OCTOVAN CONSTRUCTION, INC.
Changes in Depreciation Accounting and Long-Term Construction Contract Accounting
Octovan Construction, Inc. is a small privately held construction company. Over 60 percent of its revenue is derived from the design and construction of industrial and residential septic systems. Octovan's earnings have steadily declined over the past several years while its working capital and debt to equity ratio have deteriorated. Octovan is investigating operational and financial strategies to mitigate these trends.
One of Octovan's primary creditors, Broadmoor County Bank, has become increasingly concerned over Octovan's $600,000 unsecured demand note that it is holding. Subsequent to the current year-end, but before the issuance of any financial statements, Octovan and Broadmoor reached an agreement in principal that allows Octovan to refinance the $600,000 demand note. The refinanced debt will include 60 equal principal payments of $10,000 per month with interest at the prime rate plus 1½ percent. Octovan's motor vehicles, machinery, and equipment will be assigned as collateral. Octovan is planning on reporting the debt as a noncurrent liability in the current year balance sheet.
In reviewing its accounting policies, Octovan believes that changes are warranted for depreciation accounting and long-term construction contract accounting. In prior years, Octovan reported depreciation for both tax and financial reporting purposes based on the modified accelerated cost recovery system (MACRS) as provided for by the Internal Revenue Service code. However, for the current year, Octovan changed its method of depreciation accounting for financial reporting purposes to obtain a better matching of revenue and expense. The newly adopted method provides for depreciation by the double-declining-balance method using longer useful lives. The estimated useful lives of the assets are as follows:
Motor vehicles 3-5 years
Machinery and equipment 5-10 years
Office furniture and equipment 7-10 years
Building and leasehold improvement 18-35 years
The effect of this change is to reduce beginning of the year accumulated depreciation $250,000 and to reduce current year depreciation expense $100,000. Tax depreciation will continue to exceed book depreciation for the next several years.
Octovan also changed its method of accounting for long-term construction contracts. In previous periods, revenue was recognized whenever customers were billed for both tax and financial reporting. The timing of billings was specified in each contract. Now for financial reporting purposes, Octovan has adopted the percentage-of-completion method of accounting for long-term construction contracts in order to obtain a better matching of revenue and expense. The effect of this change increases costs and estimated earnings on uncompleted contracts (not yet billed) by $200,000 as of the beginning of the current year and increases current year revenues by $80,000.
Octovan is planning on reporting both of these changes prospectively in the current year financial statements. Octovan's effective federal tax rate is 30 percent for the current and prior years. Octovan does not anticipate a change in its future effective federal tax rate.
1. Discuss whether you agree with Octovan's plans for financial reporting as of the current year-end.
2. If you disagree with any of Octovan's plans in question 1, discuss your recommendation for financial reporting. Be specific as to financial statement impact and presentation.
3. Based on your response in question 2, draft a footnote to Octovan's financial statements for its change in depreciation accounting and long-term construction contract accounting.
Significant accounting policies and practices:
1. One unsecured demand note of $600,000 held by Broadmoor County Bank has been refinanced and Octovan will now have to pay back the principal amount in 60 equal monthly instilments at an interest rate of prime plus 1 ½ percent. This debt will now be backed by collateral of motor vehicles, machinery, and equipment. This refinanced debt is now not shown as a current liability but is a part of the long-term debt.
2. From this accounting year, there is a change in the method of depreciation from the modified accelerated cost recovery system to the double declining balance method. This method will be used for the preparation of the financial accounts. The useful lives used for the calculation of depreciation will be motor vehicles 5 years, machinery and equipment 10 years, office furniture and equipment 10 years and building and leasehold ...
This solution gives you the method of drafting a footnote for Octovan Construction, Inc financial statements.