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Construction: Grasping the accounting puzzle

Sep 25, 2007

Choices of accounting policies may distort inter-company comparisons. More so in the case of industries, where managements have significant leeway in terms of how a particular transaction is booked. In this article, we have listed some of the key items that are treated differently by different construction companies and thereby make comparison meaningless. Revenue recognition: A construction company can either follow 'Percentage Completion' method or 'Project Completion' method for the purpose of revenue recognition. Under the former, the construction company keeps booking expenses and revenues without booking the profits until a threshold limit has been achieved. After the threshold limit, revenues, expenses and profits are booked in stages, in line with the progress in the implementation of the project. Under 'Project Completion' method, revenues and expenses are booked, but not profits until the entire project is completed. Once the project is completed, profits are booked at one go. Since profits are booked only at the completion of the project; they tend to be lumpy.

Since, there is no fixed standard for revenue recognition; there is a significant variation in profit booking policies, thereby making comparisons meaningless. Even among companies who follow the 'Percentage Completion' method, there is a wide variation as to how the profits are booked. 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 'Project Completion' method for booking revenues. Hence, before doing any comparisons, investors need to check the revenue recognition policies of the companies in question.

Mobilsation advance: Mobilisation advance is the amount paid by clients to construction companies before the commencement of work. The advance is typically 10% to 15% of the total project cost. While some clients give it free of cost, some may charge an interest. There is no consensus regarding the accounting treatment of the advance on the balance sheet. While most companies book these advances (whether they carry an interest or not) as current liabilities, some companies treat advances carrying interest as debt, while interest-free advances as current liabilities. This variation in treatment of mobilisation advances makes working capital and financial leverage comparisons difficult. Also because of the recent equity fund raising by construction companies, they avoid taking interest-bearing advances from the clients. This reduces current liabilities and gives an impression of a longer working capital cycle.

Volatility in margins: Operating margins for construction companies varies significantly from quarter to quarter, depending upon the accounting policy and also on the type of work done in that particular quarter (example power, road and water). We are of the opinion, that one should look at yearly margins rather quarterly numbers, as they are a better indicator of a company's performance.

Recognition of WIP: There are two ways in which a construction company can account for the progress on projects, either through receivables or through work in progress (WIP). Under the receivables method, the company raises a bill for the work done on a monthly basis, which is booked as a receivable from the client. The bill has to be accepted and verified by the client before the payment. Hence, companies that follow this method have higher debtor days, often as high as 30 to 90 days. In the WIP method, the company raises a bill for work done on a monthly basis. However, the bill is booked not as a receivable, but as WIP inventory. Once, the bill has been accepted by the client, it is booked as a receivable. HCC, which follows this method, has very low receivables (less than 10 days) as they are recognised as such only from the period of bill acceptance to bill payment by the client. Hence, comparing debtor days of companies following different accounting policies will give a distorted picture.

Retention money: It is a common practice in the construction industry to retain 5% of the project cost as retention money as a guarantee for the defect-liability period. This money is typically retained for a period of 12 months after the project's completion. The money is generally reflected in the books as receivables, thereby bloating the debtor figure.

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