Mapping is our term for flowcharting. The end result can be described as a photograph of your company's business functions as transactions move through the system. The process may appear simple, but years of experience in interviewing, flowcharting, narrating and presentation of findings suggest that a successful effort is more of a specialized art than that of standardized procedures. The theory is based on the old axiom "If you can't draw it, you can't build it."
The OM&A process is based on the Transaction Flow Analysis method of documentation developed by Arthur Andersen & Co. to assist their clients in meeting the Federal Government internal control compliance requirements contained in the Foreign Corrupt Practices Act of 1977. This process also applies to the Sarbanes-Oxley Act of 2002 and COSO requirements as well as other regulatory and compliance mandates.
The completed document is a bound report containing the flowchart drawings, detailed narratives, departmental concurrences, identification of deficiencies if any and recommended corrective action. Tangible benefits of an OM&A engagement include business objective sustainability, supply chain effectiveness, cross-departmental training, compliance assurance and providing a substantive base to evaluate the current system and aid in its expansion or modification.
As part of the overall evaluation of your business functions, OM&A can assist in advancing your on-premise accounting, finance, cost accounting and treasury systems to a cloud based hosted system. If the case requires such action we can help plan and execute an exit strategy, negotiate settlement of declaratory judgments and assist in establishing temporary lines of credit.
Discussion Topic - Percentage of Completion Accounting
The conception of Percentage of Completion (CoP) was devised by the Internal Revenue Service (Sect. 460) to force contractors for large construction projects to recognize revenue in earlier time periods. Prior to CoP the accepted and customary revenue recognition method was the completed contract concept. This is where revenue for a long term construction project was calculated when the project was very near completed and most cost and billings were recorded. Examples in the case of large real asset development projects would include skyscraper type office buildings, condominiums and some large scale residential communities. Large construction projects of a fixed asset nature would include ship building, large aircraft and long span bridges. I think you get the picture. The Code says projects with a contract duration longer than twelve months plus some other stipulations should use CoP revenue recognition.
The point of CoP is to recognize revenue in the period when it was earned rather than near completion of all phases of the total contract. However....the process to arrive at a calculation method of the amount of revenue earned in a specific time period is not very clearly defined. Much of the math in making the calculation will come from the terms set out in the construction contract. If the contract allows the manufacturer or the developer to invoice certain costs, then this is evidence that revenue should likewise be recognized. One point that I recently came across was a client with a contract that allowed them to bill the customer as materials were purchased for the project. The stipulation was that the material needed to be identifiable to the project and stored separately. Components of the contract that are complete but not shipped can also be considered in a CoP revenue calculation. Specifically, the key factor in any CoP calculation is the engineering estimate of the current state of work performed on the contract as a whole.
Authority for PoC stems from Accounting Research Bulletin (ARB) #45 and Statement of Position (SOP) 81-1, recommending the accounting treatment for construction type and certain production type contracts. These two promulgations constitute the AICPA guideline constituted GAAP governance for PoC. There are no FASB or APB opinions issued on PoC.
So the story of CoP trial and error begins...over thinking U.S. tax law I believe is where this particular client began digging themselves into an irretraceable CoP hole. In fact it is because of their specific situation that I began to research CoP statutes, Code regulations, and related articles to try and understand the client's rationale in applying CoP to their particular contract in the first place. To set the scene for you, my client was a regional manufacturer of institutional furniture. The contracts in question involved a new product line consisting of fabricated panels, cabinets, closets and desks that were interior elements used in hospital construction or in one case hospital renovation. The trail of confusion begins with a Chief Financial Officer and Controller of the furniture manufacturer that were a bit out of their element. In case you started to wonder how they got themselves entangled in a CoP rats nest the answer is it was of their own doing.
The client's first mistake was to create an account called Construction In Progress (CIP) to record ERP generated job costs associated with the hospital contracts. Next they created an account they called Hospital Billings as a 'contra-asset' used in reversing the invoices created by the contact administrator. These contract administrator issued invoices were used to book receivables and revenue and were deemed non-compliant under CoP rules by the client's CFO.
With normal use of an ERP system after an item is manufactured and shipped costs are automatically charged supported by a job router or shipping ticket. The furniture client's ERP system was designed to automatically make inventory and cost entries all based on internal job routings, shipping tickets with associated costs and price lists. To circumvent the ERP automated entries and apply what he considered CoP supported entries for the hospital product line the CFO devised a formula to recalculate revenue and costs based on what he believed was the enginnering estimate of how far along they were in finishing the total contract. The resulting CoP entries would then credit Hospital Billing for costs while making the corresponding debit to adjust Cost of Sales. They would then create another set of entries again based on the CoP calculation to credit hospital revenue with the corresponding debit going to the CIP asset account.
Netting out the Hospital Billing contra-account and the CIP asset account would result in net revenue as set out from the CoP formula. I think the plan was to close these accounts to the income statement when the contracts were completed thus negating the prior months manipulations as the ERP system was empty of any hospital jobs and the contract administrator issued her final invoice as per the contract.
This sounds all good and fine until the contracts exceeded 50% of their completion estimate. In the calculation that the CFO and Controller worked up it allowed for revenue to exceed 100% of the contract amount because the percentage applied was an estimate of cost incurred.
After I demonstrated to them that the CoP calculation was defective, management then agreed to create a liability account called Billings In Excess in place of the contra-asset account, rename the asset Billings account Deferred Revenue, cease using the CoP calculation and rely on the ERP system as it was intended. They were so far entangled in the CoP miscalculation that correcting the Billings and corresponding contra-asset accounts would have materially misstated the financials for the period. The CFO was rightly concerned for his job and elected to manually adjust the accounts each month as costs that were identified to the hospital contracts worked their was through the ERP system. At least by the time the hospital contracts were completed everything would theatrically be even.
The short of it is...unless you are in the business of executing true long term complex construction contracts, leave CoP to the professionals.
Already making an impact on multi-national companies are the International Accounting Standards (IAS) with the governing body the Internal Financial Reporting Standards foundation (IFRS). Entities in the engineering and construction (E&C) industry applying IFRS or US GAAP have primarily followed either: IAS 11, ‘Construction contracts’ or Statement of Position 81-1, ‘Accounting for Performance of Construction-Type and Certain Production-Type Contracts’ (SOP 81-1, as codified in Topic 605-35) to account for revenue. These standards were developed to address the particular aspects of long-term construction accounting and provide guidance on a wide range of industry-specific considerations, including:
- defining the contract, such as when to combine or segment contracts, and when and
how to account for change orders and other modifications;
- defining the contract price, including variable consideration, customer-furnished
materials and claims;
- recognition methods, such as the percentage-of-completion method (and in the case
of US GAAP, the completed contract method) and input/output methods to measure
- accounting for contract costs, such as pre-contract costs and costs to fulfil a contract;
and accounting for loss-making contracts.
Once the new revenue recognition standard becomes effective, SOP 81-1, IAS 11 and all existing revenue recognitionguidance under US GAAP and IFRS will be replaced. This includes the percentage-of-completion method and the related construction-cost accounting guidance as a stand-alone model.
The following items common in the E&C industry may be significantly affected by the new revenue recognition standard. This ‘practical guide’, examples and the related assessments contained in the industry supplements are based on the Exposure Draft, ‘Revenue from contracts with customers’, which was issued on 24 June 2010. These
proposals are subject to change at any time until a final standard is issued. For a more comprehensive description of the model, refer to PricewaterhouseCoopers' (PwC) ‘Practical Guide to IFRS – Revenue recognition’ (www.pwc.com/ifrs) or visit www.ifrs.org.