Accounting makes sense of business. A good friend of mine had this realization over dinner as he shared his concerns over accounting and tax. As a contractor in the construction business, he is now about to close a big project that will take three years to complete. Since this is his biggest project to date, he wants to ensure that he complies with tax and accounting rules faithfully to protect his business from potential issues post-construction.
This is a very appropriate and relevant topic to discuss since the real estate industry is expected to continue posting sustainable growth. We especially want to help small and medium-sized contractors comply with the requirements of the regulators and pay the right taxes.
My friend is a typical business person so his main concern is about tax. I explained to him that his accounting has to be right to comply with tax properly. Paying proper tax is a primary consideration because, although he would be receiving 50 percent of the contract price in year 1, most of his costs would be incurred or spent in years 2 and 3. He sees a huge profit in years 1 and 2 but will then report a loss in year 3. He asks me, “Am I right to think this?” Without him realizing it, he was already referring to the matching principle of accounting.
To illustrate this further, I will apply a set of hypothetical numbers: The project is a construction contract worth P1,000 and will take three years to finish the proposed structure or building. The total estimated construction cost to complete the project is P800. Since the client is a good friend of the contractor, they agree on good terms. He will receive 50 percent of the payment during the first year, the next 40 percent during the second year and the remaining consideration at the completion of the project. The costs expected to be spent during years 1, 2 and 3 are P200, P250 and P350, respectively. This cost spread is consistent with our experience that a large portion of the budget is typically spent during the finishing phase of the project, usually when expensive finishing materials are consumed.
Now, my contractor friend’s accountant has advised him that in order to avoid tax issues, all collections must be declared as income when collected. He asks me if he was given sound advice. For better appreciation, I presented my friend this table showing the numbers to be reported and tax to be paid if the revenue is to be declared in the year collected:
What is glaring in the above illustration is the apparent potential overpayment of tax over the duration of the project, not to mention that the accounting policies are not compliant with the accounting standards. Assuming the budget will not be far from the actual costs, true profit for the entire project is P200 while total tax for three years should be P60. The advice of my friend’s accountant does not make sense!
Allow me to further to expound on my friend’s query – How much is the correct revenue, costs and income taxes over a period of three years?
Income from long-term contracts, such as in construction, is measured using the percentage-of-completion method. In short, revenue is measured based on the progress of the project, which represents the earned portion of the contract price delivered over the course of the construction. This is consistent with the fundamental principle of accounting that revenue is recognized, among others, when the services have been delivered, not when cash is collected. To simply equate cash collection with revenue does not make sense. When cash is received prior to actual delivery of services, it represents a customer deposit, and hence, a liability as opposed to income.
There are a number of acceptable methods on how to calculate the percentage of completion, but the cost-to-cost method is commonly used and is considered the most objective in my view. Simply put, if my friend’s company incurs actual costs of P200 in year 1, it is 25 percent complete in that year (based on a total project cost of P800). Using these accounting principles, below are the correct amounts:
When accounting is applied properly, there is consistency in both the profits and taxes over the entire duration of the project as can be observed in the table above. There is also proper matching of revenue and expenses, which are required both by tax rules and accounting standards. If there is any difference between the actual costs and estimated project costs, this will be adjusted in the profit during the completion of the project or when it is known.
The consequence of improper accounting can be detrimental to your business. Profit year-on-year will tend to be unpredictable, erratic and arbitrary; hence, business decisions may be based on unreliable accounting information. In the examples above, the first case involves tax payment of P135, while the right total income tax is only P60 for the whole project.
Here is the reality though; bill of materials may change during the course of the project. What if the cost of the project changed during the course of the construction, say in year 2?
This scenario is normally driven by changes in prices and volume of construction materials. In the event of known changes, the cost to complete will have to be updated and applied prospectively, hence, the profit may move upward or downward depending on the revised cost of materials to completion.
Accounting has often been times called the language of business. The accounting standards, more commonly referred to by accountants and non-accountants alike as GAAP or generally accepted accounting principles, are set not only to make the communication between those who speak the language easier but also to help even those who don’t speak the language make sense of business. As illustrated in the discussion above, minding the GAAP and learning basic terms and concepts used in accounting will prove to be an advantage to anyone involved in business, be it a small sari-sari store owner or the CEO of a multinational corporation.
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Roderick M. Danao is vice chairman and assurance managing partner of Isla Lipana & Co./PwC Philippines. Email your comments and questions to email@example.com. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.