Percentage of completion method, a practice problem from a CPA book

This is an old problem about the percentage-of-completion (p-o-c) method that I have seen in two different books I'm studying out of for the FAR, and it goes like this:

1. Some Co. recognizes construction revenue and expenses using the percentage-of-completion method. During 2010, a single long-term project commenced, which concluded at the end of 2011. Information on the project follows:

	2010	2011
Accounts receivable from contract	$100,000	$300,000
Construction expenses	105,000	192,000
Construction in progress	122,000	364,000
Partial billings on contract	100,000	420,000

Profit recognized from the long-term construction contract in 2011 should be:

a. $50,000
b. $108,000
c. $128,000
d. $228,000

The question is asking us to calculate 2011 Profit. Normally profit for a construction contract calculated under the p-o-c method would be calculated using this formula:

Profit  =

Σ CTD Σ CTC

(Contract price – Σ CTC) – PY Profit

Where:
Σ CTD is Total Costs To Date;
Σ CTC is Total Expected Costs To Completion;
Contract Price is the total price of the contract;
and PY Profit is the profit recognized in Prior Years.

It may seem scary, but this is the easy way to calculate profit under the p-o-c method. Unfortunately there isn't enough information to use this equation, so we have to calculate 2011 profit indirectly.

Under the p-o-c method, three things affect the Construction in Progress (CIP) account: 1) to record accumulated costs, 2) to record recognition of interim revenue and expenses, and 3) to close the CIP and Billings account at the completion of the project. In this problem we only have to worry about 2): recording recognition of interim revenues and expenses. Expenses and revenues both get debited to CIP. Here's a t-account:

CIP (similar to WIP)

2010 Expenses	105,000
2010 Profit	x0
12/31/2010 Balance	122,000
2011 Expenses	192,000
2011 Profit	x1
12/31/2011 Balance	364,000

We don't really care about x₀ in this problem, but for the record, it's $17,000. It's x₁ we're after, and that's $50,000 (364,000 – 192,000 – 122,000). Your answer is a.

The FAR section: oh the agony

So tomorrow will be the one week anniversary of when I took the FAR exam. There is a lot to learn between passing the BEC section in the summer and taking the FAR section a week ago. The contrast between the two sections is so great, you may as well obtain two different certifications.

First off, time played a major role. To say I managed my time poorly is a little bit of an understatement. The BEC section is only 2.5 hours long - the shortest of the four exams. Going into it, I was very time-conscious and it paid off. I probably had a good half hour at the end to check over the last testlet. The FAR section, on the other hand, is 4 hours long - only the Auditing exam is longer at 4.5 hours. With three testlets (of 30 multi-choice each) and two simulations, you're asked to do a lot in that amount of time. Whereas I should have been spending maybe 60 to 90 seconds on a multiple choice problem, I was spending up to 5 minutes on a single problem. By the time I was finished with the 3rd testlet, I only had 45 minutes to complete the two simulation problems.

Upon this realization, I was not only fighting the clock, I was fighting myself. I was flustered and panicked. I tried taking a deep breathe and relaxing, so as to fight the anxiety that had set in, but it was a futile effort. I tried guessing the accounts in the debits and credits that should have been the journal entries and skipped on calculating the amounts. For the Communication tab, I fired off two quick sentences summarizing something that vaguely related to what the mock-client wanted to know and left it at that (something I would never do to a real client).

What I learned from the whole thing was not just how important knowing the material is, but how valuable time is during the exam. The CPA exam isn't just testing if you know the material, but how well you know the material.

The only redeeming factor in all this is knowing that the three testlets got progressively more difficult as I took them. This is a good sign since the CPA exams are adaptive. How well you do in the earlier testlets determines how difficult the later testlets are, and the more difficult testlets weigh more for correct answers. Even assuming all of this, I have to expect to take it again 2011. Given my non-calculations of journal entries in the simulations and poor communication in the written section, I am prepared to see a grade of less than 75 when the grades are released in December.

Moving on, I have scheduled the Audit and Attestation (AUD) section for mid-November. This time will be different. For the AUD section, which is 4.5 hours, I will not take time for granted.

Happy studying.

Capitalizing software costs

On the date of the balance sheet, software should be valued at the lower of: unamortized cost OR net realizable value. 'Unamortized cost' of software is similar to 'carrying amount' of depreciable assets. Take the total software cost and divide it by the economic life (useful life), and that is your amortization expense. Unamortized cost is simply original cost minus accumulated amortization. SFAS 142 tells all about intangible assets, while SFAS 86 talks about software development for sale or lease.

Impairment losses

For long-lived assets, you test impairment by comparing undiscounted cash flows of the asset to the carrying amount of the asset. If undiscounted cash flows is less than carrying amount, recognize impairment. The asset must now be reported at fair value. So the impairment is the carrying amount minus the fair value of the asset. You would think it would be carrying amount minus undiscounted cash flows, since that's what you originally compared to determine whether to recognize an impairment in the first place, but it's not. It's seems inconsistent; it's like saying since undiscounted CF < carrying amount, you get to subtract FV from carrying amount. But that's the way SFAS 144 goes. Just remember you have to report the asset at fair value on the balance sheet.

Capitalizing interest

Let's think philosophically for a moment: what is capitalized interest? Well capitalizing is when something is reported as an asset instead of as an expense. And interest is of course the charge for borrowing money. So capitalizing interest is when a company gets to report the charge they pay on debt (interest) as an asset on the balance sheet instead of an expense on the income statement (capitalize). Only certain situations allow this sort of accounting treatment, and they are addressed in SFAS 34 (paragraphs 9 and 10).

Actual or avoidable interest, that is the question...
As SFAS 34 says, the amount of interest to capitalize is the lower of: actual interest OR avoidable interest. Actual interest is easy: it's the actual interest rate a business pays for capitalizable debt. Avoidable interest is a little tricker because it's calculated. It's the average accumulated expenditures times the incremental borrowing rate. Remember that in accounting, averages are calculated as the beginning balance plus the ending balance divided by two. Also remember to pick the lower of the two.

Remember that whichever rate you use, you can only capitalize up until the moment that asset is ready for use. Once it goes into use, starting expensing that interest just like all other interest.

Foreign Exchange Transactions

Gains and losses from foreign exchange transactions are reported on the income statement under "Other Income".

When a US company makes a sale in another country, they usually use that country's local currency. When they make a sale on account, the receivable is affected by fluctuations in the exchange rate.

More Stockholders' Equity

I guess the best place to start out would be to see what a Stockholders' Equity (SE) Section looks like. Book examples are always nice, but the companies are always made up, so it's hard to trust them. Here's a screenshot of Google's SE section (what does it say that that was the first company to come to mind?):

Here's a link to Google's entire 10-Q filing with the SEC for reference. I'm looking at the bottom of page 3.

First up, is Convertible preferred stock with outstanding shares and balance of 0 (glad that's there). Next is Common stock separated into Class A and B stock and what looks to be combined with Additional pain-in capital (APIC). Some companies combine their APIC accounts, and some separate it from among their sources. The CPA exam seems to like separating it.