Financial Accounting Standards Boards’ Codification
For my role as a staff accountant, I was assigned to research the appropriate accounting for revenue treatment of construction contracts for a client, LabCo. In specific, I was assigned to oversee LabCos’ contract involving a six-axis laser-cutting machine with Halibut Co. After researching and developing a theory based on the Financial Accounting Standards Boards’ Codification, I have concluded that LabCos’ treatment of revenue was reasonable; however, they should have changed revenue recognition principles sooner. In this situation, there are three possible ways they can handle changing their accounting method: Retrospective Application, Change in Accounting Estimate Method, or Change in Estimate Affected by Accounting Principle.
The revenue treatment principle for a construction type principle states, “In accounting for contracts, the basic accounting policy decision is the choice between two generally accepted methods: the percentage-of-completion method including units of delivery and the completed-contract method. The determination of which of the two methods is preferable is based on a careful evaluation of circumstances because the two methods should not be acceptable alternatives for the same circumstances (ASC 605-35-25-1).”
LabCo agreed to build a six-axis laser-cutting machine for Halibut. The contract entered into was a fixed price contract. A fixed price contract is, “An agreement to perform all acts under the contract for a stated price” (ASC 605-35-15-4). LabCo decided to use the percentage of completion method for recognizing income. “The percentage of completion method recognizes income as work on a contracts progress” (ASC 605-35-25-51). Income recognized shall be that percentage of estimated total income, either: “That incurred costs to date bear to estimated total costs after giving effect to estimates of costs to complete based on most recent information, or that may be indicated by such other measure of progress toward completion as may be appropriate having due regard to work performed (ASC 605-32-25-52).”
It is appropriate to use the percentage of completion method when, “The ability to make reasonably dependable estimates, which, for purposes of this Subtopic, relates to estimates of the extent of progress toward completion, contract revenues, and contract costs (ASC 605-35-25-56.)” LabCo believed they could correctly estimate the cost to build a laser cutting machine because they had completed similar contracts in the past for Halibut. After the contract went into effect, LabCo experienced difficulties designing and manufacturing the laser cutting machine. They were forced to redo initial designs, outsource engineering costs, and the price of steel used to construct the cutting machine unexpectedly rose. LabCo had to re-estimate their costs to complete the project and concluded that the excess costs would exceed the total fixed fee contract price they negotiated with Halibut.
To update their estimated costs, LabCo continued using the percentage of completion method. LabCo appropriately recorded a loss in the period in which they became aware. “When the current estimates of total contract revenue and contract cost indicate a loss, a provision for the entire loss on the contract shall be made. Provisions for losses shall be made in the period in which they become evident under either the percentage-of-completion method or the completed-contract method (ASC 605-35-25-46.)”
LabCo experienced another setback which delayed their process six more months. When the cutting machine was finally complete, they delivered it to Halibut to have it tested. During the final test, the machine failed to meet the specifications of Halibut. LabCo was forced to redesign and fix the various problems with the machine. At this point, LabCos’ chief accounting officer decided to switch to the completed contract method, which says, “Under the completed-contract method, income is recognized only when a contract is completed or substantially completed. Accordingly, during the period of performance, billings and costs are accumulated on the balance sheet, but no profit or income is recorded before completion or substantial completion of the work (ASC 605-35-25-88).”
“The completed contract method is preferable when lack of dependable estimates or inherent hazards cause forecasts to be doubtful (ASC
605-35-25-90)”, which was the case in the situation. The two methods, percentage of completion and completed contract, are not acceptable alternatives for the same situation (ASC 605-35-25-1). LabCo should have realized after running into unexpected costs the first time that they should have switched to the completed contract method. “An entity using the percentage-of-completion method as its basic accounting policy shall use the completed-contract method for a single contract or a group of contracts for which reasonably dependable estimates cannot be made or for which inherent hazards make estimates doubtful (ASC 605-35-25-61).”
LabCo is able to handle this change in of accounting principle in one of the three methods; Retrospective Application, Change in Accounting Estimate, or Change in Accounting Estimate Affected by Accounting Principle. It is clear that the percentage of completion method was not the acceptable alternative because LabCo could not effectively estimate costs. The completed contract method is the preferable method because there was a lack of dependable estimates. LabCos’ decision to switch from percentage of completion to completed contract method is in accordance with FASB Codification because this transition can be handled by the Accounting Staff to apply a retrospective application to the previous year’s financial information.
“The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years. (ASC 250-10-20)”
Since the retrospective application is applied to this situation to show the effect of the change to completed contract method; the estimated contract costs were no longer reliably determinable, therefore, disclosure for the reasons behind this change must be included within the year’s financial statements when the change actually is incurred.
The situation can also be handled with a Change in Accounting Estimate approach. When LabCo incurred significant difficulties with the design and manufacturing of the laser machine, they decided to update their estimates used in the percentage of completion method to reflect both the cost overruns incurred as well as the cost overruns expected to be incurred. Handling it with this approach prohibits the retrospective treatment to the situation. It will affect only the period of change and future periods, if the change affects both, in which case it does.
“The effect on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), and any related per-share amounts of the current period shall be disclosed for a change in estimate that affects several future periods.” (ASC 250-10-50-4)
The final approach that could have handled this situation is the Change in Estimate Affected by a Change in Accounting Principle. Due to LabCo dealing with continued problems with the Halibut contract, and prior estimates adjusted previously during the contract period, it forced the Chief Accountant of LabCo to allow the change in accounting principle from percentage of completion method to completed contract method. LabCo can make this change by it being impossible to determine whether a change in principle or a change in estimate has occurred. “If it is impracticable to determine the cumulative effect of applying a change in accounting principle to any prior period, the new accounting principle shall be applied as if the change was made prospectively as of the earliest date practicable.” (ASC 250-10-45-7)
After much continued research and intellectual thought, we have concluded that the Retrospective Application is not sufficient in this matter because the estimates have been altered drastically; to retrospectively apply the changes this year would distort Net Income figures to the point where timeliness and consistency will no longer apply. The Change in Accounting Estimate would seem sufficient to apply to this situation, but it will not work because a change in estimate cannot be
Therefore, I have concluded that the best way to handle this issue is the Change in Accounting Estimate affected by the Change in Accounting Principle approach. I have come to this conclusion based on the facts that due to a change in accounting principle and change in accounting estimate both being involved in this situation, and retrospective application not being applicable, the entire effect of the two changes should be applied in a prospective method. This free SWOT analysis shows strengths, weaknesses, opportunities and threats. We cover over 40,000 companies and industries. This SWOT analysis for Labco can provide a competitive advantage. Strengths|