Under GAAP, the general rules associated with revenue recognition are:
- Revenue from the sale of goods or provision of services should be recorded in the financial statements when a seller has transferred to a buyer, the significant risk and rewards of ownership and when the consideration (i.e. the selling price) can be reasonably determined.
- Revenue from the sale of goods or provision of services should be recorded when ultimate collection is reasonably assured.
GAAP currently provides additional guidance allowing contractors to use either the completed contract or the percentage of completion method of revenue recognition, depending on their situation. When a contractor’s contracts typically extend past two years, the CRA requires that the contractor use the percentage of completion method. A contractor can currently select the completed contract method for tax purposes (i.e. if contracts are less than two years in duration) and the percentage of completion method for financial statement purposes.
Completed Contract Method
Under the completed contract method, revenue is recognized when the sale of goods or the provision of services is complete or substantially complete. The CICA Handbook permits the use of this method only when performance of a contract consists of the execution of a single act or when company’s management cannot reasonably estimate the extent of progress toward completion of the contract.
Since most construction contracts involve the execution of many acts by a contractor, the completed contract method is not appropriate under GAAP. And it is likely only in exceptional circumstances that the stage of completion of a contract cannot be reasonably estimated. Nonetheless, some small contractors have adopted this method for the following reasons:
- It is simple and it is easy to determine when a contract is virtually complete;
- There is no need to estimate costs to complete a project (i.e. costs are all known when the profit is booked); and
- Assuming that the contractor is profitable, the income tax is deferred to the end of the contract.
For very small contractors, where the contract duration is relatively short (less than one year), this method is acceptable, provided it meets one of the two criteria. The contractor (small or otherwise) however has to weigh the benefits against the potential costs in terms of satisfying its financial statement users’ needs. Contracts, by their nature, tend to fluctuate from year to year, depending on the size, length and number of projects undertaken, and can produce wide fluctuations in net income. Gross profit percentages also fluctuate from year to year under this method, all of which can be misinterpreted by users as volatility. With volatility, there is normally an assumption of risk.
In reviewing a contractor’s financial statements, surety companies and banks look at stability of operations and growth. The misapplication of the completed contract method to contracts involving the execution of a number of acts could produce unfavourable financial results in some years and very positive results in others. This can negatively impact on the contractor’s bonding capacity and on the small contractor’s ability to grow. And, under the completed contract method, if management becomes aware that a contract will end in a loss, under GAAP the loss is to be recorded immediately (i.e. not at the end of the contract).
The completed contract method produces a balance sheet with inventory and work in progress relating to costs incurred and deferred revenue, which reflects over-billings to owners for work accomplished. The costs and the corresponding revenue do not appear on the contractor’s income statement until the contract is complete. Net income and gross profit percentages therefore are skewed from year to year. For financial statement presentation purposes, under and over billings on multiple contracts may not be netted on the balance sheet. Since contractors often must complete monthly progress applications/billings in advance of the actual end of the period covered by the invoice/application, (i.e. submit on the 27th of the month and invoice for work completed to the 31st), it is not uncommon for the amount invoiced to be more than the actual work performed.
CRA currently allows contractors to use the completed contract method for tax purposes although the contractor’s financial statements are prepared using the percentage of completion method. As a result, the contractor can, with the additional effort have the best of both worlds.
For the International Financial Reporting Standards (“IFRSs”) in Canada IFRSs do not permit the use of the completed contract method. The AcSB has not determined whether IFRSs will be required for private companies but it is unlikely that the standards applicable to private companies will be significantly different from those for publicly accountable entities. Contractors can expect to have to adopt the percentage of completion method. As a result, given that surety companies and banks are interested in historical profitability as a measure of the future success, contractors should seriously consider early adoption of the percentage of completion method.
Percentage of Completed Method
The percentage of completion method is used when the contract involves the completion of more than one act. Under the percentage of completion method, revenue is recognized proportionately with “the extent of work accomplished” by the contractor, by reference to the performance of each act.
Many contractors have adopted what they believe to be the percentage of completion method using billings or periodic payment certificates as a basis for recognizing revenue. This is only appropriate under GAAP if the amount billed is representative of the extent of work accomplished. For the reasons stated above, the amount billed can be greater than the work actually completed. This is a practical bias as it can be up to two months or more before the contractor is paid and under billing, from a cash flow perspective, can be hazardous to a contractor’s health. Using billings as a base also distorts revenue recognition, causing more revenue to be earned at the front end and a mismatch with costs incurred. This has implications for tax purposes, as income tax may be paid prematurely. Contractors should use deferred or accrued revenue to report incomplete jobs at the expected final profit percentage.
In the construction industry, the most reliable measurement of the extent of work accomplished tends to be cost based, in particular when materials, labour and equipment costs/rentals are inputs to the “production” process. Other bases that would be considered appropriate are labour hours or machine hours, where material costs in a contract are negligible (i.e. site work for road construction). The percentage of completion is then derived from a simple formula, “actual costs incurred (or hours spent) to date” divided by “total costs (or hours) to complete the contract”. The total cost to complete a project is equal to actual costs incurred to date for a project plus estimated costs to complete the project.
Since the initial costing of a contract in the bidding phase is based on estimated total costs, actual total costs to complete a contract will change as the project progresses. As a result, it is necessary for management to make its best estimate of costs to complete a project to determine the expected total cost of the project. So while the formula is simple, there is effort required on the part of management to estimate costs to complete contracts that are in process.
The frequency with which a contractor is required to provide financial statements to its bank or surety company will determine how frequently these estimates will need to be made. Most contractors are required to report on an interim basis (monthly or quarterly) and on an annual basis with a complete set of GAAP compliant financial statements each reporting period; some small or mid sized contractors may only be required to provide a complete set of GAAP compliant financial statements on an annual basis.
The intent of the recommendation to use costs as a basis for determining work completed (or another rational base such as labour hours or machine hours), is not to change the way in which contractors bill for work performed on contracts. Current practices involving owner sign off and certifications by architects and/or engineers are industry practice and are not affected by these recommendations.
These recommendations are targeted to revenue recognition in a contractor’s financial statements not changing the contractor’s billing practices.
The most compelling reason for adopting the cost based (or machine or labour hours, as appropriate) percentage of completion method, is that the contractor’s financial statements will meet the needs of important external users such as banks and surety companies. This method most closely reflects the economic activities of companies in the construction industry. The consistent adoption of this method by contractors will enhance comparability and allow these important users to make meaningful and fair assessments of contractor financial statements.
Source: Construction Accounting Best Practices by Canadian Construction Association
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