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Timing Schemes

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model for revenue recognition. IFRS, on the other hand, requires use of the percentage of completion method for service contracts unless progress toward completion cannot be measured reliably, in which case a zero‐profit methodol- ogy must be used until the contract is completed. Under the percentage of completion method of accounting, total revenue associated with a project is multiplied by the estimated percentage of completion to determine the revenue to be recognized through the end of an accounting period. The percentage of completion is usually measured by dividing the actual costs incurred to date by the estimated total costs of the project. Thus, cumu- lative revenue to be recognized is equal to the result of the following formula:

Total revenue × Costs incurred to date/Estimated total costs of the project

Premature revenue recognition can occur by manipulating either the numerator or denominator of the fraction used to measure percentage of comple- tion. Most commonly, the estimate of the remaining costs necessary to complete a project may be underestimated, resulting in the denominator being understated and, therefore, a higher percentage completion to be applied to total revenue. However, the numerator of the fraction may also be falsely stated. By over- stating the costs incurred to date, the percentage of completion can also be inflated. Overstating actual costs incurred to date can be accomplished using several techniques, including:

1. Prepaying vendors and subcontractors for goods and services not yet pro- vided and failing to set up such prepayments as assets, and instead, expens- ing the expenditures. (This can be made even more difficult to detect if vendors and subcontractors are in on the act by agreeing to invoice for undelivered goods and services early, making the invoices appear as though delivery had occurred; some vendors might not even think of this as facilitating a fraud—they view it as simply getting paid early for work they will do later!)

2. Disguising payments made to related parties as project‐related costs.

3. Creating fictitious entities made to look like vendors and subcontractors and then making or accruing payments to these shell companies.

4. Creating ghost employees and falsifying records to make it appear that these ghosts have been working on the project and getting paid.

5. Misclassifying legitimate costs that have been incurred on other projects or activities to the project for which percentage of completion is to be inflated.

6. Double‐booking costs incurred by reflecting expenditures as costs of two differ- ent projects, or as a cost of a project and an operating expense of the company.

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Revenue-Based Schemes

Utilizing actual and estimated costs to complete is not the only acceptable method of measuring percentage of completion. A physical measure of the pro-

portion of the work completed, or a units‐of‐work approach, may be used if this provides a more reliable measure.

It should be noted that progress payments made by a customer rarely rep-

resent accurate measures of the percentage of completion on a project.

A 2008 class action suit filed by investors in Integral Systems, Inc. illus-

trates a different risk involving percentage of completion accounting. One of the issues addressed in the suit pertained to a contract held by Integral, the Next Generation Global Positioning System (GPS OCX) contract. Integral had recog- nized $2.4 million of license revenue in connection with this contract, which was a subcontract with Northrup Grumman. This contract fell under Inte- gral’s accounting policy requiring application of the percentage of completion method to its software license contracts. In December 2008, Integral restated its financial statements for the first three quarters of fiscal 2008, noting that $2.0 million of the $2.4 million should have been recognized in future periods under proper application of the percentage of completion method.

In explaining the restatement, an Integral official noted that it was “debat-

able” whether Integral was “making significant modifications or merely adding functionality beyond the software’s core capabilities.” Merely adding some addi- tional functionality after the recognition of the $2.4 million in revenue would indicate that most or all of the $2.4 million was properly recognized. However, if Integral still had to make significant modifications to the software, recognition of revenue as though the contract had been completed would be inappropriate, and that appears to be the conclusion in the restatement. One of the most comprehensive and illustrative cases pertaining to per- centage of completion accounting involves Golden Bear Golf, Inc. and its wholly owned subsidiary, Paragon Construction International, Inc. (Paragon). In a 2002 complaint filed by the SEC, it was alleged that Paragon accelerated revenue recognition and hid losses that should have been recognized under percentage of completion contracts. This was accomplished in a number of manners:

1. Intentionally underestimating the costs to complete certain contracts, resulting in early recognition of income (or avoidance of recognizing losses).

2. Changing project managers’ estimates of progress on certain contracts. For example, one project manager estimated progress on the “Twin Eagles” project at 3 percent, but Paragon accrued 14 percent of contract revenue, resulting in an overstatement in revenue of $698,000. On another project,

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called the “Keene’s Pointe” project, the manager estimated 2 percent com- pletion, but Paragon accrued revenue at 12 percent, resulting in $704,000 of extra revenue.

3. Entering into contracts for amounts that were less than Paragon’s esti- mated costs as a result of underbidding to beat the competition, meaning these contracts should have been accounted for as losses from the very beginning.

At one point, Paragon even switched from the cost approach of estimat- ing percentage of completion. Since understating estimated costs to complete became more difficult to conceal on certain projects, Paragon changed to the “earned value” approach to estimating percentage of completion. Under this method, a judgment of the physical progress on a project was used to estimate the percentage completed. The additional judgment involved in this approach allowed Paragon officials to overestimate the progress on certain contracts. In its announcement that former Paragon executives had pled guilty to criminal charges and had settled the SEC’s enforcement action filed against them, the SEC noted that the loss to shareholders in connection with this scheme was in excess of $49 million.

connection with this scheme was in excess of $49 million. IMPROPER ESTIMATES OF REVENUE RECOGNITION PERIOD

IMPROPER ESTIMATES OF REVENUE RECOGNITION PERIOD

The percentage of completion method of accounting only applies to certain types of long‐term contracts, as explained in the preceding section. There are numerous other revenue arrangements in which some factor other than costs must be identified as a basis for measuring the portion of revenue that is attributable to a specific accounting period. Whenever an initial sales price includes an amount allocable for subsequent services, that amount should be deferred and recognized as revenue over the period during which the service is rendered. With some arrangements, this requires that an esti- mate be made by management in order to allocate revenue among account- ing periods. Take, for example, a transaction in which a one‐time initiation fee is paid by a customer. That initiation fee entitles the customer to certain benefits for an unlimited time period, potentially extending up to the person’s death. The accounting question in this transaction is: Over how many years should the company allocate the initiation fee?