WHY DOES COMPLETED CONTRACT METHOD HAVE HIGHER LIABILITIES THEN % COMPLETION?
Re: percentage-of-completion and ROE Posted by: chebychev (IP Logged) [hide posts from this user] Date: November 27, 2007 02:26PM The key difference between percentage of completion and completed contract is that in percentage of completion, a portion of the gross profit is recognized over time. The proportion of gross profit recognized is equal to the proportion of total costs incurred. The gross profit shows up in the retained earnings account, and it would also be recognized on the income statement. Retained earnings and net income are being adjusted by the same amount – the proportionate amount of gross profit. Alternatively, recall that retained earnings in one period is equal to the retained earnings in the last period, plus net income, minus dividends. Here there are no dividends. So any increase in retained earnings must have come from an equivalent amount of net income. The best way to see all this is probably to do some problems where you project a balance sheet out for a few years under percentage of completion and completed contract. Liabilities are the same in percentage of completion and completed contract – under both methods, advanced billings is computed in the same manner. http://www.analystforum.com/phorums/read.php?11,635324
I think about it this way: Since you don’t recognize revenue until completion, but you incur expenses, if the contract isn’t completed, you have incurred costs that you may not be paid for. I know it sounds simple, but it helps me remember.
its because, with completed contract method, profits aren’t realised until the END… thehrefore, a liability must be created for this FUTURE profit… therefore, liability is greater (or asstes less)
Check this example I typed a while ago, then you might understand e.g. 10M project, cost is 8M, it takes 3 yrs Cost and billing schedule Year | 1 | 2 | 3 Cost | 2 | 4 | 2 Billing | 3 | 3 | 4 Abbreviations Net CIP = Net Construction in Progress (Asset) Net AB = Net Advance Billings (Liabilities) RE = Retained Earnings (Equity) My analysis: %-of completion method Income statement Year | 1 | 2 | 3 Revenue | 2.5 | 5 | 2.5 Expense | 2 | 4 | 2 Income | 0.5 | 1 | 0.5 Balance sheet Year | 1 | 2 | 3 Cash | 1 | 0 | 2 Net CIP | 0 | 1.5 | 0 Net AB | 0.5 | 0 | 0 RE | 0.5 | 1.5 | 2 Completed contract method Income statement Year | 1 | 2 | 3 Revenue | 0 | 0 | 10 Expense | 0 | 0 | 8 Income | 0 | 0 | 2 Balance sheet Year | 1 | 2 | 3 Cash | 1 | 0 | 2 Net CIP | 0 | 0 | 0 Net AB | 1 | 0 | 0 RE | 0 | 0 | 2
I think another way to answer why total liabilities are higher under completed contract is that the liability item “net advanced billings” will be higher under completed contract, not because advance billings itself is calculated any differently than percentage of completion, but because construction in progress (which is subtracted from advanced billings in arriving at net advance billings) is a smaller number in completed contract.
WJG, I was thinking about it the same way you are. However here is where my question arises. Shouldn’t you have the same COGS per say under both methods. Yes under % completed you have more assets (since they paid you) but same liabilities as completed contract?
If you are paid for a liability, it is not a liability anymore. Accounts receivable is reduced when you are paid. I think you are getting expenses and liabilities confused.
WJG Thank you, had those two confused in this case. THank you to everyone else as well…