Debit This, Credit That, isn’t that Accounting?

Sometimes all you can do is simply stare at a speaker and wonder what is going through his mind.  “Accounting says you have to debit receivables and credit revenues.”

Um, no.

Accounting makes no such claim.  Effective accountants (and auditors) know that often earning revenues is divorced from demands for payment.  Demanding payment is a contract right – your attorney might require a retainer, your roofer wants a deposit, you want to be paid for the feet of pipe laid; but none of these are revenues. Yet.

Accounting is about reporting the economic substance of a transaction.  Accounting has to look for features which support the premise that the efforts necessary have been expended and accepted by the buyer in order to record revenue.  It doesn’t have to be hard, but it does have to be consistently applied.

Take for example, that piping contractor.  Let’s say he has a contract to

  • Dig a 1,000 foot ditch for $20/foot
  • Lay 1,000 of 24″ concrete pipe at $18/foot
  • Backfill and compact the trench for a lump sum of $8,000

The contract requires that the contractor submit a schedule of values (work completed) in order to be paid.

On the first billing, the contractor submits the schedule for the 1,000 feet of ditch dug for $20,000.  The effective accountant does not immediately do this for the invoice:

  • Accounts Receivable       $20,000
  •     Contract Revenues                         $20,000

That is because the rules for recognizing revenues is not based upon something as arbitrary as a schedule of values.  The smart accountant understands that the true measure of the revenue for a contractor is based upon an analysis of costs expended to actual anticipated costs.  So the accountant creates a little spreadsheet:

Anticipated Period Actual
Contract Revenue Costs Gross Profit Costs % Complete Revenue Billings Over/Under CIE BIE
ABCD     46,000   35,000          11,000   6,500 18.57%       8,543   20,000          11,457     –   11,457

The Company incurred only $6,500 of costs in the period.  This represents less than 20% of the total anticipated costs for the project.  The reality is, the contractor front-loaded the bid.  This is perfectly acceptable – provided the owner accepts the schedule of values and is a great way to get project funds in early.  But, GAAP says to recognize the contract’s revenue based on the relationship between actual costs incurred and the estimated total costs to complete.

In this case, only 18.6% of the project costs were incurred so really only 18.56% of the contracts revenues are earned.  The remainder is considered unearned revenues or, in construction accounting parlance, Billings in Excess of Costs and Gross Profits.  The accounting principle is called the percentage of completion method of accounting for long-term construction contracts.  The rule says that the form – the schedule of values – is not the appropriate measurement for recording revenues: The comparison of actual to anticipated costs is the appropriate basis for recording revenues.  Economic substance over the form.  $8,500 not $20,000 for revenues.

Accounting is more than debits and credits.  That is, assuming you need to know what is actually happening economically in an enterprise.  Most non-employee investors in a business should be thinking about the true substance of transactions and how they impact today’s profits and tomorrow’s cash flows.  Revenues and profits generate true cash flow, not the other way around.  The effective accountant knows this is far more important than debits and credits.

 

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