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Using POC Accounting, What is the Best Way to Evaluate Working Capital Requirements?

POC accounting to evaluate working capital requirementsValuation of balance sheet accounts when preparing foa an asset purchase presents unusual dynamics under percentage of completion accounting for long term projects.

Answers

Peter Lyons, MBA, CMA
Title: Finance and Technology Enthusiast
Company: Currently Looking
(Finance and Technology Enthusiast, Currently Looking) |

Shoot me a note and I'll share a model that I have that forecasts future working capital requirements based on the following categories. You'll need to adjust the assumptions to fit your organization and types of projects you're involved in.

1. The Percentage of Income Associated with The Project - Under the percentage-of-completion method, a percentage of the income associated with a project is recognized in proportion to the estimated percentage of completion of the project. An approach under the completed-contract method is to wait until a construction project has been completed in all respects before recognizing any related revenue. The completed contract method is not in accordance with IFRS, but this is an allowable method of accounting for long-term construction contracts in the United States, Canada, and Japan—and the only method permitted in Germany.

2. The Expenses - Under the percentage-of-completion method, accounting must be performed for each project, in which the entity accumulates all project-related expenses. At the end of each reporting period, the budgeted gross margin associated with each project is added to the total expenses accumulated in each account and subtracted from the accumulated billings to date. If the amount of expenses and gross profit exceeds the billings figure, then the company recognizes revenue, matching the difference between the two figures. If the expenses and gross profit figure are less than the amount of billings, the difference is stored in a liability account.

3. Construction in Progress (CIP) Asset - Under the percentage-of-completion method, the accounting staff creates a new asset construction-in-progress (CIP) account to accumulate costs and recognize income. When the CIP exceeds billings, the difference is reported as a current asset. If billings exceed CIP, the difference is reported as a current liability. Where more than one contract exists, the excess cost or liability should be determined on a project-by-project basis, with the accumulated costs and liabilities being stated separately on the statement of financial position. Assets and liabilities may not be offset unless a right of offset exists. Thus, the net debit balances for certain contracts should not ordinarily be offset against net credit balances for other contracts. An exception may exist if the balances relate to contracts that meet the criteria for combining.

4. The Contract Cost - Under the percentage-of-completion method, income should not be based on advances (cash collections) or progress (interim) billings. Cash collections and interim billings are based on contract terms that do not necessarily measure contract performance. Costs and estimated earnings in excess of billings should be classified as an asset. If billings exceed costs and estimated earnings, the difference should be classified as a liability. Contract costs are comprised of costs that are identifiable with a specific contract, those that are attributable to contracting activity in general—and can be allocated to the contract—and those that are contractually chargeable to a customer. Generally, contract costs would include all direct costs, such as direct materials, direct labor, and direct expenses, as well as any construction overhead that could specifically be allocated to specific contracts. Contract costs can be broken down into two categories:

(1). Costs Incurred To Date : The costs incurred to date include pre-contract costs and costs incurred after contract acceptance. Pre-contract costs are costs incurred before a contract has been entered into, with the expectation that the contract will be accepted and these costs will thereby be recoverable through billings. Pre-contract costs include costs of architectural designs, costs of learning a new process, cost of securing the contract, and any other costs that are expected to be recovered if the contract is accepted. Contract costs incurred after the acceptance of the contract are put toward the completion of the project, and are capitalized in the construction-in-progress (CIP) account. The contract does not have to be identified before the capitalization decision is made; it is only necessary that there be an expectation of the recovery of the costs. Once the contract has been accepted, the pre-contract costs become contract costs incurred to date. Nevertheless, if the pre-contract costs are already recognized as an expense in the period in which they are incurred, they are not included in contract costs when the contract is obtained in a subsequent period.

(2) Estimated Costs to Complete: Estimated costs to complete are the anticipated costs required to complete a project at a scheduled time. They would be comprised of the same elements as the original total estimated contract costs and would be based on prices expected to be in effect when the costs are incurred. The latest estimates should be used to determine the progress toward completion.

Michael Scherbourg
Title: CFO
Company: Miklan Manufacturing
(CFO, Miklan Manufacturing) |

Sounds like a great model. i didn't ask the original question, but would you mind posting it as a resource on the Resources tab on Proformative? I and I bet others would love to have access if it's not too dear to you.

Peter Lyons, MBA, CMA
Title: Finance and Technology Enthusiast
Company: Currently Looking
(Finance and Technology Enthusiast, Currently Looking) |

Just posted the model under "Cash Conversion Analysis" here at Proformative:

https://www.proformative.com/resources/cash-conversion-analysis

Thanks

Michael B. Hutchison
Title: Chief Financial Officer
Company: Pine Island Chemicals
(Chief Financial Officer, Pine Island Chemicals) |

Only one thought, my understanding is POC is the only revenue recognition method allowable under GAAP. Completed contract is allowed for tax purposes, but not financial purposes.

Thanks

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