percentage-of-completion vs completed contract

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Dreary

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Which of the following statements accurately reflects the effects of the percentage-of-completion method for recognizing income on long-term projects versus the use of the completed contract method?
a. Pretax cash flows are greater under the percentage-of-completion method.
b. The percentage-of-completion method generates a smoother earnings pattern over the life of the project.
c. The debt-to-equity ratio will generally be higher for companies that use the percentage-of-completion method.
d. Use of the percentage-of-completion method generally results in lower assets on the balance sheet
What’s wrong with choice a?
Dreary
 
Cash flows are unaffected by the type of accounting treatment you elected for a project.
Cash is cash. In each type the cash flows are when you receive the money…not when you book revenue.
 
‘B’ should be the correct answer, Total Cash Flows remain unaffected irrespective of the Revenue Recognition Method used for accounting purpose.
- Dinesh S
 
That’s the correct answer, but how about if you get $1 million in revenue in the first year, with your cost for that year at, say, $0.8 million. Isn’t your cash flow $0.2 fo that year? While it is probably negative using the completed contract method? I am not sure that cash flows are the same regardless of method! Could you explain?
Dreary
 
How could how you account for it affect your cash flow? Your cash flow is affected by how you bill for it and what you spend getting it done…
 
But I did receive cash in the percentage-of-completion method, didn’t I?
 
Example: Company sells a product to customer for $15 million, and customer pays $9 million first year, then $6 milion second year with total cost for the company at $10 million. In the first year, when company receives $9 million it records its cost at $6 million (9/15 * $10 million). So isn’t that cash?
Dreary
 
dreary you have to sepparate the two recongnisng revenue and receiving cash
they really are two separate things
if the customer pays in first year 9 mil , that will be an inflow no matter what accounting method you choose
cost again has nothing to do with outflows because it could be generated by inventories not new purchases of goods sold
 
even the fact that you say if you get 1 million in revenue that means you record it not necessarily that you get the cash, you might get more or less and that will show in the balance sheet
 
Yep - there’s a really important point here and I’m probably not the guy to be making it. Cash flows and accounting revenues/costs have some connection but way looser than would usually be assumed. Percentage-of-completion vs completed contract is about how you recognize accruals. Cash is just cash (like, did I get a check?). This is a really fundamental concept in accounting that you need to get down.
 
Cash is real world. Accounting is pseudo-world.
In the real world if you receive $1M then you have $1M. Doesn’t matter how you account for it. It is in your bank account whether you use % completion or completed contract.
 
I think perhaps we can look at it this way.
Assume contract sum under (a) percentage-of-completion method and (b) completed contract method is USD$1 million with contract life of 3 years.
Assume cash flows flowing through (a) is 300k, 400k, 300k annually respectively while for (b) its 1 million in the end.
Either way, we can say cash flowing through both methods (a) and (b) is still a million.
Maybe my illustration aint great but I guess that’s the gist of it?
Feel free to correct.
 
The concept of accrual is clear, what is not clear is why the answer to the problem says cash flows are the same under both methods. In arty’s example above, what’s you cash flow in the first year under both methods? Check again.
What some of the posters are trying to say (but didn’t really say it as such) is that if the contract ‘s life is 3 years and you receive no payments whatsoever until the end of the 3rd year, then under percentage of completion and completed contract methods, cash flows are the same for 1st and 2nd year (both are actually zero).
However, in the examples I am looking at they do assume you receive cash every year.
Dreary
 
taking your last example with the project of 3 years. what would be the difference is in first year you got 1 mil cash payment , second year 2 mil and 3rd year 3 mil ?
no matter how you record revenue you would still get the same amt of money in the bank for the 3 years
and if you associate that with cost remember that just the same a cost does not necessarly mean a cash outflow
if you paid for good first year 0.5 mil , second 1 mil and third 1.5 mil no matter how you record your cost the cash outflow will be the same
there is a point that you don’t get
 
Please read the example again:
Example: Company sells a product to customer for $15 million, and customer pays $9 million first year, then $6 milion second year with total cost for the company being at $10 million. In the first year, when company receives $9 million it records its cost at $6 million (9/15 * $10 million). This is cash in the first year, but not so under the completed contract method.
Dreary
 
that is exactly where you are wrong
the cash is received and recorded in both situations
Cash inflow means you receive money no matter if you record it as revenue.
for procent of completion you record that portion as a revenue
for completed contract you do not record it as revenue you but record it as a liability, is money you received and for which you have to return services or goods, its considered a cash advance from clients(it’s exactly like insurance companies take money for the whole year sometimes but they have to record the revenue monthly or magazine subscriptions)
 
Good point. I figured that in completed contract, nothing is recorded till the end of the contrat period, no matter what. Obviously, you do have to record it if it actually pours in.
However, you have to assume that you use the same cost recognition method under both senarios, or else your cash flows will be different.
Thanks
Dreary
 
cost is not an outflow
just paying your suppliers is
even in the completed contract if you use goods from inventory or goods that you received from suppliers and not paid for then it’s not an outflow
and just the opposite even if you don’t record cost but you have paid your suppliers it will be an outflow
 
Sure, what I meant to say (which is obvious now) is that the senario of making a payment under one method and not having to make a payment under the other method is not allowed. In both cases, actual payments for cost (and revenue) occur at the same time.
The confusion arises because it is assmued that no payments of any kind are made in the completed contract method, whereas payments do occur in the percentage of completion method. And so it appears as if we are comparing a method where actual cash is involved in intermediate years, versus no cash till the end of the contrcat period.
Dreary
 
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