Conflicts of Interest in Long-Term Construction Projects
A guest article by Dr. Harald Riedel, tax advisor and certified public accountant, on profits from long-term contracts, depreciation, and the burden of taxes
A defining characteristic of large-scale projects—such as the construction of a new factory or logistics center—is that they extend over a long period of time, usually spanning several years.
The client, architect, structural engineers, building services engineers, and others—as well as the planners for IT processes and workflows, the planners for production and/or logistics processes, and finally the general contractor and its subcontractors—work together over several years.
Such long-term projects or contracts often involve a conflict of interest between the client (building owner) and the contractor (architect, planner, general contractor, etc.)—provided these are business entities that prepare financial statements and enter into contracts for work and services. This conflict of interest manifests itself in the question of when a project is “realized,” that is, completed. While the client typically views realization as occurring only at the end of the entire project duration, it is often in the contractor’s interest to achieve completion in several phases. This is due in no small part to the realization principle prevailing in German accounting law, which determines when profits from the project are recognized for commercial and tax purposes. The basis for this is the German Principles of Proper Accounting (GoB).
Recognition of Profits in Long-Term Construction Projects
Ultimately, the GoB determine when—that is, in which fiscal year—profits from large-scale projects are recognized or reported. From the contractor’s perspective, this issue is significant, on the one hand, for the allocation of profits to shareholders and the amount of potential profit distributions. On the other hand, it also significantly determines the timing and amount of the tax liability on those profits. From the client’s perspective, the timing of profit recognition determines, among other things, when the project can be depreciated and, in non-balance-sheet matters, primarily when the warranty period begins.
Dr. Harald Riedel
Dr. Harald Riedel is a certified public accountant, tax advisor, and founding partner of PKF Riedel Appel Hornig GmbH, with more than 30 years of experience in auditing, tax consulting, and management consulting. He specializes in auditing and advising manufacturing, retail, and service companies; designing tax models; conducting business valuations; and advising on structural measures. Dr. Riedel is a member of the executive board of PKF Deutschland GmbH and a member of the Chamber of Tax Consultants and the Chamber of Public Accountants.
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The Prudence Principle in German Accounting Law
German accounting law is strongly dominated by the so-called principle of prudence, which requires that, in cases of doubt, assets be valued on the low side and liabilities on the high side, thereby serving to protect creditors. Profits are to be recognized only if they have been realized as of the balance sheet date (the so-called realization principle). The profit must be “virtually certain.”
In the context of contracts for work and services, profits are therefore recognized under German accounting law only upon completion of the project. This is typically the date of acceptance. This means that, until then, any progress payments received for the project must be recorded as advance payments received—with no effect on income—while services rendered must be capitalized as work in progress. The profit is recognized “all at once,” so to speak, only in the year of completion or acceptance (the so-called completed-contract method). If this results in a material distortion of the earnings position, this must be disclosed in the notes to the annual financial statements.
Alternative Courses of Action and Potential Solutions
The question now arises as to what options exist within the German legal system to mitigate any significant distortions in earnings beyond what is disclosed in the notes to the financial statements. In principle, the following alternatives for action exist:
First of all, one could attempt to define subprojects already during the drafting of long-term contracts and to invoice and accept these separately. For such partial acceptances, the subject matter of the contract must have been transferred to the customer both legally and economically (transfer of risk), and there must be no risk of losses arising from the long-term manufacturing contract in subsequent periods. If the risk has thus been transferred to the customer, partial profit recognition is required. However, the necessary transfer of risk requires independently definable and self-contained partial services; the individual partial services must not be functionally interrelated. Whether this is achieved depends largely on the contract terms and on the willingness—particularly on the part of the client—to divide the project and assume the transfer of risk in several stages. Another way to mitigate income distortions would be to follow a view expressed in the literature and, under very restrictive conditions, deviate from the realization principle described above.
The following requirements are listed:
- The production must involve long-term projects that constitute a significant portion of the company’s business activities.
- Accounting based on the realization principle results in a significant impairment of insight into the company’s earnings situation.
- Profit from long-term production must be determinable with near-zero risk.
- The total output must be capable of being broken down, on a cost-accounting basis, into partial outputs and conservatively determined partial profits.
- There are no indications of objections from the customer that would affect the overall result.
However, the acceptability of such accounting treatment is viewed very controversially among experts.
The concept of breaking down total performance—such as that of a large-scale project—into several partial services and recognizing partial profits based on the degree of completion is also known as the “Percentage of Completion” (PoC) method.
Furthermore, under certain conditions, revenue could be recognized over a specific period of time in accordance with International Financial Reporting Standards (IFRS). Revenue recognition based on time could occur, for example, if the customer derives benefits from the service and is already using it while the service is being performed, or if the customer already obtains control over the asset while it is being created or improved. However, accounting in accordance with IFRS involves considerable effort and is currently not possible in Germany for the purposes of annual financial statements with discharging effect.
Resolving Conflicts of Interest—A Win-Win Situation?
In summary, it can be said that while there are ways to spread out the profits of a large-scale project over the long term, In this specific case, however, this is likely to be feasible only under very limited conditions, so that, as a rule, the “one-time recognition of profits”—namely, at the end of the project upon acceptance—will still generally apply in practice.
This approach is also followed for tax purposes. This means that the profit from such large-scale projects is likewise realized only upon acceptance at the very end, triggering correspondingly high tax liabilities. From a liquidity perspective, this can also have a positive effect (tax credit). However, care must then be taken—and plans made—to ensure that this liquidity is available in a timely manner to cover the tax payment. On the other hand, the client can typically only capitalize the project as completed at that point—namely, at the end—and depreciate it for tax purposes, thereby achieving corresponding “tax savings.”
The interests of the contractor and the client may thus align. With regard to realizing profits at the end of the project, it may well be in the contractor’s interest to delay profit recognition in order to generate liquidity from “tax credits” (deferring tax payments until after the major project is completed). On the other hand, it may also be in the contractor’s interest to accept partial project deliverables earlier, because from that point on, “tax savings”—and thus liquidity advantages—can be achieved through depreciation. Finally, conflicts of interest could also be resolved to the extent that the client does not receive final acceptance of the entire project until the project’s completion, while the contractor realizes partial profits within the scope of the limited accounting options described above.
