The more complex the accounting, the more easily that someone can manipulate the financial statements. A good example involves the recent accounting problems at Toshiba.
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Percentage of completion accounting
Percentage of completion is an accounting method used for long-term construction contracts. One challenge with long-term construction is that the estimated total cost of the project can (and usually does) change. In most cases, the contractor has agreed to a fixed price for the project. If revenue is fixed and total costs change, total profit also changes.
Here’s a simple example of percentage of completion accounting:
Deep Water Pools contracts with the City of Pleasantville to build a $100,000 municipal pool. Deep Water’s cost is $80,000, so the initial profit calculation is $20,000. The business expects the project to take place over two years.
A quick point to keep in mind: Deep Water’s billing and collections is not connected to profit recognition. The fixed contract means that Deep Water will collect a fixed amount of $100,000. The pool company’s profit is $20,000- regardless of when the firm collects the cash.
Percentage of completion also means that Deep Water recognizes profit based on how much of the work has been completed. If, at the end of year one, Deep Water has finished 40% of the project, the pool company would recognize $8,000 in profit (40% * $20,000).
A change in total costs
What complicates this accounting method is when there is a change in the total cost estimate. Assume that, three months into construction, Deep Water estimates that the project’s total cost has increased to $90,000. That estimate generates these changes:
· The new total profit calculation is $100,000 - $90,000 = $10,000
· If Deep Water completes 40% of the project in year one, the profit recognized is (40% * $10,000), or $4,000
You’ve probably figured out by now that this accounting method can lead to some types of manipulation. One way to manipulate earnings is to underestimate the total cost of a project. This article explains that Toshiba’s profits were reportedly inflated by $4.1 billion over the three fiscal years starting from March 2012.
Here’s the problem with this scheme: At the end of a project, total revenue less total costs equals profit. If you overstate profit in early years, you end up “paying for it”. That’s because you’ll post less profit in later years. There’s only so much profit to recognize.
Have you dealt with percentage of completion accounting in your career? Was this a difficult concept to grasp in college? I’d love to hear from you.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
Image: Ron Cogswell
Construction Crane -- Wilson and Clarendon Boulevards at North Irving Street Arlington (VA) September 2013, CC/by/2.0/