Timing Schemes ◾ 13

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.
14 ◾ 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,
 Timing Schemes ◾ 15

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.

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?