of resources, material, or labor.
One or more of these factors may be enough to support the use of the completed-contract method.
A profit center is the base unit used for the accumulation of revenue and costs and the measurement of income. For a business enterprise in the construction industry, a profit center is normally considered to be a single contract. Under certain specified circumstances, a profit center may be a segment of a contract or a combination of several contracts. The following sections describe if contracts should be combined or segmented.
More than one contract may be combined for purposes of income recognition if accounting for the contracts on an individual basis is not realistic or appropriate.
Accounting literature (paragraph 37 of SOP 81-1) recommends, but does not require, that contracts may be combined for accounting purposes under certain circumstances.
If a series of contracts have been negotiated as part of an overall project and the intent was to achieve a certain profit level based on the overall project results, it may be appropriate to account for the project as one combined contract. If, for example, contracts constituting the project have been negotiated with high and low profit margins, but within the context of achieving an overall profit objective, combining the contracts for income recognition purposes will result in recognizing a constant profit margin as opposed to variable profit margins assuming that the work was performed in more than one accounting period.
In making a decision to combine contracts, certain conditions should exist. Even though separate contracts exist, each contract should be closely interrelated or interdependent on the other. Because of the close relationship of each project, common costs are expected to be incurred that would be difficult to allocate to or identify with specific contracts. In addition, the contracts should constitute an agreement to complete a continuous effort for a single customer.
Situations may exist for which it is appropriate to break down a contract into segments for purposes of income recognition. It would be appropriate to segment a contract provided that the contract had separate bids for the components of the contract, the customer had the option to accept or reject the proposal for each segment, and the summation of the price for each segment approximated the total contract value.
When determining if it is feasible to segment a contract, consideration should be given to factors that support the decision to segment it. For example, the contract should specifically identify separate phases or elements, each phase or element should be bid separately, and the phase or elements should have different risks and, therefore, different profit margins.
If the criteria noted above do not apply, the project may still be segmented if all of the criteria from paragraph 31 of SOP 81-1 are met:
The contractor has a significant history of providing similar services to other customers under separate contracts for each significant segment to which a profit margin higher than the overall profit margin on the project is ascribed.
Therefore, a contractor may, but is not required to, combine or segment projects. Many contractors will probably conclude that the sophistication needed to document properly the process to combine or segment contracts is not available or that the costs of combining or segmenting contracts outweigh the benefits. Accordingly, most contractors continue to consider a single contract as a profit center.