Q: If Costs and Profits in Excess of Billings declined, that means that Accounts Receivable went up because they billed for that work. It doesn't necessarily mean that the cash was received. Can you explain how this is a cash inflow?
A: The question just focused on two of the three accounts that determine cash inflows or outflows from billing practices. The intent was to examine if the company's 2018 billing practices would tend to increase or decrease its cash inflow from those practices. That is, we wanted to see if the company was able to decrease Cost and Profits in Excess of Billings and increase Billings in Excess of Cost and Profits. Such a reversal can have a very positive impact on a contractor's ability to increase cash inflows from clients to help finance the project as it unfolds.
Focusing just on Cost and Profits in Excess of Billings and Billings in Excess of Cost and Profits, the movements in those two accounts signal a cash inflow. An asset account decreased – a cash inflow according to the standard rules of thumb – and a liability account increase – another cash inflow according to the rules of thumb.
However, if we had included movements in all three accounts that determine cash inflows or cash outflows from billing practices, we would conclude that the billing (and collections) in 2018 resulted in a cash outflow. We reach this conclusion since Contracts Receivable increased by $417,472 – a cash outflow that more than swamps the cash flow movements in the other two accounts.
Q: I have come across notes in financial statements several times similar to the note below. Net income for the period was $9,000,000. Does this mean that Net Income would have actually been a net loss if this change in estimate had not taken place?
Change in Estimate
During the year ended December 31, 2022, the Company had an increase in estimated profit on contracts, which resulted in a current period increase in net income of approximately $15,500,000, net of income taxes of ($144,000). The increase would have been reported in the preceding period had the increase in estimated profit been known at that time. Revisions in the estimated profits are made in the period in which circumstances requiring the revisions become known.
A: The 2022 financial statements should be re-stated. That is, after the fact, the company needs to go back and include all the income, expenses, and taxes that it failed to properly acknowledge at the time it took place, which was 2022.
To include 2022 net profit in the 2023 financial statements only makes sense if the company files its tax returns on a cash basis. However, to do so, gross receipts must be less than $25M under the 2018 Tax Cuts and Jobs Act. And if the contractor had net profit of $15,500,000, the gross receipts associated with that level of profit must be at least twice this amount - which puts it over the limit for using a cash-based approach to filing - and recognizing - revenue and profit.
So, if the contractor is filing taxes on an accrual basis, which appears to be the only possibility, it must take the $15,500,000 and all associated revenue and expenses back to 2022 and not recognize these events in 2023.
Course overview: Understanding and Analyzing Contractor Financial Statements: Part II of II