“Normal” accounting

Accounting statements typically measure the success (or lack of it) of geographical or functional units of a company.  The measurement is also usually organized through units of time, such as a fiscal quarter or a fiscal year.  So the accounting statements answer questions like “What were the profits of the Americas division for the third quarter?” or “What were the profits of the plate glass business last year?”

Project accounting

One notable exception to this rule is project accounting, which is designed to measure the economic performance of a specific task.  The task is typically relatively large and takes place over an extended period of time.  Examples include:  public works construction projects; government research and procurement, like work done under national defense contracts; and movies.

What characterizes this type of accounting, from an investor’s point of view, is the necessity for estimating revenues, costs or both over a multi-year period.  In the best of cases, this is a difficult task.  At worst, it gives great scope for a company to delude itself about the profits it is making.  And it leaves the door open to the possibility of fraud, through deliberately inflated revenue/cost estimates, which will likely not be detected until the project is finally completed.

A construction project

Here’s an example:

Let’s say a company wins in competitive bidding a contract for $1 billion to build a dam.  Construction will take two years.  It’s a fixed-price contract, meaning that the government body that has awarded the contract will make no adjustment to the contract amount for things like changes in materials or labor costs.

Our company has estimated that it will cost it $850 million to build the dam, so that it will have profits of $150 million and an operating profit margin of 15%.  How does it record on its financial statements the money it is earning on the project?

The usual method companies use is percentage of completion, meaning that from its project estimates it determines what constitutes 10% of the job, what constitutes 20%, and so on.  If, in a given quarter, it believes it has accomplished 10% of the job, it will report $100 million as revenue, $85 million as cost and $15 million as operating profit.

(Note:  The government body will have a parallel process for determining the progress of the project.  It will set milestones whose achievement trigger progress payments to the company from the $1 billion.  The sequence of these payments may be very different from what our company records on its income statement.  For example, the government body may make an initial payment of $100 million before any work is done.  Such differences are reconciled through entries on the balance sheet.  In this case, our company would enter $100 million in deferred revenues on the balance sheet.)

Typically a company will stick with its estimate unless there is overwhelming evidence that it has been too optimistic.  It’s usually very difficult for even professional investors to have any real sense that this may be happening, because projects are normally very complex with very long lives.  We also don’t often get to see the company’s project estimates in any detail.  So we may well get into the final quarter of year two, when the company has already booked $130 million in profit, only to learn that the area where the dam is not as geologically stable as the company thought and it has to spend $50 million more than anticipated to reinforce the structure of the dam.  What results from this?  a big writedown!

Early completion bonuses, late delivery penalties

It can also happen that the contract has provisions for a sizable bonus for early completion of the work, as well as hefty penalties for late completion.  No one that I’m aware of will factor the bonus into its estimates.  But neither will anyone plan on paying late-completion penalties.  But in construction it does happen that the company says the project is coming in on time until the very last minute, when it reveals a delay.  The result?…another writedown.

In sum, the issues with project accounting for an investor are that the project is hard to monitor form the outside, and that there’s always the potential for an ugly negative surprise at the end.

Movie production accounting

One special instance of project accounting worth mentioning is movie production accounting. The principles are the same, but –unlike the construction company that knew its revenue for certain but not its costs–in this case the key estimate the movie studio makes is what total revenue from a given film will be.  It knows pretty accurately what its costs have been.  (Note: movie accounting is as arcane, convoluted and jargon-filled as anything I’ve ever seen–even oil and gas accounting.  So my last sentence is a real simplification.)

From its revenue estimate, the studio gets a total operating profit estimate and an operating margin.  If it thinks it will get total revenue of $500 million from the film and $100 million comes in during the period, it will record that figure, deduct 20% of the movie’s cost, and get an operating profit.

The big current issue with movie accounting (the perennial issues are its opacity and perceived tendency to favor insiders) is that movie revenue comes from many sources, among them:  theatrical release, which may occur at different times in different countries; DVDs; video on demand; and TV rights.

Until the financial crisis, a good guess would be that DVD would account for at least half of a hit film’s revenues and be as much as 1.5x the size of the money a studio would earn from showing it in theaters.  But in the past two years or so, people have stopped buying DVDs.  And, as luck would have it, DVD revenue comes toward the tail end of the project.  So studio estimates for the profit of movie projects which have been started between 2007 and relatively recently are probably way too high.  Hence the rash of writedowns we are starting to see from movie companies.

Conclusion

Although I’ve concentrated on the uncertainties surrounding project accounting, I don’t want to say it’s a totally bad thing.  In the final analysis, even though the project accounting technique presents managements with more than the usual number of chances to hope against hope, the accounting uncertainties reflect the uncertainties inherent in taking on multi-year projects and making multi-year revenue and cost estimates.

Nevertheless, these uncertainties typically mean the companies in these industries trade at lower price-earnings multiples than those in other industries.