 # percentage-of-completion and ROE

if use percentage of completion, Asset will increase, liabillity will decrease, so increase the equity. net income will increase ROE is higher compare to using complete contract method. here, because both net income and equity increase, how to quantify that ROE must increase ? Thanks.

Because net income is smaller than equity. Assume net income is 1 and equity is 5. ROE is 20%. Increase both by 1. Now you have ROE of 2/6 or 33%. This type of question where numerator and denominator both change in the same direction is common. Ascertaining the cumulative effect requires determining whether numerator or denominator is typically larger.

Chebychev, Can I assume the following a. For number ( numerator < denominator) like 5/10 By increasing numerator and denominiator by same amount, new number will be greater c. For number ( numerator > denominator) like 10/5 By increasing numberator and denominiator by same amount, new number will be lesser Thanks

That’s correct. You can prove it to yourself with some simple examples. You can also imagine adding a very large number to the numerator and denominator: A) 5/10 is 50%, but 1005/1010 is almost one. The fraction has increased. B) 10/5 is 2, but 1010/1005 is just over one. The fraction has decreased. As you can see, adding the same amount to numerator and denominator makes the quotient move closer to one. If the quotient was more than one to begin with, it gets smaller (example B). If it was less than one to begin with, it gets bigger (example A).

Chebychev, Excellent. Thanks a lot for quick reply. Chinni

how net income and equity increased the same amount? for example, the asset got increased, and liability got decrease, so the equity will be increased by amount of increase of asset PLUS the amount of decrease in liability, it is like the equinty increase is much much higher. net income got increased due to regonized revenue, I think that mount could not beat down the increase of equity. let me know how you think. Thanks. chebychev Wrote: ------------------------------------------------------- > Because net income is smaller than equity. Assume > net income is 1 and equity is 5. ROE is 20%. > Increase both by 1. Now you have ROE of 2/6 or > 33%. This type of question where numerator and > denominator both change in the same direction is > common. Ascertaining the cumulative effect > requires determining whether numerator or > denominator is typically larger.

Hi guys, Why would liability decrease in Percentage of completion. Wont assets and equity ncrease?

Another thing is if advance billings is greater than CIP, wont liability increase in this case.

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.

chebychev Wrote: ------------------------------------------------------- > 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. I understand what you say. My question is regarding liability going down. Wont we recognize a Liability only if the advance billings is > CIP. If this is not the case, we recognize an asset call Net CIP. This will be same as the increase in the retained earnings which will balance both the sides.

I agree with you – a liability is recognized if AB>CIP.

thanks.butwhen you recognize revenue,you will reduce the liability,is it? say,a 5million construction , at time 0, liability is5 million. CIP, you recognize revenue 2 million in year, liability drop down from 5 to 3 million.is it?Thanks. chebychev Wrote: ------------------------------------------------------- > 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.

The only way that the liability would be 5 million in year 0 is if you already billed for the entire amount. And if you had, that same 5 million would be balanced by either accounts receivable or cash. The liability of advanced billings is equal to the cumulative amount billed, it does not start at the construction cost and then get depleted.