Accounting Method for Halibut Contract
It has recently come to the attention of our audit team that a change in accounting methods has been proposed to LabCo’s contract with Halibut. The current accounting method is percentage-of-completion, while the plan proposed is a switch to the completed contract method. During our investigation into this matter, we analyzed the codification and validation for the percentage-of-completion method, and determined that the proposed change would be an inappropriate course of action. Justification of Existing Methods
The Financial Accounting Standards Board’s codification helps reinforce our decision to not switch accounting methods. The current policy for revenue recognition, percentage-of-completion, is in accordance with our business practices. In order for a company to use the percentage-of-completion, four primary conditions must be met: Total costs are reasonable dependable estimates
The enforceable rights regarding goods and services to be provided are clearly specified The buyer is expected to satisfy all obligations
The contractor is expected to perform to the buyer’s expectations (ASC-605-35-25-57). LabCo’s primary business concerns involve designing and manufacturing of industrial-sized machinery that is used by its customers in a variety of manufacturing ways, which satisfy the contact clause of the codification (ASC 605-35-15-2,3). The codification goes on to state that the percentage-of-completion method depends on the ability to make reasonable dependable estimates, which in turn relates to estimates of the extent of progress toward completion, revenues, and costs. In compliance with this, LabCo believe they could reasonably determine the estimates of the contract with Halibut. In previous contracts and agreements with Halibut, their method of revenue recognition was never questioned and a change to a different method was never mentioned. However, during this contract with Halibut specific difficulties did arise. One of these issues was the unforeseeable rising cost of steel. When the initial contract with Halibut was drawn up, this extra cost was not anticipated.
The extra cost caused a construction impairment of the laser’s progress. At the time the contract was created, the rising cost of steel information was not available. For this reason, the difference is planned cost versus actual cost is not considered to be an error (FASB Statement 154). There is reasonable evidence that suggests that these issues will not happen again. Instead of a change of accounting method, there would need to be a change in the accounting estimate. This change is needed to include the tribulations that occurred during construction. This includes unanticipated extra cost of steel. We have decided that the retrospective applications called for in ASC 250-10-05-2 need not apply. Furthermore, the information from the codification tells us that because there will be a change in the accounting estimate, we will have to account for this estimate (FASB Statement 154). Accounting for the Estimate
Change in accounting estimate is defined as a revision of an estimate because of new information or of a new experience. Accounting for a new estimate occurs at the end of each accounting period, which is useful for preparing financial statements. Since these facts change from one accounting period to the next, it does not make it feasible to recreate a financial statement each time there is new information. To account for these changes, management must apply its best judgment during the preparation of a contract. In the case of the Halibut contract, extra costs were unpredictable and as a result such estimates must change in each subsequent accounting period (FASB Statement 154). This change is handled on a prospective basis. This prospective approach is used when the retrospective approach is impractical, which was proven by not converting to the completed contract accounting method. This prospective basis is how we will account for the new estimate in the case of the Halibut-LabCo contract. The audit team and myself will ensure that these estimates are being carried out to their entirety.
We have come to the decision that changing the accounting method from percentage-of-completion to the completed contract method is unnecessary. During our internal investigation, it became clear that LabCo needed a change in the accounting estimate of the contract rather than the accounting method. This was substantiated by reviewing the four primary conditions that must be present to use the percentage-of-completion method: total costs are reasonable dependable estimates; the enforceable rights regarding goods and services to be provided are clearly specified; the buyer is expected to satisfy all obligations; and the contractor is expected to perform to the buyer’s expectations (ASC-605-35-25-57). For further clarification or questions regarding this matter, please do not hesitate to contact me.