Percentage of completion method of recognizing revenue on long-term contracts Part One: Determining Gross profit The accountant must

determine revenue, expense, and gross profit using percentage of completion (POC) at the end of each reporting period. The POC is a ratio of costs incurred to date over total expected costs. The basic idea is that the firm will recognize the gross profit on the contract on a pro rata basis, using POC, over the period of time it takes to complete the project. However, complications arise if the estimate of total project cost (or revenue) changes over time. We illustrate these complications with three different scenarios.

Example: Each of the three scenarios begins with the same data: Arakian Construction Company agrees to construct a building for $5,000,000 million. The project is originally estimated to cost $3,750,000 million, with an expected gross profit of $1,250,000 million. Also assume Arakian bills and collects from its customer as follows: Year 1: Bills customer for $1,200,000 million, collects $1,000,000 million. Year 2: Bills customer for $2,000,000 million, collects $1,400,000 million. Year 3: Bills customer for $1,800,000 million, collects $2,600,000 million. At the end of the third year, Arakian transfers the title to the building to the customer. You will note that when we calculate revenue, cost of revenue (CGS), and gross profit under each of the three scenarios, billings and collections do not play any role. The only information we need to calculate revenue, cost of revenue (CGS), and gross profit is cost incurred to date, total expected cost, revenues, and profits recognized to date. The billing and collections data are relevant when we make journal entries.

Scenario One: There is no change in cost estimate over the construction period. (note: this scenario is not illustrated in the textbook.) Year 1: Arakian incurs costs of $1,500,000. Total expected costs are still $3,750,000. Year 2: Arakian incurs costs of $1,000,000. Total expected costs are still $3,750,000. Year 3: Arakian incurs costs of $1,250,000. Total expected costs are still $3,750,000.

year

Costs incurred this year

Total expected costs

Total expected gross profit

Percentage complete (cumulative costs/total expected costs)

Percentage complete times expected gross profit

Profit recognized to date

Profit to be recognized this year

1500

3750

5000-3750 = 1250 50003750=1250 5000 3750 = 1250

1500/3750= 40% 2500/3750 = 67% (rounded) 3750/3750 = 100%

.40 x 1250 = 500 .67 x 1250 = 833 1.0 x 1250= 1250

500-0=500

1000

3750

500

833500=333 1250833=417

1250

3750

833

Fill in the following table Scenario One: Year 1

Revenues

CGS

Gross profit

Gross margin

Total

Scenario Two-A: Cost estimate increases once, firm still expects a profit on the contract. (Note: this scenario is not illustrated in the textbook.) Year 1: Arakian incurs costs of $1,500,000. Total expected costs are $3,750,000. Year 2: Arakian incurs costs of $1,000,000. Total expected costs are $4,100,000. Year 3: Arakian incurs costs of $1,600,000. Total expected costs are $4,100,000.

year

Costs incurred this year

Total expected costs

Total expected gross profit

Percentage complete

Percentage complete times expected gross profit

Profit recognized to date

Profit to be recognized this year

1 2 3

Scenario Two-A: Year Revenues 1

CGS

Gross profit

Gross margin

Total

Scenario Two-B: This is the same as scenario 2-A above except that the company changes its cost estimate to $4000 in year 2, and increases to $4100 in year 3.
(This is illustration 5-12D in textbook, p. 249) Year 1: Arakian incurs costs of $1,500,000. Total expected costs are $3,750,000. Year 2: Arakian incurs costs of $1,000,000. Total expected costs are $4,000,000. Year 3: Arakian incurs costs of $1,600,000. Total expected costs are $4,100,000.

year

Costs incurred this year

Total expected costs

Total expected gross profit

Percentage complete

Percentage complete times expected gross profit

Profit recognized to date

Profit to be recognized this year

1 2 3

Scenario Two-B: Year Revenues 1

CGS

Gross profit

Gross margin

Total

Scenario Three: Periodic loss occurs for project. (This is from example on page 252 in textbook.) Year 1: Arakian incurs costs of $1,500,000. Total expected costs are $3,750,000. Year 2: Arakian incurs costs of $1,260,000. Total expected costs are $4,600,000. Year 3: Arakian incurs costs of $1,840,000. Total expected costs are $4,600,000. year Costs incurred this year Total expected costs Total expected gross profit Percentage complete Percentage complete times expected gross profit Profit recognized to date Profit to be recognized this year

1 2 3

Scenario Three: Year Revenues 1

CGS

Gross profit

Gross margin

Total

Scenario Three: Loss projected on entire project. (This is from example on page 253 in textbook.) Year 1: Arakian incurs costs of $1,500,000. Total expected costs are $3,750,000. Year 2: Arakian incurs costs of $1,260,000. Total expected costs are $5,100,000. Year 3: Arakian incurs costs of $2,440,000. Total expected costs are $5,200,000. year Costs incurred this year Total expected costs Total expected gross profit Percentage complete Percentage complete times expected gross profit
The firm must recognize the entire loss Recognize any incremental loss

Profit recognized to date

Profit to be recognized this year

1 2 3
No longer applied* No longer applied*

* GAAP requires that a firm recognize 100% of an expected loss immediately. If the firm has previously recognized profit on the contract, it must reverse the cumulative profits and recognize the loss. Scenario Three: for loss contracts, use percentage complete to calculate revenues. Plug for Cost of Goods Sold. Its a GAAP thing. Year Revenues CGS Gross profit Gross margin 1

Total

Part Two: Making journal entries The accountant must make entries during the period to record costs incurred, billings to the customer, and collections from the customer. In addition, at the end of each reporting period, she must make an entry to report revenues, cost of revenues, and gross profit. First we present the journal entries without numbers, then we will illustrate this process using the data from scenario one above. Summary of Journal entries using Percentage of Completion 1. As costs are incurred: Costs and profits on uncompleted contracts (asset) xxx Cash

xxx

2. As customer is billed: Accounts receivable xx Billings on uncompleted contracts (contra-asset to costs and profits) xx

3. Cash

As cash is collected: xxx Accounts receivable xxx

4.

As profits are recognized:

Costs and profits on uncompleted contracts (asset) xxx CGS* yyy Revenues* *note: Revenues CGS = Gross Profit

zzz

5. When project is completed and delivered (assume all billing is complete) : Billings on uncompleted contracts xxx

Costs and profits on uncompleted contracts (asset) xxx

Illustration of Journal Entries for Percentage Completion Accounting

We will use this data to make journal entries on the following page. Scenario Two-B: Cost estimate increases, firm still expects a profit on the contract. (This is illustration 5-12D in textbook, p. 249). Year 1: Arakian incurs costs of $1,500,000. Total expected costs are $3,750,000. Year 2: Arakian incurs costs of $1,000,000. Total expected costs are $4,000,000. Year 3: Arakian incurs costs of $1,600,000. Total expected costs are $4,100,000. We now add data on billings and collections. Year 1: Billings total 1,200,000; Collections total $1,000,000. Year 2: Billings total $2,000,000; Collections total $1,400,000. Year 3: Billings total $1,800,000; Collections total $2,600,000. Scenario Two: Year Revenues CGS Gross profit Gross margin 2000 1500 500 25% 1 1125 2 1875 3 5000 Total 4100 900 18% 1600 275 14.7% 1000 125 11% (rounded)

Year One:
Year 1: Arakian incurs costs of $1,500,000. Total expected costs are $3,750,000. Billings total 1,200,000; Collections total $1,000,000. Gross profit = 500. As costs are incurred: Costs and profits on uncompleted contracts CIP (asset) 1500 Cash, accounts payable, etc. 1500

As customer is billed: Accounts receivable 1200 Billings on uncompleted contracts (contra-asset to CIP) As cash is collected: Cash Accounts receivable As profits are recognized: *to create the income statement, the entry will be made as follows: Costs and profits on uncompleted contracts (CIP) 500 CGS 1500 Revenues 1000 1000

1200

2000

At end of first year, the balance sheet will show the following account balances related to this contract. Assets Cash -500 Accounts receivable 200 CIP in excess of billings 800 Liabilities Billings in excess of CIP Retained earnings

0 500

The income statement will show revenues of 2000, cost of goods sold of 1500, and gross profit of $500.

Year Two: Year 2: Arakian incurs costs of $1,000,000. Total expected costs are $4,000,000. Billings total $2,000,000; Collections total $1,400,000. Gross profit: 125,000. As costs are incurred:

As customer is billed:

As cash is collected:

As profits are recognized:

At end of the second year, the balance sheet will show the following account balances related to this contract.

Assets
Cash Accounts receivable CIP in excess of billings -

Liabilities
Billings in excess of CIP Retained earnings

The income statement will show revenues of , cost of goods sold of , and gross profit of .

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Year Three:
Year 3: Arakian incurs costs of $1,600,000. Total expected costs are $4,100,000. Year 3: Billings total $1,800,000; Collections total $2,600,000. Gross profit is 275,000.

As costs are incurred:

As customer is billed:

As cash is collected:

As profits are recognized:

As title is transferred:

At end of the third year, the balance sheet will show the following account balances related to this contract. Assets Liabilities Cash Billings in excess of CIP Accounts receivable Retained earnings CIP in excess of billings The income statement will show revenues of , cost of goods sold of , and gross profit of .

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Part Three: Analyzing financial statements of companies using percentage completion accounting

Percentage completion accounting is a really squishy accounting method. Firms can change the amount of profit they recognize in a particular year by changing their estimate of the total costs expected to complete a project. Construction firms, software firms, and consulting firms all use this method of recognizing revenue. Since the estimates of total costs to complete and the percentage completed to date are so subjective, analysts tend to use other information to try to determine whether a firm is too aggressive in recording profits. The key indicator is the difference between costs and profits on uncompleted projects and amounts actually billed or collected. Recall that once the firm bills the client, the following entry is made: Accounts receivable Billings on construction in progress The billings on construction in progress is a contra account to the asset Costs and profit on uncompleted projects. Therefore the balance in Costs and profit on uncompleted contracts reported on the balance sheet represents only the unbilled portion of the contract. In fact, some firms call the account Unbilled revenues, and most analysts refer to it as unbilled revenues. When unbilled revenues seem to be growing faster than the cash the firm collects from customers, it suggests there may be problems with the contracts. The key metric used to determine whether there is a problem is Days of Unbilled Revenues, which is the ratio of Costs and profits on uncompleted contracts in excess of billings to revenues, multiplied by the number of days in the reporting period. It is analogous to Days Sales Outstanding. Firms using POC accounting are also required to report claims included in unbilled revenues. Claims usually result from unapproved change orders, or changes in the contract that were made without prior customer approval. Often these amounts are hotly contested. If no claims are reported you can assume the amount is immaterial.

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STEWART & STEVENSON SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
January 31, 2005 2004 (In thousands, except share data)

Assets Current Assets: Cash and cash equivalents Short-term investments Accounts receivable, net Recoverable costs and accrued profits not yet billed Inventories Excess of current cost over LIFO values Deferred income tax asset Income tax receivable Other current assets Total assets of discontinued operations Total Current Assets Property, Plant and Equipment, net Deferred Income Tax Asset Intangibles and Other Assets, net Total Assets Liabilities and Shareholders' Equity Current Liabilities: Notes payable Accounts payable Accrued payrolls and incentives Billings in excess of incurred costs Other current liabilities Total liabilities of discontinued operations Total Current Liabilities Long-Term Debt, net Accrued Postretirement Benefits and Pension Other Long-Term Liabilities Total Liabilities Shareholders' Equity: Common stock, without par value, 100,000,000 shares authorized; 28,865,070 and 28,644,510 shares issued, respectively Retained earnings Accumulated other comprehensive loss Total Shareholders' Equity Total Liabilities & Shareholders' Equity

$ 130,447 $ 53,941 2,480 7,745 153,383 141,263 27,328 15,406 122,937 126,491 (35,657) (39,288) 6,307 4,791 7,223 28,899 5,025 15,161 43,482 93,397 462,955 447,806 119,261 133,203 20,973 12,391 10,153 9,263 $ 613,342 $ 602,663

1,671 82,943 23,758 59,894 37,748 35,669 241,683 25,000 57,621 4,318 328,622 59,616

1,932 63,087 17,280 69,066 36,065 35,814 223,244 25,160 52,056 4,720 305,180 57,056 265,961 (25,534) 297,483 602,663

261,152 (36,048) 284,720 $ 613,342 $

See accompanying notes to the consolidated financial statements. 44

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STEWART & STEVENSON SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended January 31, 2005 2004 2003 (In thousands, except per share data)

Sales $ 1,156,608 $ 1,066,966 $ 1,064,641 Cost of sales 996,724 941,826 915,302 Gross profit 159,884 125,140 149,339 Selling and administrative expenses 100,228 129,975 110,334 Impairment of assets 6,983 Pension curtailment expense 2,400 Other income, net (3,695) (620) (580) Operating profit (loss) 63,351 (13,598) 39,585 Interest expense 2,029 3,202 4,261 Interest income (1,388) (1,475) (1,763) Earnings (loss) from continuing operations before income 62,710 (15,325) 37,087 taxes Income tax expense (benefit) 20,656 (6,927) 11,377 Net earnings (loss) from continuing operations before 42,054 (8,398) 25,710 cumulative effect of change in accounting Loss from discontinued operations, net of tax of ($22,714), (39,346) (44,805) (23,678) ($25,542) and ($12,918) Gain (loss) on sale of discontinued operations, net of tax 2,270 (5,551) expense (benefit) of $1,311 and ($2,706) Cumulative effect of change in accounting principle, net of tax (3,682) of ($1,798) Net earnings (loss) $ 4,978 $ (53,203) $ (7,201) Weighted average shares outstanding: Basic 28,749 28,560 28,479 Diluted 28,984 28,560 28,690 Earnings (loss) per share: Basic: Continuing operations before $ 1.46 $ (0.29) $ 0.90 cumulative effect Discontinued operations (1.29) (1.57) (1.02) Cumulative effect of change in (0.13) accounting principle Net earnings (loss) per share $ 0.17 $ (1.86) $ (0.25) Diluted: Continuing operations before $ 1.45 $ (0.29) $ 0.90 cumulative effect Discontinued operations (1.28) (1.57) (1.02) Cumulative effect of change in (0.13) accounting principle Net earnings (loss) per share $ 0.17 $ (1.86) $ (0.25)

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Note 6: Contracts in Process Amounts included in the financial statements which relate to recoverable costs and accrued profits not yet billed on contracts in process are classified as current assets. Billings on uncompleted contracts in excess of incurred costs and accrued profits are classified as current liabilities. Progress billings on contracts are made in accordance with the terms and conditions of the contracts, which often differ from the revenue recognition process. A summary of the status of uncompleted contracts is as follows:
Fiscal Fiscal 2004 2003 (In thousands)

Costs incurred on uncompleted contracts Accrued profits, net of losses Less billings to date Less customer performance-based payments Recoverable costs and accrued profits not yet billed Billings in excess of incurred costs and accrued profits

$ $ $

87,793 $ 5,636 93,429 (19,127) (106,868) (32,566) $ 27,328 $ (59,894) (32,566) $

117,595 11,158 128,753 (83,352) (99,061) (53,660) 15,406 (69,066) (53,660)

Recoverable costs and accrued profits not yet billed primarily relate to petroleum equipment projects within the Engineered Products segment. Billings in excess of incurred costs and accrued profits primarily relate to the Tactical Vehicle Systems segment. In the Tactical Vehicle Systems segment, overhead costs include selling and administrative expenses which are fully allocated to the contract. The U.S. government has a security interest in unbilled amounts associated with contracts that provide for performance-based payments.

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