6.1 Long-Term Contract Accounting Methods
5 min read•july 30, 2024
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
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- The recognizes revenue and expenses gradually over the life of a long-term contract as the contract is completed
- The 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 , 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 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)
Key Terms to Review (18)
Billings on contracts: Billings on contracts refer to the amounts that a company invoices to its clients for work completed on long-term contracts, typically in construction or manufacturing. This concept is critical in determining revenue recognition and cash flow management, as it allows companies to match their billing to the progress of the work performed, thus ensuring that financial statements accurately reflect the company’s performance and position over time.
Change Orders: Change orders are formal documents that modify the original construction contract to accommodate changes in the project's scope, design, or specifications. They are crucial in long-term contracts as they outline adjustments to the project timeline, costs, and overall deliverables, ensuring that both parties agree to any deviations from the initial agreement.
Completed-contract method: The completed-contract method is an accounting approach used for recognizing revenue and expenses associated with long-term contracts. Under this method, revenue and expenses are only recognized once the contract is fully completed, which helps ensure that all costs and income are matched together at the end of the project. This method is especially beneficial in industries where projects take a long time to complete, as it allows for clearer financial reporting at the project's conclusion.
Contingency Provisions: Contingency provisions are amounts set aside in financial statements to cover potential future liabilities or losses that are uncertain in timing or amount. These provisions help ensure that financial statements reflect a company's true financial position by anticipating future expenses, such as legal claims or warranties, that may arise from current operations. Recognizing these provisions allows businesses to present a more accurate picture of their financial health and maintain compliance with accounting standards.
Contract Revenue: Contract revenue refers to the income recognized by a company from executing a contract, usually for goods or services, over a specified period. This concept is crucial in accounting for long-term contracts, as it dictates how and when revenue is recorded based on the progress of the project or the completion of deliverables.
Contractual Obligations: Contractual obligations are legally binding agreements between parties that outline specific duties, rights, and responsibilities. These obligations are crucial for ensuring that both parties fulfill their commitments as stipulated in the contract, which can include timelines, payment terms, and performance expectations. Understanding these obligations is vital in financial contexts as they can significantly impact revenue recognition, liabilities, and retained earnings.
Costs Incurred: Costs incurred refer to the expenses that are recognized when a company has completed a certain part of its production or service delivery. This concept is crucial in long-term contract accounting, as it helps to determine revenue and profit recognition over the life of the contract. Understanding costs incurred allows companies to match expenses with revenues, ensuring accurate financial reporting and compliance with accounting standards.
Earnings Before Interest and Taxes (EBIT): Earnings Before Interest and Taxes (EBIT) refers to a company's profitability measure that calculates earnings by excluding interest and income tax expenses. This figure is crucial as it provides a clearer view of a company's operational performance, allowing for comparisons across businesses regardless of their financing structures or tax situations. EBIT is often used in various financial analyses, including those assessing long-term contracts and evaluating profitability and leverage ratios.
Estimated Total Cost: Estimated total cost refers to the projected overall expenses that will be incurred throughout the duration of a long-term contract. This figure is essential for assessing the profitability and feasibility of projects, as it encompasses all anticipated costs, including direct materials, labor, overhead, and any other related expenses. A precise estimation helps in determining billing schedules and revenue recognition methods, which are crucial in managing long-term contracts effectively.
FASB: The Financial Accounting Standards Board (FASB) is an independent organization that establishes financial accounting and reporting standards for companies and nonprofits in the United States. It plays a crucial role in maintaining consistency and transparency in financial reporting, ensuring that stakeholders can rely on accurate and comparable financial information across various entities. FASB's standards are essential for long-term contract accounting, fair value measurements, retained earnings management, and partnership formations.
Gross Profit Margin on Contracts: Gross profit margin on contracts is a financial metric that assesses the profitability of a long-term contract by measuring the difference between contract revenue and direct costs associated with that contract, expressed as a percentage of contract revenue. This metric helps stakeholders understand how efficiently a company is managing its costs relative to the income generated from contracts, influencing pricing, project management, and financial reporting.
IFRS: International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. IFRS provides a common global language for business affairs, ensuring consistency in the financial reporting and making it easier for investors to compare financial statements from different countries.
Matching Principle: The matching principle is an accounting concept that requires expenses to be recorded in the same period as the revenues they help generate. This principle ensures that a company's financial statements accurately reflect its financial performance, linking income and related expenses for a clearer view of profitability over specific time frames.
Milestone billing: Milestone billing is a payment structure used in long-term contracts where payments are made at specific stages or milestones of a project, rather than at the completion of the entire project. This method helps manage cash flow for both contractors and clients, ensuring that funds are released as work progresses and major phases are completed. It aligns payment schedules with the achievement of significant deliverables, which can help reduce financial risk and ensure accountability.
Percentage-of-completion method: The percentage-of-completion method is an accounting technique used to recognize revenue and expenses for long-term contracts based on the progress of the project. This method allows companies to report income and expenses proportionate to the work completed during an accounting period, providing a more accurate picture of financial performance over time. By recognizing revenue as construction progresses, companies can match income with related costs, reflecting a more realistic view of ongoing projects.
Revenue Recognition Principle: The revenue recognition principle dictates that revenue should be recognized when it is earned and realizable, regardless of when cash is received. This principle is crucial as it ensures that financial statements accurately reflect a company's performance during a specific period, aligning income with the expenses incurred to generate that income. Proper application of this principle is vital for various accounting methods, including those used for long-term contracts and installment sales, where timing and recognition can significantly impact reported revenues.
Risk of cost overruns: The risk of cost overruns refers to the potential for a project to exceed its initial budgeted costs, which can lead to financial losses and project delays. This risk is particularly significant in long-term contracts, where expenses can fluctuate due to unforeseen circumstances, changes in project scope, or inefficiencies in project execution. Managing this risk is essential for ensuring that projects remain financially viable and meet contractual obligations.
Work-in-progress: Work-in-progress refers to the costs associated with partially completed goods in a manufacturing or production process. This term captures all expenses related to materials, labor, and overhead incurred up to a certain point before the final product is completed. Understanding work-in-progress is crucial for long-term contract accounting methods, as it allows businesses to recognize revenue and expenses accurately over the duration of a project, ensuring financial statements reflect the true state of production.