Opinion ID: 201697
Heading Depth: 1
Heading Rank: 5

Heading: Applicable Accounting Standards

Text: 22 Before turning to the precise allegations of the Complaint, we pause to discuss briefly certain accounting standards for long-term construction contracts, which are integral to an understanding of the Complaint. 23 Long-term construction contracts can characteristically involve early periods during which the contractor's expenditures far exceed its revenues and later periods during which its revenues far exceed expenditures. Depending how the revenues and expenditures are accounted for, the profit and loss statements of contractors engaged in such long-term construction projects might present the appearance of drastic gyrations, beginning with large losses and later shifting to large profits, even though on a sophisticated analysis, the company's experience would reflect a predictable, orderly progress toward a predictable result. 24 To counteract such misleading appearances of unpredictable gyrations, and present a more realistic picture of the stability of operating results, the accounting profession has developed, as part of GAAP, two accounting methods designed in proper circumstances to smooth out the reported operating results of such businesses. The Complaint points to, and quotes extensively from, three accounting documents, which provide guidance: American Institute of Certified Public Accountants Statement of Position 81-1: Accounting for Performance of Construction-Type and Certain Production-Type Contracts (1981) (SOP 81-1), see ¶ 40, Accounting Research Bulletin 45: Long-Term Construction-Type Contracts (1955) (ARB 45), see id., and Financial Accounting Standards Board Statement of Financial Accounting Standards No. 5 (FAS 5), see, e.g., ¶¶ 44, 76. 25 According to SOP 81-1 and ARB 45, as we understand them, the most favored method for a contractor to account for long-term construction contracts, in appropriate circumstances, is percentage-of-completion accounting. Under this approach, the contractor recognizes revenues expected to be received in the future, as well as net profits expected to be realized, as work on a contract progresses, notwithstanding that the contractor may not yet have received payment. In appropriate circumstances, this accounting method is thought to best reflect the actual economic substance of a contractor's transactions and therefore to be preferable. SOP 81-1 ¶¶ .22, .25. Under percentage-of-completion accounting, generally speaking, regardless of whether revenues have been received, a company recognizes as current revenue on its profit and loss statement that percentage of total expected revenue, which reflects the percentage that the costs incurred in the period bear to total estimated costs on the project. ARB 45 ¶ 4. Various conditions must be present to justify the use of this method, such as the expectation that the buyer will satisfy its obligations under the contract, and the ability to make reasonably dependable estimates, including estimates of the extent of progress toward completion, contract revenues, and contract costs. SOP 81-1 ¶ .23. The current recognition of expected future profit, furthermore, presupposes that the contract be expected to yield a profit. See id. ¶¶ .25, .85. 26 The second generally accepted method of accounting for such contracts is called the completed-contract method. See generally id. ¶¶ .04, .30-.33. Under this method, income is recognized only when a contract is completed or substantially completed. Id. ¶ .30. Until that point, for the duration of contract performance, billings and costs are accumulated on the balance sheet, but no profit or income is recorded. Id. The completed-contract method is viewed as preferable when reasonably dependable estimates cannot be made or inherent hazards relating to contract conditions make profit predictions unreliable. See id. ¶ .32. A recognized weakness of the completed-contract method is that it does not reflect current performance when the period of a contract extends beyond one accounting period, and may result in irregular recognition of income. See id. ¶ .30. 27 Third, in circumstances where estimating the final outcome may be impractical except to assure that no loss will be incurred, percentage-of-completion accounting, with a zero estimate of profit, may be utilized. See id. ¶ .25. In doing so, a company recognizes revenues (even though not yet received) equal to its costs incurred in the period until results can be estimated more precisely. Id. 28 This zero-profit-margin approach resembles the completed-contract method in some respects and resembles percentage-of-completion in others. The similarity to completed-contract lies in the fact that, under both methods, no estimated future profit is recognized on a current basis as the job progresses. Profit is recognized only upon substantial completion. Its greater resemblance to percentage-of-completion lies in the fact that current costs, matched by equal amounts of anticipated revenue, are recognized in the current profit and loss statement, while under the completed-contract method, neither costs nor revenues from the project are reflected in the current profit and loss statement until substantial completion of the project. 7 See id. ¶ .33. Thus, the zero-profit-margin approach provides an indication in the income statement of the volume of a company's business activity while the completed-contract approach does not. Id. 29 Regardless of the method employed, however, anticipated losses are accounted for differently from anticipated profits. [W]hen the current estimates of total contract revenue and contract cost indicate a loss, a provision for the entire loss on the contract should be made. Id. ¶ .85; see also ARB 45 ¶¶ 6, 11. Such provision for losses should be made in the period in which they become evident. SOP 81-1 ¶ .85. 30 The full amount of a probable loss should be taken as a charge against income if the amount of the loss can be reasonably estimated, according to FAS 5. See FAS 5 ¶ 8. If the amount of the loss cannot be reasonably estimated, disclosure of the contingency shall [instead] be made ... indicat[ing] the nature of the contingency and ... giv[ing] an estimate of the possible loss or range of loss where possible. Id. ¶ 10. Likewise, if there is only a reasonable possibility of a loss instead of a probable loss, disclosure instead of accrual is appropriate. Id. Probable is defined by FAS 5 to mean likely to occur. Id. ¶ 3.