The Georgia Tech Financial Analysis Lab conducts unbiased research on issues of financial reporting and analysis. Unbiased information is vital to effective investment decision-making. Accordingly, we think that independent research organizations, such as our own, have an important role to play in providing information to market participants.
Because our lab is housed within a university, all of our research reports have an educational quality, as they are designed to impart knowledge and understanding to those who read them. Our focus is on issues that we believe will be of interest to a large segment of stock market participants. Depending on the issue, we may focus our attention on individual companies, groups of companies, or on large segments of the market at large.
A recurring theme in our work is the identification of reporting practices that give investors a misleading signal, whether positive or negative, of corporate earning power. We define earning power as the ability to generate a sustainable stream of earnings that is backed by cash flow. Accordingly, our research may look into reporting practices that affect either earnings or cash flow, or both. At times our research may look at stock prices generally, though from a fundamental and not technical point of view.
Percentage-of-Completion Accounting and The New Accounting Standard for Revenue Recognition: A Look at the Aerospace and Defense Industry
In this study, we examine the treatment of percentage of completion accounting (POC) for financial reporting purposes within the aerospace and defense industry, an industry that utilizes POC accounting extensively. POC accounting addresses revenue recognition practices for long-term contracts. In applying POC accounting, companies recognize revenues primarily by comparing costs incurred to total estimated costs to complete the contract. Because estimates are used, unexpected cost overruns can lead to significant losses late in a contact’s life. Under the POC method, customer billings and cash flow can also proceed at rates that are significantly at odds with the timing of revenue recognition. For many firms, the unique risks associated with POC accounting lead them to list POC accounting as an explicit risk factor of which readers of their financial statements should be cognizant. With examples, the paper details how the POC method of revenue recognition is applied. Requirements from the new revenue recognition standard contained in Accounting Standards Codification 606, Revenue Recognition, are provided along with a summary of the changes that can be expected as companies move to adopt the new standard.
Presently, we find disclosures related to POC accounting to be lacking. In the aerospace and defense industry only seven companies, or 44% of the 16 firms in the sample, disclose the percentage of revenues derived from POC accounting. Approximately half of the sample report the amount of progress payments made on contracts, while nine disclose whether the company is in an over-billed or under-billed position. Finally, only five companies provide information on the timing of revenue recognition versus cash receipt. Nine companies list POC accounting as an explicit risk factor.
For analysts and investors, our findings demonstrate that given the lack of disclosure, care must be taken with the financial statements of companies who use the POC method extensively. For CFOs, the results highlight the changes that will need to be made to their companies’ financial statements in upcoming years to comply with new revenue recognition standards. For regulators and accounting standards setters, the results highlight the shortcomings of current accounting and disclosure practices for long-term contracts and the improvements that can be expected as companies move to adopt the new revenue recognition standard.
Earnings Quality: Reports on Individual Companies and Industries
In these reports we examine one or more dimensions of earnings quality: the cash flow support of earnings, the sustainability of earnings, or the quality of the balance sheet.