6.1 Long-Term Contract Accounting Methods

Long-term contract accounting is a crucial aspect of revenue recognition. It deals with how companies record income and expenses for projects spanning multiple accounting periods, like construction or defense contracts.

Two main methods exist: percentage-of-completion and completed-contract. The former recognizes revenue gradually as work progresses, while the latter waits until the project is finished. Each has its pros and cons, impacting financial statements differently.

Percentage-of-Completion vs Completed-Contract Methods

Recognizing Revenue and Expenses

• The percentage-of-completion method recognizes revenue and expenses gradually over the life of a long-term contract as the contract is completed
• The completed-contract method does not recognize any revenue or expenses until the entire contract is fully completed

Estimating Progress and Completion

• The percentage-of-completion method requires a company to estimate the percentage of the contract that has been completed each period based on costs incurred, labor hours, or units delivered
• The completed-contract method does not require any estimates during the contract

Providing Relevant Information to Financial Statement Users

• The percentage-of-completion method provides users of financial statements with more current and relevant information about a company's long-term contracts and performance obligations
• The completed-contract method may not reflect economic reality of long contracts that span multiple periods (construction projects, defense contracts)

GAAP Requirements

• The percentage-of-completion method is required under U.S. GAAP when certain conditions are met, such as a contract extending beyond one year or covering multiple accounting periods
• The completed-contract method is only allowed in specific circumstances where reliable estimates cannot be made or there are inherent hazards in the contract

Revenue Recognition for Long-Term Contracts

Calculating Percentage Completed and Revenue Recognized

• The percentage-of-completion method calculates the percentage completed by comparing actual costs incurred to date to the total estimated costs of the entire contract
• This percentage is then applied to the total contract price to determine revenue to recognize in the current period
• Revenue Recognized = (Actual Costs to Date / Total Estimated Costs) x Total Contract Price

Recognizing Expenses Proportionately

• Expenses are recognized proportionately with the revenue based on the percentage completed
• A company must estimate total expected costs to complete the contract and the total contract price to apply this method

Updating Estimates and Accounting for Changes

• At the end of each accounting period, a company must update its estimates and calculations to reflect the most current expectations about total costs and contract price
• These changes are accounted for prospectively by adjusting the remaining revenue and expenses to be recognized

Requirements for Reasonable Estimates

• The percentage-of-completion method requires that a company be able to make reasonably dependable estimates about the progress toward completion, total costs to be incurred, and total contract price in order to recognize revenue and expenses
• Without reliable estimates, the percentage-of-completion method cannot be used

Maintaining Cost Records and Tracking Systems

• Companies must maintain careful cost records and tracking systems to capture actual costs incurred to date for each contract
• Additionally, they need processes to develop reasonable estimates of remaining costs to complete a contract
• Detailed job cost sheets, time tracking, and regular progress reports are often used to support the percentage-of-completion calculations

Advantages and Disadvantages of Percentage-of-Completion

Advantages

• Provides a more accurate reflection of a company's performance and economic activities by recognizing revenue and expenses gradually as work is performed
• More consistent with accrual accounting and the matching principle by aligning revenue with the expenses incurred to earn that revenue
• Provides more relevant and timely information to financial statement users about the status and profitability of long-term contracts

Disadvantages

• Requires a company to make estimates which may prove to be incorrect, leading to misstatements of financial results
• Can be complex to apply and maintain appropriate records, especially for companies with many different contracts in progress
• May enable companies to manipulate earnings by changing estimates of total costs or percentage complete

When Percentage-of-Completion is Advantageous

• The percentage-of-completion method is advantageous when a company has a long-term contract that spans multiple accounting periods (multi-year construction projects, long-term manufacturing orders)
• Allows a company to recognize revenue and expenses gradually as the work is performed, rather than waiting until the very end which may distort periodic results

Limitations and Risks

• The percentage-of-completion method can be disadvantageous if a company does not have reliable systems for tracking costs and estimating total contract costs
• Inaccurate estimates can lead to misstatements of revenue, expenses and net income that may require restatements
• Aggressive or overly optimistic estimates can mislead financial statement users

Completed-Contract Method for Revenue Recognition

When to Use Completed-Contract Method

• The completed-contract method should only be used when a company cannot reasonably estimate the costs to complete a contract or the percentage of the contract completed
• Appropriate for very unique or highly customized contracts where progress is difficult to measure (specialized equipment, new technology)

Contracts with Inherent Hazards or Risks

• The completed-contract method is appropriate when there are inherent hazards or risks in a contract that make it very difficult to develop reliable estimates
• This may be the case when prices for materials are highly volatile or there is a single act or delivery required to fulfill the contract (launching a satellite)

Short-Term Contracts Within an Accounting Period

• The completed-contract method may be used for short-term contracts that will be completed in the same accounting period in which they were started
• In this case, there is no need to estimate percentage completion and the completed-contract method is simpler

Inability to Meet Percentage-of-Completion Criteria

• Companies should use the completed-contract method for contracts in which the financial statement user cannot be reasonably assured that the estimates of total costs and percentage complete are dependable
• Also required when a company cannot meet the criteria to use percentage-of-completion method as specified in ASC 605-35-25-57 (fixed price, ability to estimate, profitability can be measured)