Stopping To Measure Profit: Manipulating Percentage of Completion Accounting

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.

An example

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

Manipulating earnings

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.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

Co-Founder: accountinged.com

Image: Ron Cogswell

Construction Crane -- Wilson and Clarendon Boulevards at North Irving Street Arlington (VA) September 2013, CC/by/2.0/

Weak Link in the Chain: Material Weaknesses in Financial Reporting

In accounting, moving from posting a transaction to generating financial statements is a long and winding road. There are many steps along the way. You can think of the process as a chain. If there is a weakness in the chain, the company may end up with financial statements that are incorrect. An external auditor has a duty to audit the internal controls over financial reporting.

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Public companies and PCAOB

The importance of internal controls has been ramped up with the passage of Sarbares-Oxley (SOX) legislation. SOX has a large impact on public-traded companies. To understand how internal controls are addressed, consider these players:

·      PCAOB: The Public Company Oversight Board has oversight over the accounting and financial statements for public companies. Part of that oversight means that PCAOB inspects the work performed by auditors of public companies.

·      Auditors: External auditors have an obligation to assess the effectiveness of internal controls. If the auditor finds internal control weaknesses, they must discuss those weaknesses to company management. If management does not take action to correct the weaknesses, that situation may affect the type of audit opinion issued.

·      Audit Committee: A company’s audit committee hires the auditor and receives the audit report. The audit committee is obligated to perform a due diligence investigation into the auditor’s work. Essentially, and audit committee asks questions to ensure that the audit is performed correctly.

Audit Committee Dialogue- New Guidance

The National Law Review recently explained that PCAOB is publishing guidance to Audit Committees. The guidance is referred to as the Audit Committee Dialogue. The Dialogue is based on the results of the PCAOB’s inspections of public company auditors. The communication provides the Audit Committee with specific questions they should be asking their auditors.

The Audit Committee Dialogue discusses three types of material weaknesses that currently need to be addressed. This post discusses one of those weaknesses: Internal controls over financial reporting.

ICFR: Internal Controls over Financial Reporting

The PCAOB performed a review of 2012 and 2013 audit reports. They found that 77% of the material weaknesses in internal controls were not disclosed until after financial statements were issued with reporting errors. In other words, the auditor was not able to identify a weakness before the weakness cause an error.

An example

To clarify, let’s use an example. Assume that Acme Clothing manufactures and sells clothing to retailers. The contracts with the retailers allows for certain sales returns and allowances. These transactions require some complex journal entries.

Acme Clothing does not require the Controller to review these complex journal entries on a timely basis. This control weakness means that incorrect journal entries generate errors in the financial statements.

The weak link in the chain is the journal entry review process.

Questions to find the weakness

Audit Committee Dialogue recommends that Audit Committees ask the auditor these questions:

·      What component of the internal controls over financial reporting has the highest risk for a material weakness? Have you planned your audit test work to address these potential weaknesses?

·      What would you do if you found a weakness?

·      Are these steps in your audit plan?

Issuing financial statements that must be restated is a huge issue for investors, lenders and other stakeholders. After all, the stakeholders all make decisions based on the original set of financial statements. These questions can help prevent material misstatement of the financials.

What types of internal control weaknesses have you seen? What problems did they cause? I’d love to hear from you.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

Co-Founder: accountinged.com

Image: Chain by Pratanit

https://creativecommons.org/licenses/by/2.0/

Red Flag: Changing Auditors Due To Disagreement On Audit Opinion

How does your company make money?

Now, that may seen like a silly question, but it has everything do to with your firm’s ability to succeed over the long term. Your business should generate the vast majority of sales and earnings from continuing operations. Continuing operations refers to your day-to-day business.

Accountinged.com is a think tank and training site for accountants. Click here for a free trial.

Connecting to the cash flow statement

If you manufacture blue jeans, for example, that’s your operating business. Profit from the sale of a building is non-operating income. You’re not in the business of selling buildings- you make blue jeans. You can also make a connection to the statement of cash flows. Customer payments for blue jeans would be a cash flow from operating activities. If you sell a building, that’s a cash flow from investing. Buying and selling assets is an investing activity.

Understanding solvency and a going concern opinion

Solvency refers to a company’s ability to survive over the long term. If you make blue jeans, you’ll generate sales and earnings from blue jean sales. You can’t rely on selling assets to make a profit. Eventually, you’ll run out of assets to sell.

Solvency relates to a going concern audit opinion. This opinion means that the auditor has serious doubts that the firm can survive over the long-term. If a business posts a loss for several consecutive years- or has a growing debt load- an auditor may issue this type of opinion.

Now, a going concern opinion is serious. The company under audit may lose its ability to borrow. Equity investors may sell their holdings. Perhaps most serious, it’s an acknowledgement that senior management does not have a plan to manage the business over the long haul.

Swisher Hygiene Dismisses Auditor

Here’s a quote from the May 2015 Charlotte Observer:

“Charlotte-based Swisher Hygiene has dismissed its accounting firm, saying it doesn’t agree with the firm’s assessment that Swisher might not be able to continue as a going concern, a term that refers to the company’s ability to stay afloat.

Swisher, which provides sanitizing services and cleaning chemicals, said its management had “several disagreements and discussions” with BDO USA about completing the audit and filing the company’s 2014 annual report, according to a securities filing Thursday.

The company said its own assessment of its finances found that “no material weaknesses and one significant deficiency” existed as of December 31, 2014, while BDO’s audit concluded that 12 material weaknesses and five significant deficiencies were present.

Swisher said a review of its bad debt write-offs and recorded bad debt reserve, as well as its process to account for its dish machine assets, had resulted in adjustments to the financial statements initially presented to BDO.

BDO therefore had expressed doubt about the company’s ability to continue as a going concern, while Swisher’s analysis found that no going concern issues were present.”

A few things struck me after reading the article:

·      Accounting requires judgment: There are certainly areas of accounting that require judgment. Bad debt policy is a good example. To estimate a reserve for bad debt, a company typically makes an estimate on percentage of accounts receivable balances that may not be collected. So, I can see some room for disagreement between the business and the external auditor.

·      Material weaknesses, significant deficiencies: A red flag for me were the huge differences in this area. The company found no material weaknesses- but the auditor found 12? That’s hard to believe- especially since auditors and clients work on identifying and improving internal controls each year.

·      Sarbanes-Oxley (SOX) Requirements: SOX raises the stakes on the importance of internal controls. Senior management is now required to review internal controls and report on any weaknesses found. With this added emphasis on controls, it’s even more unusual for a company and the auditor to have such a huge disagreement. 

Changing auditors

You can click on a link in the news story and see the Form 8-K. This form is used to report a change of auditor to the SEC. Regardless of who audits the books, will the multiple weaknesses remain? A real red flag for a potential lender of investor.

Have you dealt with a situation when a company changed auditors- due to an accounting disagreement? I’d love to hear your comments.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

Co-Founder: accountinged.com

(email) ken@stltest.net

(website) www.stltest.net

Image: Calculator and Money , CC by 2.0