Evaluating Borrower Performance: Understand the Percentage of Completion Method
One way to ensure the long-term success of your loans is to familiarize yourself with the specific accounting methods your borrowers may use. Gaining an understanding of these methods can help you better evaluate your borrowers’ financial status and whether they’re generating sufficient revenues over time. For instance, according to Generally Accepted Accounting Principles (GAAP), businesses are likely to use the percentage of completion method to record long-term contracts and revenues from projects that unfold over more than one year.
The ins and outs
When a borrower enters into long-term contracts, the percentage of completion method affects its financial statements. The subjective use of estimates could put you at risk for financial misstatement.
Homebuilders, commercial developers, architects, creative agencies and engineering firms are examples of companies that may enter into long-term contracts. There are two methods of reporting long-term contracts, according to the AICPA’s Accounting Research Bulletin (ARB) No. 45, Long-Term Construction-Type Contracts, and Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts.
The first is known as the “completed contract method.” Here, revenues and expenses are recorded when the contractor fulfills the terms of the contract. The “percentage of completion method”ties revenue recognition to the incurrence of job costs (or estimates of an annual completion factor). SOP 81-1 establishes a strong preference for the percentage of completion method, as long as companies have the ability to make estimates that are “sufficiently dependable.” Most contractors also use the method for income tax purposes. An exception is permitted for contractors with less than $10 million in annual revenues.
The revenue recognition principle
GAAP requires all borrowers to report revenues as earned, regardless of when cash is received. Usually revenues are considered “earned” when a company delivers products or services to its customer. The percentage of completion method deviates from the revenue recognition principle by recognizing income prior to a job’s completion.
This method matches revenues to costs incurred, including direct labor, material and overhead. Usually borrowers use the cost comparison method to estimate percentage complete. And occasionally, contractors estimate the percentage complete with an annual completion factor. However, the IRS requires detailed documentation or certification from an architect or engineer to support annual completion factors.
Here’s a simplified example of how percentage of completion affects financial statements. Suppose a $1 million job is expected to span two years and cost $800,000. In Year 1, the contractor incurs $400,000 in costs and then invoices the client $450,000.
At the end of Year 1, the percentage complete is 50% ($400,000 in actual costs divided by $800,000 in expected total costs). So the contractor would record $500,000 in revenues ($1 million times 50%) to match the $400,000 in costs. The net gross profit is $100,000 in Year 1.
Next, the contractor reports costs in excess of billings (an asset) or billings in excess of costs (a liability) on the balance sheet. In this example, the borrower has billed $450,000 but has recorded $500,000 in revenues. The $50,000 difference shows up as costs in excess of billings, a current asset account that reflects underbillings in Year 1.
Keep in mind that most companies run several jobs simultaneously. GAAP doesn’t allow contractors to offset (or net) assets against liabilities. So don’t be surprised if a contractor reports both costs and billings in excess on its balance sheet.
Percentage of completion accounting necessitates subjective estimates about expected costs. It’s further complicated by job cost allocation policies, change orders, changes in estimates, and differences between book and tax accounting methods. The more you understand about this method, the better you may be able to head off problems early.