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  • Nov 13, 2007

    Construction: Revenue recognition methods

    The past few years have seen tremendous buoyancy in the Indian construction sector, with activity being witnessed in housing, real estate, road, airport and port construction. This has benefited construction companies in terms of strong revenue growth and better visibility into the future (by way of them building up large order backlogs).

    However, considering that these companies follow different methods of recognising revenues, comparison becomes a tough ask. In this article, we analyse the tow most popular ways that construction companies follow to recognize revenues in the books - 'Percentage Completion' and 'Completed Contract'.

    Percentage completion method: This method is used for long-term projects when there is a contract and there are reliable estimates of revenues, costs and completion time. This method recognises revenues and corresponding costs in proportion to the work completed. There are two methods that can be used to measure the proportion of work completed:

    • An engineering estimate.
    • The ratio of incurred costs to the total estimated costs.

    Completed contract method: This method is used for long-term projects when there is no contract or estimates of revenues and costs are unreliable. In this method, revenues and expenses are not recognised until the entire project has been completed i.e., the company does not recognises profits until the contract has been completed. This method must be used for short-term contracts as well.

    Now, since the percentage completion method recognises revenues and income earlier then the project completion method, it is viewed as a better indicator of trends in earnings.

    Financial impact
    Sr. No. Impact on Percentage completion Completed contract
    1 Income recognition Recognised based on percentage of project completed No income recognised till completion
    2 Cash flows Same Same
    3 Amounts billed Same Same
    4 Net Income Percentage of profits is recognised No profits recognised until last year
    5 Total Assets Percentage of profits is recognised No profits recognised until last year
    6 Shareholders fund Increase to the extent of profits booked No impact
    7 Construction in progress Adjusted to factor percentage non-completion No impact

    *Construction in progress represents the costs incurred plus cumulative pro rata share in gross profits.

    Let us understand, by way of the following example, how a company recognises revenues using the percentage completion method.

    Suppose 'Company A' has to construct a commercial complex for Rs 10 m and estimated total cost of the project is Rs 8 m. Consider the following assumptions:

    (Rs m) FY05 FY06 FY07 Total
    Amount billed 6 2 2 10
    Costs incurred 4 3 1 8

    In FY05, since half of the total costs have been incurred (Rs 4 m out of Rs 8 m), half of the total revenue (Rs 10m / 2 = Rs 5 m) is recognised under the percentage completion method. So, the resulting net income is Rs 1 m (Rs 5 m - Rs 4 m). Under the completed contract method, the profit of Rs 2 m (Rs 10m - Rs 8m) will be recognised entirely in FY07.

    Profit and loss account under percentage completion method
    (Rs m) FY05 FY06 FY07 Total
    Revenues 5.00 3.75 1.25 10.00
    Costs 4.00 3.00 1.00 8.00
    Profit 1.00 0.75 0.25 2.00

    In India, different companies follow different methods for recognising revenues. Some companies follow a threshold level for profit booking (L&T follows 50% limit). In case the projects do not cross a particular threshold limit, revenues are booked equal to the expenses, without booking any profits. Profits will be booked only after the threshold limit is achieved. However, some companies do not follow any threshold limits for booking profits. Instead, they start booking profits proportionately with the completion of the project (IVRCL, Madhucon Projects). On the other hand, a company like HDIL follows the 'Completed contract' method for booking revenues.

    One of the main concerns with construction companies is that they have very poor disclosure policies. As such, investors trying to compare two companies in the sector must ensure that both the companies follow the same method of recognising revenues, or there might be differences in the way these companies are valued.

     
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    1 Responses to "Construction: Revenue recognition methods"
    eappanphilip
    Aug 17, 2009
    I have few querries
    1.can we take billing %(billed amt/contract amtX100)and aplly this % to estimated cost for recognition.(estimates arrived at after deducting the profit from toatal contract value)
    2.i have 5% of the contract value as preliminary exp.before starting billing, can I take this 5% and recognise revenue for this.
    3.can i change the revenue recognition method in between starting and completion of the job.
    4.receipt of advance payment of the contract(against bank guarantee)is having any impact on revenue recognition at any stage.
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