Revenue recognition of construction company, is it still doubtful ?

By : Rizka Muharyana

01071003094

Abstract

The purposes of this paper are to find out the weaknesses of revenue recognition
in long-term contract by percentage of completion method both with the physical
approach and the cost approach, also to provide alternative solutions to
overcome these weaknesses. The percentage of completion used in physical
approach is derived based on the physical progress of work, whereas in the cost
approach the percentage of completion is derived based on the number of actual
costs incurred for the contruction project during the period.
In the discussion part of this paper will be explained the weaknesses of the
percentage of completion method both with physical approach and cost approach.
The weakness in the physical approach was ignore the aspect of actual costs that
actually incurred for the project during the period while the weakness in the cost
approach was ignore the physical aspects of project’s completion progres. To
overcome these weaknesses was chosen an integrative approach alternative based
on elementary costs that combine both approaches and eliminates the
weaknesses of each. This method uses the physical percentage of completion of
the projects during the current period, actual costs and income measurement
basis using elements of costs that actually already used in the project during
current period and did not use the estimation cost as the two previous
approaches.

Keyword  : revenue recognition, construction company, percentage of completion

method

1. Introduction

1.1 Background

Construction company is a company whose activities are engaged in

construction services such as construction of roads, bridges, housing, buildings,

apartments and others. Just like most other companies, construction companies

also aim to get income. Recognition of income is closely related with the

recognition of revenues and expenses. Inaccuracies in the measurement of revenue

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and expenses will affect the inaccuracies in the measurement of income. This

condition causes the information used by decision makers would be misleading.

Therefore, information about the company’s revenues and expenses should be

presented fairly and reasonably.

Revenue is one of the main element in determining company’s profits.

Generally there are two approaches in the recognition of revenue for a

construction company that are the completed contract method, especially for

short-term contracts (less than one accounting period) or contract that has a high

level of uncertainty and the percentage of completion method. This method is

used if the construction project takes a long term completion (more than one

accounting period). In the percentage of completion method, there are two

approaches that consist of physical approach and cost approach. But the two

approaches have generate the numbers not reasonable, feasible and accurate so the

revenue recognition was less representative for the current period (Narsa, 1999).

If the condition run just like that then the information presented will mislead the

decision makers. This condition is a problem that must be solved.

If used the physical approach to recognize revenue in the current period, the

amount of numbers attached to the revenues merely based on physical progress

(results achieved) without considering the cost or effort that has been expended or

incurred for the project during the period. Conversely, if the cost approach was

used, the amount of revenue recognized for the current period merely based on the

cost and effort that has been expended or incurred without linking it to physical

progress or the actual results in the current period. Two of these cases clearly

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shows that there is no matching process between revenues with expenses within

the meaning of a causal and positive correlation. As a result the revenues which

are presented does not reflect the company’s performance, because what is

reported does not match the actual achievement.

But besides these weaknesses there is one more weakness that has huge

influence on the feasibility and fairness of the revenue figure which has not been

ever mentioned. The weakness is on the basis of calculation to determine the

amount of revenue to be recognized in the period. Base that used is the selling

price of projects and total project costs by contract (Narsa, 1999). This way is less

rational because when we observe that the huge projects in reality takes a long-

term completion time and some even for several years and use the cost elements

in the large number. The elements of that cost are not incurred in a lump-sum

from the beginning contract but their spending are gradually (step by step) in

accordance with the progress of the project. Thus, it would be rational if the

calculation is based on the cost of elementary, namely the total of cost elements or

the cost that the elements have been used in the project (Narsa, 1999).

1.2 Problem Statement

1. What are the weaknesses that existed in the percentage of completion

method both with the physical approach and cost approach?

2. How should the revenue for long-term contracts be recognized?

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1.3 Study Purposes

1. Knowing the weaknesses in the percentage of completion method by using

the physical approach

2. Knowing the weaknesses in the percentage of completion method by using

the cost approach

3. Knowing the best alternative in revenue recognition for long-term

construction contracts.

1.4 Study Benefits

1. For the author, adding more in-depth insight and knowledge about revenue

recognition in long-term contract especially in percentage of completion

method

2. As an evaluation of percentage of completion method by using phisically

approach and cost approach that generally implemented in revenue

measurement in long-term contract

3. As a reference for students and other researchers who want to discuss

about the revenue measurement by percentage of completion method in

more depth

2. Discussion

2.1 Definition of Construction Contract

Contracts in construction work is an important element in a process of

cooperation between the various parties to achieve the objectives and work that

has been agreed. Work under the contract referred to the project.

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 According to the IAI (Tampubolon, 2006) construction contract is a

contract specifically negotiated for the construction of an asset or a combination

of an asset that is closely linked to each other or depending each other on terms of

design, technology and function or purpose or use of the principal.

A construction contract may be negotiated to build a single asset such as

bridges, buildings, pipelines, roads and tunnels. A construction contract is also

associated with a number of closely-related assets or mutually dependent on each

other in terms of design, technology and function or purpose and use of principal,

such contracts such as construction of oil refineries or other parts of the complex

plan of or equipment.

Long-term contract is a construction contract which the completion of the

development projects take more than one accounting period. Beside that, actually

there is a contract that less than one year but at the financial statement preparation

the contract has not been completed. In order for achievement of the project is

reflected in the financial statements, it must be allocated over the total revenue

expected from the project to periods during the life of the project.

2.2 Types of Construction Contract

According Wulfram (Ronal Hilton, 2005), type of contract are classified t

based on arrangemen of replacement cost:

1. Unit Price Contract

In the unit price contract, the assessment price of each unit of work has

been done before construction begins. The owners have been count the

number of units contained in each element of work. The weakness of the

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 use of these types of contracts is the owner can not know with certainty the

actual cost of the project until the project is completed. To avoid this

uncertainty, the calculation of the quantity of each unit needs to be done

accurately.

2. Cost Plus Fee Contract

In this type, the contractor will receive payment for expenses plus a fee for

overhead and profit. Generally, these profits are calculated based on the

percentage of the cost incurred. Methods of payment in this type is divided

into two, namely:

1. Cost Payment Plus Specific Services Fee Payment

In this method, the contractor did not get a chance to raise fees to

increase profit and overhead

2. Cost Payment Plus Fee Payment Percentage of total maximum

This method can convince the owner (the employer) that the total

project cost will not exceed a certain amount. The owner put the

staff to monitor the progress of work so the charges billed actually

incurred can be known. Determination of fee for the contractor

under this contract type is done by a variety of ways:

a. Cost plus fixed price

In this method have been considered back payments to

contractors in the form of real costs incurred by the contractor

plus the general fee and a fixed number of advantages.

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 b. Cost plus percentage

In terms of cost plus percentage the contractor will receive back

all the real costs incurred and will receive compensation based

on a percentage of real costs in accordance with an agreement

with the employer (owner of the project)

c. Cost plus fee with maximum guaranteed price

The contractor will receive back all of costs incurred plus the

amount of compensation based on an agreed percentage

3. Lump Sum Contract

This type of contract states that contractors will build the project in

accordance with the design at a certain cost. If there are changes in the

contract, negotiations between the owner and the contractor will be held to

establish payment that will be given to the contractor for the job. The cost

for each job whether more or less will be negotiated between the owner

(employer) and the contractor.

Beside that, there was also a split construction contracts by type of

construction project which is divided into four main categories: the residental

construction, building construction, heavy engineering constraction, and industrial

construction.

Selection of an appropriate contract for a construction project is based on

the characteristics and conditions of the project itself. Viewed from the

perspective of the project owner (owner) this is closely related to the anticipation

and the handling or solve of the inherent risks or problem in the construction.

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2.3 Definition of Revenue

Operationally, revenue is defined as the realized income derived from

transactions during a certain period with the relevant historical cost of good

sold.

According to FASB, Skousen et al (Ronal Hilton, 2005) revenues are

inflows or increasing in other assets of an entity or establishment of its debts

(or a combination of both) from the delivery of goods or production of goods

that contribute services or conduct other activities that form the basic

operations or central operations place of an entity.

Sofyan (2001: 206) defines revenue as a result of the sale of goods or

services charged to customers or those who receive services.

Meanwhile, according to Belkaoui (Ronal Hilton, 2005) revenues are

inflows of assets for companies that occurs after the sale of goods or

provision of services. Assets may include cash from the sale of goods and the

emergence of accounts receivable if the sale is made on credit. In other

words, revenue is rising of asset and declining of debt.

Some examples of revenues are: revenue from merchandise sales, service

revenue and other revenues. Revenue from merchandise sales and services

revenue from principal operations which are commonly done by a company

that from the company’s core activities called main revenue, while other

revenues represents revenues generated from activities outside the company’s

main activities, such as interest income from corporate deposits, rental

income obtained from the rental of excess office space and other companies.

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 From the definitions above can be concluded that revenue is an increase from

the inflow of cash, receivables, etc. or the use of corporate resources that

generate interest, royalties and dividends that could alter or affect the amount

of capital ownership, but not the addition of new capital from their owners

and are not a major asset additions that caused the increasing in liabilities.

2.4 Revenue Recognition for Construction Companies

Companies engaged in the construction its main source of revenue is from

the completion of a construction contract. Hence the special problems arise in

the assessment, measurement and recognition of revenue of constraction

company in implementing jobs based on contract such as making buildings,

bridges and others. Contract that require the completion period of more than

one accounting period will cause problems. This problem arises in

determining when, how and how much revenue will be recognized.

According to Skousen et al (Ronal Hilton, 2005) there are two revenue

recognition methods known in the construction industry, namely:

1. Completed Contract Method

Revenue and gross profit are recognized only at the time the contract is

completed. Development costs are accumulated into inventory account

(construction in progress). This method can only be used if:

 If most of the company’s contracts are short-term contracts (less

than one accounting period)

 If the conditions for using the percentage of completion method

can not be fulfilled

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  If there is uncertainty contained in the contract

 Being outside the normal business risk

2. Percentage of Completion Method

Revenue and gross profit recognized in each period based on

progress in development, namely the percentage of completion.

Construction cost plus gross profit earned are accumulated in the inventory

account (construction in progress) and progress in receivable accumulated

in inventory account (construction in progress). This method can be used if

there is an estimation progress of revenues completion and expenses which

are reasonable to believe (Ronal Hilton, 2005).

According to Skousen et al (Ronal Hilton, 2005) there are

conditions for applying this method in the construction contract, such as:

 There is a reliable estimation of contract’s revenues, contract’s

costs and the level of completion progress until the contract is

completed

 The contracts are long-term contracts (more than one accounting

period)

 The contract clearly states the rights that can be carried out on

goods or services to be provided and accepted by both parties, the

consideration for the exchange and the nature and terms of

completion

 Buyers can be expected to meet contractual obligations

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  Contractors can be expected to perform its contractual obligations

According to the International Accounting Standards Committee

(Narsa, 1999) the percentage of completion method is defined as follows:

“Percentage of completion method is a method of accounting which

recognises revenue in the income statements proportionally with the

degree of completion of goods or servise under contract ”.

The definition is very general, meaning that only mentions that revenues

are recognized in proportion to the progress of work. The definition also

implies that between revenues and costs must be related. So what will be

discussed in this paper is to describe the meaning implicit in that

definition. If the discussion is outside the definition, the author argues that

efforts for improvement should still be done. The approach that the author

used in the discussion is very simple, namely by looking at the weaknesses

and good aspects in the traditional approach (conventional), then eliminate

the weaknesses of each and combine good aspects of both approaches

(Narsa, 1999).

In the percentage of completion method there are two approaches

commonly used in construction companies namely:

1. Physical Approach

Physical approach is an approach which is used to determine the

percentage of completion of a long-term contracts that are in execution.

With this approach the size of the results is made regarding the results

achieved (outputs). Included in this approach are the methods based on

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 resulted unit and value added (value added). There are two possibilities or

ways that can be used to determine the percentage of completion based on

physical completion according to Smith & Skousen (Narsa, 1999) such as:

a. Calculated by comparing the units that have been produced with a total

volume of activity or work under the contract agreement. This method is

usually used for the type of contract that each activity or each unit of the

results can be easily identified.

b. Determined based on expert reports, the architect or engineer who was

assigned to supervise and assess the progress of work. This method is

usually used for the type of contract that is difficult in specifying the unit

or quantity.

The above ways are not shows the alternatives than can be choose one of

them, but each one is used for certain conditions. If a physical approach in

the conventional models applied in the recognition of revenue, then a

mathematical calculation mechanism is as follows:

Rn = Xf x (C + E) ......................................(1)

Rn = current period revenues

Xf = percentage of physical completion

C = the estimated of project cost

E = total expected revenues

The amount of Xf, defined by estimated or by comparing the results or

physical progress that has been achieved or units that have been produced

with a total volume of activities under the contract agreement.

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2. Cost Approach

Cost approach is a way used to determine the percentage of completion

of a chartering contract which is under implementation or execution.

The methods included in this approach are, Smith & Skousen

(Narsa, 1999):

a) Cost to Cost Method

According to this method, the degree or percentage of completion is

determined by comparing the costs incurred through the current period by

the latest estimation of the total estimated costs to complete the project.

b) Effort - expenditures Method

These methods rely on the efforts that have been poured into the project,

such as machine hours, hours of service, wage labor, the quantity of

materials used and etc. Percentage of completion is determined by

compare the efforts that have been poured to complete the project.

Actually the essence of both approaches on both the cost to cost method as

well as effort-expenditures method is indifferent, because the elements

contained on them are basically the same, namely forming the overall cost

of goods. If the cost approach was applied to recognize the amount of

revenue, then mathematically have the same model with the physical

approach, only different is the notation Xc (percentage of completion on

the basis of cost).

Rn = Xc x (C + E)..................................... (2)

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 Rn = current period revenues

Xc= percentage of completion on the basis of cost

C = the estimated of project cost

E = total expected revenues

The percentage of completion on the basis of cost (Xc) obtained by

comparing the costs incurred until the current period with the estimated

total cost until the project is completed.

2.5 Weaknesses of Physical Approach and Cost Approach

The two approaches both physical approach and cost approach in the

percentage of completion method, if the result is shown in the figures of an

illustration, it will show that there are enormous differences between the two,

both concerning the amount of revenue and the amount of expense recognized

during the period.

In the cost approach, there is the necessity to estimate the total cost

which is still needed to complete the work in the future. In this estimatimation

there are many factors and variables that must be considered or taken into

consideration because the factors and variables have very strong influence

on the size of the numbers generated in the percentage. Thus the measurement

results are likely to deviate from actual circumstances. In addition, in the cost

approach the total cost incurred during the current period directly charged

without considering the condition or the physical progress of work in the

field.

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 Opposite situation occurs in the physical approach. The amount of

revenues recognized is based on the level of progress of the work that

actually accomplished. Thus, the costs factor treated differently when

compared with treatment in the cost approach. Cost charged is not the cost

that really happened, but based on the estimation. As a result the possibility of

manipulation in the financial statements using one of the two approaches are

very large.

Summary of the explanation above, there are three weaknesses in the

recognition of revenue with the percentage of completion method both in

physical and cost approach (Narsa, 1999):

a.In the physical approach, the amount of revenues during the current period

is not related with the aspects of real costs that occur in the same period.

b.In the cost approach, the amount of revenues during the current period, is

not related with the physical aspect of progress that shows the number of

results that can be achieved in the same period.

c.Both the physical approach and cost approach does not rely on the

elementary costs in determining the amount of revenues, the elementary

costs are the costs that had actually been used in the project.

2.6 An alternative to overcome the weaknesses in the physical approach and

cost approach

The weakness of the two approaches can be overcome by embracing

both aspects of the approach together by combine them here in after referred

to as Integration Approach Based on elementary costs (Narsa, 1999).

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The core of the integration approach is, combining two existing approaches,

taking into account the aspects of cost and results together. Then, in its

application integration approach will be base on the total cost of elementary,

means will only take into account the total of the costs elements or elements

of costs that already used or occured during the project. This means that the

basis of revenue recognition with the integration approach is the concept of

earning process. So with this concept, it is very logical that revenue will

occur only if there are existing business.

Integration approach based on elementary cost is essentially combines

the two previous approaches (physical and cost approach) and eliminate the

weaknesses of each, which can be explained as follows:

a. The percentage of completion used in the integration approach is derived

from the percentage obtained using the physical approach. So, to

determine the amount of revenue we consider the achievements of truly

achieved in the current period. And not forget how much the total effort

that has been done. Thus, the possibility of manipulation in the income

statement can be minimized.

b. Costs that will be charged to current period are those costs that are

actually happened and occured for the project during the current period.

c. Base to be used to assess the amount of revenue is the total cost of

elementary, namely the total of cost elements or elements have been used

in the project.

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In line with these treatments, then it can be determined a formula that can be used

in the integration approach, as follows:

Rn = Xf x (C + E).............................. (1)

Rn = Xc x (C + E)...............................(2)

Rn = Xf x (C’ + E).............................(3)

Equation (1) and equation (3) look similar, but actually very different the

similarity only the use of physical completion percentage (Xf) and total expected

income (E). As for the C’ represents the total cost of elementary namely the total

of cost elements or elements have been used in the project.

This formula combines a physical approach and cost approach with cost element

that really - really has been used in the project. This integration approach is more

realistic and closer to reality because not only consider physical progress aspects

but also the cost aspect. Where the cost base is used is the costs that have actually

been used in the project and not the estimation cost as the previous approach.

3. Conclusions and Limitations

3.1 Conclusion

1. Percentage of completion method for revenue recognition on long-term

contracts both with the physical approach and cost approach still have

weaknesses.

2. The weakness of the percentage of completion method with a physical

approach is ignore the aspects of the real costs that actually incurred

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 during the period and only focus on the assessment of physical progress in

the development of long-term construction projects

3. The weakness of the percentage of completion method with the cost

approach is ignore the aspects of the physical progress of development of

long-term construction projects and just focus on costs incurred for

construction projects during the current period.

4. The weaknesses can be solved with integrative approach based on

elementary cost that combines both methods and eliminates the

weaknesses of each. This method uses the percentage of physical

completion of construction projects in the current period, actual costs and

revenue base measurement using cost elements that actually already used

in the project during current period and did not use the estimation cost as

the two previous methods.

5. Recognition of revenue with integrative approach based on elementary

costs will produce a more feasible and reasonable description when

compared with the two previous approaches.

6. Recognition of revenue for long-term contract with a physical approach

and cost approach still doubtful.

3.2 Limitations

Limitations in this paper include:

1. Author did not take an object that can be used as a reference company in

the implementation of the three approach physical approach, cost approach

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 and integrative approach based on elementary cost in the percentage of

completion method of long-term contracts

2. Author only focuses on the problems with revenue recognition by

percentage of completion method, when there is one more method of

revenue recognition for construction companies it is the completed

contract method

3. Author did not give examples of cases for the implementation of the three

approaches in the percentage of completion method

4. Did not present the impact of this change in approach to the income

statement

5. Just use the library research

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