Constructing And Assessing Income Statements Using Percentag

Constructing And Assessing Income Statements Using Percentage Of Compl

Constructing and assessing income statements using the percentage-of-completion method involves evaluating the progress of a construction project and recognizing revenue and expenses proportionally based on the degree of completion. This approach aligns revenue recognition with the work performed, offering a more accurate depiction of financial performance over the course of a project. In this context, Frankel Construction's project to build a shopping center provides an illustrative example of applying this method using the given data.

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Introduction

The percentage-of-completion method is a crucial accounting technique employed in the construction industry to recognize revenue and expenses aligned with the stage of project completion. This method enhances the accuracy of financial reporting by reflecting ongoing progress and provides stakeholders with timely insights into a company's operational performance. The case of Frankel Construction exemplifies the application of this method through the analysis of a large contract to construct a shopping center valued at $120 million, with data provided for the years 2012 through 2014.

Background of the Case

On March 15, 2012, Frankel Construction entered into a contract to build a shopping center with a total contract price of $120 million. The project involves significant financial transactions, including cash collections and incurred costs over several years. Specifically, for the year 2012, Frankel received $30 million in cash collections and incurred costs amounting to a portion of the total expected costs, which ultimately sum to $85 million over the project’s duration. This data sets the stage for employing the percentage-of-completion method to recognize revenue and profit as work progresses.

Calculating the Percent of Completion

The first step in applying the percentage-of-completion method is to determine the percentage of total expected costs incurred each year, which indicates the proportion of work completed. The calculation for 2012 is:

Percentage of Completion in 2012 = (Costs Incurred in 2012 / Total Expected Costs) × 100

Given that the total expected costs amount to $85 million and costs incurred in 2012 are $10 million, the percentage becomes (10 / 85) × 100 ≈ 12%. For illustration, assuming the partial data, the subsequent years would be calculated similarly once specific costs incurred are provided.

Recognizing Revenue and Expenses

Next, revenue recognized in each year is proportional to the percentage of completion, multiplied by the total contract price. Assuming the total is $120 million:

Revenue Recognized in 2012 = Percentage of Completion in 2012 × Total Contract Price

For expenses, the accumulated costs incurred are matched against revenue to determine profit or loss for each period:

Net Income = Revenue Recognized - Expenses Incurred

Application to the Data

Using the provided data, the calculations for 2012 approximate as follows:

  • Costs Incurred: $10 million (assumption based on partial data)
  • Percentage of Completion: (10 / 85) × 100 ≈ 12%
  • Revenue Recognized: 12% × $120 million = $14.4 million
  • Expenses Recognized: $10 million
  • Net Income: $14.4 million - $10 million = $4.4 million

Similarly, for subsequent years, as costs incurred increase and the percentage of completion rises, revenue and income are proportionally recognized. For example, if in the following year the costs increase to $25 million and total incurred costs reach $35 million, the percentage increases accordingly, guiding the revenue recognition.

Implications and Assessment

The percentage-of-completion method provides a dynamic view of project progress, enabling more timely recognition of income compared to the completed-contract method. It allows management and investors to monitor ongoing performance, forecast future profitability, and manage cash flows more effectively. However, this method requires reliable estimates of costs and progress, which can be susceptible to bias or estimation errors.

Limitations and Considerations

One of the main challenges of this approach is ensuring accurate percentage calculations, especially in projects with unpredictable costs or delays. Overestimating progress can lead to premature income recognition, potentially inflating profitability. Conversely, underestimating progress may understate income and harm stakeholder perception. Therefore, companies must establish rigorous monitoring and estimation procedures to ensure the integrity of their financial statements.

Conclusion

Constructing and assessing income statements using the percentage-of-completion method allows for more accurate reflection of a construction company's ongoing performance. By aligning revenue recognition with project progress, this method provides stakeholders with timely and relevant financial insights. In the case of Frankel Construction, applying this method facilitates better project management, financial planning, and reporting. Nonetheless, it demands reliable estimation processes and constant oversight to mitigate potential inaccuracies, emphasizing the importance of diligent financial control in large-scale construction projects.

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