Percentage of Completion Accounting – Bookkeeping Tricks

Percentage of Completion Accounting – Bookkeeping Tricks

Thursday December 24th 2020

Joris Kersten MSc RAB

Kersten Corporate Finance (M&A and Business Valuation)

Uden – The Netherlands

Source used – book: Financial Shenanigans – How to detect accounting gimmicks and fraud in financial reports – 4th edition (2018). Howard M. Schilit, Jeremy Perler and Yoni Engelhart. McGraw-Hill New York.

Please leave your email address in the comments below when you want to receive my monthly valuation/ M&A articles in your email box in PDF (100% free and also free of any subscription).

Introduction

As a M&A consultant and Business Valuator I need to understand accounting since it is the “grammar” of the language of business.

The source of this article is the book mentioned; Financial Shenanigans, and it is just lovely!

Learned so much on how the books can be “cooked” and how to detect that.

When you are not an accountant and work in corporate finance like me, I highly recommend you to read the book! ??

In this sequence of blogs on “Accounting Tricks” I share the most important tricks that I have learned from the book.

Changing revenue recognition policy to record revenue sooner

In this blog I will discuss “revenue recognition” when the seller has started to deliver on the contract obligation.

However, sometimes management records revenue in far greater amount than actually is warranted.

When we take a look at an example of the Japanese manufacturer “Ulvac” we can see that when the business struggled, they “solved” the problem by changing an accounting policy.

The sales of the company decreased with 7% from 2009 on 2008.

And the operating profit decreased with 62% from 2009 on 2008.

But then 2010 looked relatively good again since sales only decreased with 1 % from 2010 on 2009.

And operating profit increased again with 38% from 2010 on 2009.

But the company “Ulvac” just changed its “revenue recognition policy” to so called POC (“percentage of completion”).

And with this approach it recognised sales much earlier than it did with its traditional approach.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

Comparison ‘before & after’ for company “Ulvac”

With change to the POC method the results looked quite OK for “Ulvac”.

This since turnover sort of stabilised and costs were managed well, with a big increase in operating profit as a result.

But when “Ulvac” would have reported without the revenue recognition policy change, the results would have been chocking.

Sales would have further decrease from 2010 over 2009 with 21%.

And operating profit would have dropped from (at least) positive to far in negative numbers.

But changing the revenue recognition method was inexplicably approved by the auditors, and this covered the problems back then to the investors of the company.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

Background on POC method

“Percentage of completion” (POC) revenue recognition allows companies to report revenue even before a project has been completed.

It was introduced so that companies could report “business activities” in each period, even if a product was not delivered to the customer.

Thinks of long term construction type contracts.

Within this method companies are asked to estimate the proportion of the project that has been completed.

And then 'pro rata' the part of the project’s revenue, expenses and profits can be recognised.

So you need to be careful here, since when you analyse a company with POC accounting, you need to be aware that the numbers are based on estimates of the company itself.

This on how far they think they are with certain long term projects.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

Another example with POC

The case of Ulvac shows us that we need to be careful with this POC method, specifically when companies switch from 'standard revenue recognition' practices to POC.

Another issue is that when companies use POC, than their revenue can be inflated with changes in key estimates or assumptions.

Let’s take a look at an example.

Solar energy leader “First Solar” (FSLR) was building some of the largest solar power plants in the US in 2014.

Obviously these were long term construction projects.

FSLR applied POC accounting and it determined the percentage of completion on each contract by:

·       Calculating the 'costs incurred on the project' as a percentage of the 'total expected costs'.

But under this method any changes in the company’s estimate for “total project costs” had an immediate impact on the reported revenue.

This since it increased, or decreased, the estimated percentage of completion of the project.

So when the company updated its estimates for 'total project costs' in 2014, management immediately recognised an additional 40 million of revenue.

And because no additional costs were associated with this increase in revenue, it worked all the way down to 'gross profit' and 'operating income'.

(H.M. Schilit, J. Perler & Y. Engelhart 2018)

In the next article in the sequence I will talk about:

·       Revenue recording before the buyer’s final acceptance of the product.

Source used – book: Financial Shenanigans – How to detect accounting gimmicks and fraud in financial reports – 4th edition (2018). Howard M. Schilit, Jeremy Perler and Yoni Engelhart. McGraw-Hill New York.

Please leave your email address in the comments below when you want to receive my monthly valuation/ M&A articles in your email box in PDF (100% free and also free of any subscription).

Kersten Corporate Finance

Joris Kersten (1980) buys and sells SMEs (small & medium sized companies) for his clients in The Netherlands.

And he conducts business valuations.

In addition he provides training all over the globe on business valuation and mergers & acquisitions (M&A) at leading investment banks in New York, London and Hong Kong (“bulge bracket”), corporates and universities.

Right now (in the middle of covid-19) Joris’ full focus in on M&As of SMEs in The Netherlands.

Feel free to contact him when you need M&A advise in both sell side and buy side transactions.

By the way, the new website of KCF M&A Consulting is ready soon ??, this in January 2021.