Day Eight Long-term contracts with customers

Transcription

1 Day Eight Long-term contracts with customers Barry M Frohlinger

2 Contractor Accounting What is a contractor? One who enters into a binding agreement to perform a certain service or provide a certain product in accordance with the contract documents. These documents are signed with the buyer prior to the start of construction. 1

3 Contractor Accounting Military Aerospace Capital Goods Software Consulting Infrastructure 2

4 Analyzing Long-term contracts with customers Income Statement Issues Revenue Recognition Cost Matching Credit Issues Business Risk Cash Flow & Liquidity Billings and Collections 3

5 Analyzing Long-term contracts with customers Balance Sheet Issues Receivables Billed Retainage Unbilled Contracts In Progress Inventory Progress Billings Rules on Netting 4

6 General or Sub? Remember the chain of command: Owner [Sponsor] => General => Subcontractor The further from the owner, the slower the payments [Business and Financial Risk] However, Business Risk is not always the same as Financial Risk 5

7 Contract of sale/to sell Manufacturers either work under the concept of Contract of sale or Contract to sell 6

8 Contract of sale/to sell Most manufacturers work under the concept of contract of sale They sell inventory which was built prior to an order Contractor accounting rules are applied under the concept of contract to sell The contractor and the buyer agree to a future exchange of property 7

9 Contract to sell vs. Contract of sale Assume that Boeing receives an order on July 5, 2013 to build s for Delta Airlines with delivery of all the aircraft on November 15, Is this a contract to sell or contract of sale? 8

10 Accounting Rules Under a Contract to Sell, there are two methods of recording revenue: Completed Contract or Percentage of Completion 9

11 Revenue Recognition Companies that contract to sell [manufacture for contract] are required to use the percentage-of-completion method. Two exceptions allow the use of the completed contract method: (common) the manufacturing period is so short (unusual) the business has such great uncertainty that estimates cannot be made for the percentage-of-completion method. 10

12 Revenue Recognition [Percent of Completion] Revenue is recognized in each accounting period (month) based on the work performed during that period. cash collection does not determine the timing of revenue recognition. The revenue recognition requires an estimate of the performance completed during the period This is corrected, as needed, in future periods (without restatement of prior periods). 11

13 Which of these six scenarios are possible? Contract terms Paid Up Front Paid in Installments Paid at Completion Accounting Percentage of Completion [Revenue Recognition] A B C Completed Contract [RR] D E F 12

14 Accounting Boeing receives an order on July 5, 2013 for s, receives payment for the s on July 25, 2014 and delivers all the aircraft on November 15, On July 5, 2013 Boeing orders 20 engines from GE. 2. On April 22, 2014, Boeing receives the engines 3. On June 3, 2014, Boeing pays GE for the engines. When should Boeing record the expense for the engines? 13

15 Accounting Process Manufacturer [not under contract] Transaction Buy Inventory Sell Inventory Expense Inventory Two-sided effect Increase one asset [inventory] Increase a liability [accounts payable] Increase in an asset [Acc Rec] Record Revenue Record Expense Decrease Inventory 14

16 Accounting Process Contract Accounting Transaction Two-sided effect Produce Inventory Sell Inventory Expense Inventory Increase one asset [inventory] Increase a liability [accounts payable] Increase in an asset [CIP] Record Revenue Record Expense Decrease Inventory Bill [per contract terms] Increase asset [Acc Rec] Increase a liability [Progress Billings] 15

17 Cost to Cost Estimate the revenue for the following three year $600,000 contract. Period 1 Period 2 Period 3 Costs Incurred during period $100,000 $120,000 $210,000 Estimated Costs to Complete $300,000 $200,000 $0 % work completed [total] Revenue 16

18 Cost Matching For the percentage-of-completion method, revenue is recognized each period and product (inventory) costs are matched to the revenue each period. This cost matching should result in a good measurement of gross profit, except when costs to complete change. 17

19 Balance Sheet As a result of the recognition of revenue each period, an asset is added to current assets. This asset is called As a result of the concurrent matching of product costs, the inventory costs are removed from current assets. 18

20 Balance Sheet If the revenue can be billed, the asset is designated as "billed" (if the contract allows the company to request payment now) or "unbilled" if the contract requires the company to wait before requesting payment. 19

21 Balance Sheet Unbilled receivables have two components that are shown net: +when revenue is recognized [CIP] - [less] amounts billed So, unbilled receivables represent all revenue recognized less amounts that have been set up as billed receivables. 20

22 Balance Sheet Whenever billings exceed the amount of revenue recognized for a contract the "unbilled" receivable will have a negative balance and must be shown as a current liability. 21

23 Balance Sheet For a contractor engaged in many contracts, netting rules are applied: All contracts with more CIP than progress billings are reported as a net asset All contracts with more progress billings than CIP are reported as a net liability 22

24 Inventories A company that only manufactures for contract [using percentage of completion] would show: no finished goods inventories and no work in process inventories because the inventory amounts have been transferred to cost of sales each period. 23

25 Where is the inventory? Global Industries BALANCE SHEETS December ASSETS Current Assets: Cash $ 96,572 Receivables - net of allowance of $10,135 for 2005 and $9,456 for 2004, respectively 159,008 Unbilled work on un completed contracts 29,168 Prepaid expenses and other 25,374 Total current assets 310,122 Property and Equipment, net 338,659 Other Assets: Deferred charges, net 23,972 Goodwill, net 37,388 Other 2,184 Total other assets 63,544 Total $ 712,325 24

26 Backlog How much backlog does the firm have? What does the change represent? 25

27 Backlog An increase in backlog indicates that the company's marketing performance has exceeded its production performance during the period. A decrease in backlog indicates that the company's marketing performance has fallen short of its production performance during the period. The analyst should be very interested in significant increases or decreases as: likely impact on revenue during future periods. 26

28 Progress Billings Progress billings Progress billings are the contractor s ongoing invoices per the contract. The billings will differ from the revenue recorded Billings are per the contract Revenue is recorded as work is done 27

29 Summary Companies that manufacture for contract use the percentage-of-completion method for revenue. The analyst should be alert to the following: Revenue recognition (along with inventory cost matching) provides a good measurement of production performance if estimates are good Corrections of estimates are made continuously and are not required to be disclosed Increase (decrease) in backlog indicates that the marketing results have exceeded (fallen short) revenues Physical work in process inventories are reported in the balance sheet as receivables [or CIP] 28

30 Summary Disclosure of the two components of unbilled receivables is very useful but is seldom reported by companies: (i) contracts-in-progress less (ii) progress billings The first represents "inventories" valued at sales price and the second reflects customer financing. Backlog carries an obligation to manufacture and deliver the product at whatever cost is required. Customer financing (or lack of) is a very important component of operating cash flow 29

31 Ratio Analysis Ratios analysis for a contractor falls into the following groupings: Profitability Same analysis of typical C&I firms with awareness that contractors rely on estimates and a change in estimate can have a significant impact on earnings Liquidity & Leverage Gross numbers are key Working does not change, but Days of Inventory are more correctly calculated Days of AR can be calculated correctly Leverage can be more appropriately calculated 30