Determination of income and financial reporting for long-term construction-type contracts

In recent decades, accountants have developed many basic postulates and principles. Emphasis has shifted from the balance sheet to the income statement, or more specifically to the determination of income by objectively matching revenue with costs and expenses in light of the accounting period concept. Much of the work in the area of income determination has been based on the “average” firm; one in which the basic postulates and principles may be applied without undue difficulty in assigning revenues, costs and expenses to specific accounting periods. In such cases, the matching of revenues with costs and expenses, while presenting problems, can be managed with existing accounting knowledge. However, the accounting profession has apparently offered little in the way of basic accounting postulates and principles to those businessmen whose operating cycle is longer than twelve months. The accounting problems of one of those groups of businessmen, the construction industry, is the basis of this study. Furthermore, the study is limited to those construction firms involved with long-term contracts; i.e., those requiring a period of time greater than twelve months to complete. The specific problem is a determination of the applicability or lack of applicability of generally accepted accounting postulates and principles to the long-term construction-type enterprise, with the study limited to determination of income and financial reporting. The approach to the problem is theoretical; no case studies were made since the problem pertains to what constitutes correct procedure and not to current procedure. As a starting point, the composition of basic accounting postulates and principles is considered. Next, with revenue determined to be the governing factor in periodic income determination, an examination of the most common revenue-recognition bases is made. In the consideration of each revenue-recognition basis, emphasis is placed on the fulfillment or lack of fulfillment of the basic postulates and principles. Subsequently, consideration is given to financial reporting under each of the bases of revenue recognition, again with emphasis on the fulfillment or lack of fulfillment of the basic accounting postulates and principles. The major conclusion is that the percentage-of-completion basis is in accord with more of the basic postulates and principles of accounting than any other basis currently in use. However, the percentage-of-completion basis fails to provide for price-level changes, and also fails to distinguish operating profits and losses from profits and losses caused by physical possession of assets. The other bases in current use, i.e., the cash, completedcontract, and completed sales bases, also neglect price-level changes and holding profits or losses. These bases moreover fail to recognize revenue, costs and expenses as production occurs, and thus have more shortcomings than does the percentage-of-completion basis. In order to solve the problems of reporting price-level changes and holding profits or losses, the accrual basis is recommended. With income defined as the amount that can be distributed to its owners while permitting the business to remain as well off at the end of the period of time as at the beginning, price-level changes must be considered. Though the accrual basis does not spell out the necessity of separating operating income or loss from holding income or loss, the term 'accrual' indicates income is to be recognized when earned and losses when incurred. Thus, holding profits or losses must be given separate recognition. The accrual basis provides the best measurement of income or loss, in addition to supplying the fullest disclosure of income or loss components, assets, liabilities and owner's equity. Employment of the accrual basis is recommended for long-term construction-type contractors.