Friday, August 21, 2009

How You Can Make Millions of Dollars And Go Bankrupt

One of the principles of accounting is to match revenue and expenses to the period they are incurred. That becomes problematic when you are working on a long term project like building a house. You might start the house in August but not finish and sell it until February. Under normal circumstances, you would show your profit in February. However, you've been working on it, and incurring costs on it, for the seven months previous. Shouldn't your income statement take that into account?

The percentage of completion accounting method allows you to do so. When you start building that house in August you also start recognizing some of the profit. Assuming you build at a steady pace, you would finish 12.5% of the house per month. Accordingly, you would recognize 12.5% of the projected cost and revenue each month.

But here's the problem. This only works if you are certain to sell the building when it's done, ie. you have a contract in place. Commercial construction works this way, but the housing market only partially so. When you contract with a builder to start a home, you generally have to put in some earnest money. This assures the builder you won't walk away in the middle of construction and leave them with an unsold property. However, and this happened a lot during the recently ended housing boom, the earnest amount can be quite low. So low that it isn't much of a barrier to backing out of the contract.

If the builder was using the percentage of completion method in this case, then not only have they lost the sale, but they've already recognized a portion of the expected profit from that house. Couple that with the rapid decline in housing prices we've just experienced, and you can see how a builder can see profits on one income statement and nothing but red ink on the next.

This is a lesson on reading financial statements. I have talked to troubled business owners who say they were profitable and don't fully understand what happened. They didn't understand what accounting system they were using, and so didn't understand the risks involved.


Randy said...

Good information. Hopefully it wasn't a lesson learned the hard way.

Cameron said...

Not by me, fortunately. Though it has affected a couple of companies I am familiar with.