SCENARIO ANALYSIS NO 23: PROJECT-BASED BUSINESS AND WORKING CAPITAL FOR FINANCIAL MANAGEMENT

During the last seminar, I was asked by one of the participants regarding the idea of business cycle and working capital in a Project/Contract based business. I mentioned in the seminar that the Financial Management of a business can be internally generated from the working capital within the business cycle. Under the stylised version of the business cycle, Accounts Payable is created when supplies are received from the Supplier. This represents expenses or costs to the business. The amount owing is settled when payment is made to the Supplier from Cash/Bank. Similarly, Accounts Receivable is created when items/services are delivered to the Customer. This transaction represents Sales Revenue to the business and the amount owed is settled when the Customer pays to the business and the amount updated as Cash/Bank. There would be many transactions involving Accounts Payable and Accounts Receivable within a pre-defined period, such as, in a month.

In a Project/Contract based business, the business cycle for Accounts Receivable may not be as clear since the Project/Contract would normally be completed after a duration of time which could be more than six months, or perhaps more than a year. Examples are: the ship-building business or term-supply contracts. Under such circumstance, there is a need to recognise sales revenue based on costs expended to date to the total costs contracted. There would also be a need to update progress payments (or milestone payments) transacted, where applicable.

In order to capture the essence of the business cycle for Project/Contract based business, there is a need to be clear on where and when the Accounts Payable balances and Accounts Receivable balances happened.

WHEN THE CONTRACT IS SIGNED

When the contract is signed, the accounting entries need to be updated by the business to reflect this situation. Hence, the entries should be as follows:

DR          Total Receivable Due                                      CR           Unbilled Sales Revenue

Note that both these accounts are under Balance Sheet items and reflect the total revenue of the contract that has been agreed/signed. If there is a signature/milestone payment, the following entries would also be updated.

DR          Bank                                                                      CR           Total Receivable Due

DURING THE CONTRACT PERIOD

At month-end (or at a suitable pre-defined point in time), the costs expended would be accumulated and the accounts updated as follows:

DR          Expenses/Costs                                                CR           Accounts Payable

And based on the cumulated costs incurred and the estimated total project costs, the ratio of completion of the project is calculated; and this ratio is then applied against the total contract value (Total Receivable Due at start) to determine the Sales revenue to be recognised.

Based on the information available, the accounting entries would be as follows:

DR          Accounts Receivable                                       CR           Total Receivable Due

DR          Unbilled Sales Revenue                                 CR           Billed Sales Revenue

Notice that the Total Receivable Due is reduced by the Accounts Receivable arising from the recognised Sales Revenue for the stipulated period; and similarly, the Unbilled Sales Revenue is reduced by the Billed Sales Revenue. This is to enable the monitoring and tracking of the remaining balance receivable from the Contract Value.

Thus, for the purposes of Business Cycle, the balances for Receivables and Payables coming out from the Contract/Project are thus identified for the stipulated period.

Sales Revenue and Expenses/Costs are also identified accordingly, from which the profit margin could be derived for the period concerned.

In cases where payments are received under progress or milestone payment schedule, the Accounts Receivable balance would accordingly be reduced. The accounting entries for those incoming receipts would then be as follows:

DR          Bank                                                                      CR           Accounts Receivable

When payments are made against the Accounts Payable balance, the accounting entries for the outgoing payments would be as follows:

DR          Accounts Payable                                             CR           Bank

Based on the current assets and current liabilities balances, the working capital position of the business could then be derived.

AT COMPLETION OF CONTRACT

Upon completion, and at the end of the Contract/Project, the account balances for Total Receivable Due and Unbilled Sales Revenue should be nil. This is the check-point to ensure that all amounts under the contract/project have been duly recognised as Sales Revenue and that incoming receipts are received in the bank.

GNZ.