Question

Case Study

Revenue Recognition

For this case, you are the lead analyst for a team considering the potential acquisition of three separate projects of a single company, Gasco. You are to determine if your team will acquire one, two, all three of the projects; or none of them. The team intends to acquire any project it deems profitable over the duration of the project. For purposes of this case, ignore purchase price of the projects.

Gasco is a natural gas company. It transports natural gas to its customers through pipelines and constructs such pipelines. In some cases Gasco contracts only to build the pipeline. Sometimes, it contracts to deliver gas through pipelines built by another company. Sometimes it does both. Therefore, its revenues may arise from the sale and delivery of natural gas through those pipelines, as well as from the construction of the pipelines.

In order to make the determination of which projects to acquire, if any, your due diligence will primarily require revenue recognition research, as well as recognition of the related costs. This research will be in the FASB’s Accounting Standards Codification (ASC) as well as by reviewing similar companies’ financial statements, looking particularly at percentage-of-completion accounting and accounting for Contributions in Aid of Construction (CIAC). First, extend the projected financial information received from Gasco (shown below) out to five years. Then, you will need to determine whether or not you agree with Gasco’s revenue and cost recognition policies. If you do not agree, you’ll have to revise the pro-forma financial statements based on what you do believe is correct. Following are brief descriptions of the three projects:

Project A

Gasco has a contract with a factory in a remote area. Under the contract, Gasco will build a pipeline to the factory. At the end of the construction, which is expected to take three years, the factory will determine whether to contract with Gasco or another company to deliver its natural gas. Although the factory is paying for the construction of the pipeline, Gasco will retain ownership of the pipeline. This contract will provide revenue of $3.6 million to Gasco. It is anticipated that the percentage-of-completion method will result in that revenue being recognized evenly over the three-year period of construction. Related direct costs are anticipated to be about $3 million Because Gasco will retain ownership of the pipeline, which is expected to have a useful life of thirty years, direct costs will be capitalized and depreciated over the thirty-year expected useful life of the pipelines. Depreciation is planned to begin after construction is complete and the pipeline is placed in service.

Project B

Gasco has a contract with a developer who is building a business office complex. The contract consists of two parts. The first part is for construction of a pipeline, expected to take two years. The second part is an exclusive right to deliver natural gas through that pipeline for a period of 30 years. The developer is paying Gasco for construction of the pipeline but Gasco will retain ownership of the pipeline. Although Gasco has an exclusive right, for 30 years, to deliver gas through that pipeline, its revenue depends on the developer’s ability to lease offices to businesses who will be under a required subcontract for the receipt of and payment for that gas. Gasco anticipates full capacity within two years after the pipeline and development are completed. About half the annual projected revenue is expected for each of those first two years. The pipeline construction contract will provide revenue of $2.4 million to Gasco. It is anticipated that the percentage-of-completion method will result in that revenue being recognized evenly over the two-year period of construction. Related direct costs are anticipated to be about $1.6 million Because Gasco will retain ownership of the pipeline, which is expected to have a useful life of thirty years, direct costs will be capitalized and depreciated over the thirty-year expected useful life of the pipelines. Depreciation is planned to begin after construction is complete and the pipeline is placed in service. Annual revenue from sale and delivery of the natural gas, at full capacity, is expected to be $120,000 per year, with direct costs of $60,000 per year.

Project C

Gasco has a contract with a developer who is building a residential complex. This contract also consists of two parts. The first part is for construction of a pipeline, expected to take two years. The second part is an exclusive right to deliver natural gas through that pipeline for a period of 30 years. Although Gasco has an exclusive right, for 30 years, to deliver gas through that pipeline, its revenue depends on the developer’s ability to sell apartments to individuals who will be under a required subcontract for the receipt of and payment for that gas. Gasco anticipates full capacity within two years after the pipeline and development are completed. About half the annual projected revenue is expected for each of those first two years. This contract will provide revenue of $1.2 million to Gasco. It is anticipated that the percentage-of-completion method will result in that revenue being recognized evenly over the two-year period of construction. Related direct costs are anticipated to be about $800,000 Because Gasco will retain ownership of the pipeline, which is expected to have a useful life of thirty years, direct costs will be capitalized and depreciated over the thirty-year expected useful life of the pipelines. Depreciation is planned to begin after construction is complete and the pipeline is placed in service. Annual revenue from sale and delivery of the natural gas, at full capacity, is expected to be $60,000 per year, with direct costs of $30,000 per year.

Indirect administrative costs of Gasco are expected to be $600,000 each of the first two years, while construction is going on all three projects, $400,000 in the third year, and $200,000 annually after that.

Following is the projected financial information Gasco gave you for the next two years, based on the information provided above:

Year 1 Project A Project B Project C Total

Revenues 1,200,000 1,200,000 600,000 3,000,000

Direct Cost

Indirect cost 600,000

Net Income ? ? ?

Year 2 1,200,000 1,200,000 600,000 3,000,000

Direct Cost ? ? ?

Indirect cost 600,000

Net Income ? ? ?

Based on Gasco's numbers, it looks like each of these projects are expected to be very profitable and the combined projects appear to be profitable in total, especially with direct costs being capitalized and depreciated in the future. Therefore, the team's first inclination is to acquire all three projects. Do you agree?

Answer 1

Projection of Profits for Year 1

Projects	A	B	C	Total
Revenue	1200000	1200000	1200000	3000000
Depreciation	-100000	-53333.33	-26666.66	-180000
Indirect Cost	-600000	-600000	-600000	-1800000
Sale and Delivery of Gas	0	120000	60000	180000
Cost related to Sale and Delivery of Gas	0	-60000	-30000	-90000
Profit	500000	606666.7	603333.33	1710000

The overall profit looks positive and attractive. The teams decision to acquire 3 projects is appropriate.