Question

XM, Ltd. was a small engineering firm that built high-tech robotic devices for electronics manufacturers. One very complex device was partially completed at the end of 2018. Barb McLauren, head engineer, knew the experimental technology was a failure and XM would not be able to complete the $20,000,000 contract next year. However, the corporation was getting ready to be sold in January. She told the controller that the device was 80% complete at year-end and on track for successful completion the following spring; the controller accrued 80% of the contract revenue at December 31, 2018. McLauren sold the company in January 2019 and retired. By mid-year, it became apparent that XM would not be able to complete the project successfully and the new owner would never recoup his investment.

Requirements

1. For complex, high-tech contracts, how does a company determine the percentage of completion and the amount of revenue to accrue?

2. What action do you think was taken by XM in 2019 with regard to the revenue that had been accrued the previous year?

Short answer

1. The percentage of completion is determined on the basis of cost, effort (resource), or units delivered. The revenue accrued under the percent of completion may become a loss if the project has not been completed successfully.
2. XM should reverse the recognized revenue of $16,000,000.

Step-by-step solution

Percentage of completion method for complex, high-tech contracts

The percentage of completion method is a method of apportioning income and expenses based on the percent of work completed. This method is used by different construction companies and engineering firms that operate complex and long-term contracts.

Determining the percent of completion –The percent of completion can be determined in several ways. Some of the most common practice to determine the percentage of completion are as follow –

a) Cost-to-cost method – This is the most common method of determining the percent of completion. Under this method first of all the cost of the entire project is determined first. Then the cost incurred to date is compared with the total cost. The percent of the cost incurred to date would represent the percent of completion of work. This is the simplest method to determine the percentage of completion.

b) Effort-Expanded method – This is the second most common method of determining the percentage of completion. Under this method in place of expense, the effort or resources utilized are compared with the total estimated resource or efforts to be put into the project.

For example, direct labor hours used to date in comparison to the total estimated direct labor hour for the project, etc.

c) Units-of-delivery method – This method is used by manufacturing companies. Under this method, the percentage of units delivered to the buyer out of the total number of units to be delivered is considered to be the percent of work completion.

Determination of amount of revenue to accrue –

The amount of revenue to accrue under the percent of completion method depends upon the percent of the project completed to date.

For example – if a project is estimated to generate $5m revenue and to date, only 45% of the project has been completed. So the amount of revenue to be accrued would be 45% of the total estimated revenue which is - $2.25m.

Action regarding accrued revenue

As the project has not been completed successfully, so the product would not be able to be sold in the market. In such a case, all the expenses incurred on the product were a loss and no revenue would be generated by the product. In such a case the ethical accounting practice is to reverse the accrued revenue by showing a revenue loss and to consider the expense incurred on the product as an experiment expense.

Thus as per this practice, XM must have shown the $16,000,000 revenue loss and reversed the accrued revenue. This is 80% of the total contract value. The XM may recover some amount from the party on the basis of recycling value or reselling value of the unsuccessful product.