2.3 Long-term contracts

Accounting for Long-term Contracts

Long-term contracts span multiple accounting periods, which creates a core question: when should you recognize revenue and expenses? You can't just wait years until a bridge or building is finished to report any financial activity. Two main methods handle this: the percentage of completion method and the completed contract method. They differ in timing, complexity, and how they affect financial statements.

Getting this right involves estimating costs, measuring progress, handling losses, and dealing with change orders. These topics show up heavily in construction and manufacturing industries.

Percentage of Completion Method

This method recognizes revenue and expenses gradually as work progresses. It's the preferred approach under GAAP (and required under IFRS via ASC 606 / IFRS 15 for most contracts) because it better reflects economic reality.

Measuring Progress Toward Completion

The most common way to measure progress is the cost-to-cost method: you compare costs incurred so far to total estimated costs.

$\text{Percentage complete} = \frac{\text{Costs incurred to date}}{\text{Total estimated contract costs}} \times 100\%$

For example, if a contract has total estimated costs of $5,000,000 and you've spent $2,000,000 so far, you're 40% complete.

Other approaches include measuring physical completion (e.g., miles of road paved) or units of work performed. Regardless of the method, you need reliable estimates of total costs, revenues, and progress. Without those, this method falls apart.

Estimating Total Contract Costs

Total estimated costs include:

• Direct costs: materials, labor, subcontracting
• Allocated indirect costs: overhead such as equipment depreciation, site supervision

These estimates draw on historical experience, industry benchmarks, and current market conditions. They aren't set once and forgotten. You review and update them each period as new information comes in.

When estimates change, the adjustment is handled prospectively using a catch-up approach. That means you recalculate the cumulative revenue that should have been recognized to date under the new estimate, then recognize the difference in the current period. You don't restate prior periods.

Recognizing Revenues and Expenses

Each period, you recognize revenue and costs based on the cumulative percentage complete, minus what you've already recognized in prior periods:

$\text{Revenue to date} = \text{Percentage complete} \times \text{Total contract revenue}$

$\text{Current period revenue} = \text{Revenue to date} - \text{Revenue recognized in prior periods}$

The same logic applies to costs:

$\text{Current period cost} = \text{Costs to date} - \text{Costs recognized in prior periods}$

Gross profit each period is simply current period revenue minus current period cost.

When work has been performed but not yet billed, the difference shows up as unbilled receivables (a current asset). This is sometimes called "costs and recognized profit in excess of billings."

Completed Contract Method

When to Use the Completed Contract Method

This method defers all revenue and expense recognition until the contract is finished. It's used when:

• Reliable estimates of progress cannot be made
• The contract carries unusually high inherent risk
• The contract is short-term enough that results wouldn't differ materially from percentage of completion

You'll see it more often with smaller, less complex construction projects. Note that under ASC 606 and IFRS 15, this method is significantly restricted. It's generally only acceptable when you truly cannot measure progress reliably.

Deferring Revenues and Expenses

During the contract:

• All costs are accumulated in Construction in Progress (an asset account on the balance sheet)
• All billings to the customer are accumulated in Billings on Uncompleted Contracts (a contra-asset or liability account)
• No revenue, expense, or gross profit is recognized until completion

The balance sheet still reflects the contract activity through these accounts, but the income statement stays untouched until the project wraps up.

Recognizing Income at Completion

Once the contract is complete:

1. Close out the Construction in Progress and Billings on Uncompleted Contracts accounts against each other
2. Recognize revenue equal to the total contract price
3. Recognize expenses equal to total accumulated costs
4. The difference is gross profit (or loss)

All the profit hits the income statement in a single period, which is the main drawback of this method.

Comparing Percentage of Completion vs. Completed Contract

The percentage of completion method gives users more useful information period by period, but it demands more judgment. The completed contract method is simpler and more objective, but it can make a company's performance look erratic.

Loss Provisions in Long-term Contracts

Estimating and Recording Losses

Here's a critical rule: if at any point during the contract you estimate that total costs will exceed total revenue, you must recognize the entire expected loss immediately. This applies under both methods.

$\text{Loss provision} = \text{Total estimated contract costs} - \text{Total contract revenue}$

For example, if a contract has a price of $10,000,000 but you now estimate total costs of $11,500,000, you record a loss provision of $1,500,000 right away, even if you're only 30% through the project.

The loss is recorded as a current period expense with a corresponding liability (Provision for Estimated Losses on Contracts). No further profit is recognized until the loss provision has been fully absorbed.

Impact on Financial Statements

• Income statement: Current period net income drops by the full loss amount
• Balance sheet: Liabilities increase, retained earnings decrease
• Ratios: Debt covenants, return on assets, and other metrics may be affected
• Future periods: Will show relatively higher gross profits as the previously recognized loss is "absorbed" by ongoing contract activity

This conservatism principle (recognize losses immediately, but recognize gains only as earned) is a recurring theme in accounting.

Change Orders and Contract Modifications

Approved Change Orders

When a change order is approved by both parties, it becomes part of the original contract. You adjust:

• Total contract revenue (up or down)
• Total estimated contract costs
• The percentage of completion calculation going forward

The catch-up adjustment method applies: recalculate cumulative revenue to date under the revised terms, then recognize the difference in the current period.

Unapproved Change Orders and Claims

Unapproved change orders and claims require more caution:

• Do not recognize additional revenue until approval is probable and the amount can be reliably estimated
• Costs related to unapproved change orders are expensed as incurred (they don't sit in Construction in Progress waiting for approval)
• Once approved, the amounts are folded into the contract using a catch-up adjustment

This conservative treatment prevents companies from inflating revenue based on change orders that may never be approved.

Contract-related Balances

These two balance sheet items come up constantly with long-term contracts. Understanding what they represent is essential.

Unbilled Receivables (Costs in Excess of Billings)

• Arises when recognized revenue exceeds amounts billed to the customer
• Reported as a current asset
• Means you've done more work than you've billed for so far

Billings in Excess of Costs (Deferred Revenue)

• Arises when amounts billed exceed recognized revenue
• Reported as a current liability
• Means you've billed the customer for work you haven't yet performed or revenue you haven't yet earned

On any given contract, you'll have one or the other, never both. Across a portfolio of contracts, a company might report both on the balance sheet (some contracts overbilled, others underbilled).

Disclosures for Long-term Contracts

Required Disclosures Under GAAP

Companies must disclose enough information for users to understand the nature and financial impact of their long-term contracts:

• The accounting policy used for revenue recognition (which method, how progress is measured)
• Revenue recognized in the current period
• Contract balances: unbilled receivables, billings in excess of costs, and how these changed during the period
• Significant judgments and estimates used, including how total costs and progress were determined

Disaggregation of Contract Information

ASC 606 requires companies to break down contract revenue into categories that reflect how the nature, timing, and uncertainty of revenue differ. Common ways to disaggregate include:

• By major product line or service type
• By geographic region
• By type of customer (government vs. private)

This disaggregation helps financial statement users assess risk and predict future cash flows more accurately.

Long-term Contract Auditing Considerations

Assessing Risk and Materiality

Long-term contracts carry higher inherent risk than most transactions because of the heavy reliance on estimates. Auditors focus on:

• The risk of material misstatement in revenue recognition and cost estimates
• Whether the contract's size is material relative to overall financial statements
• Industry-specific risks (cost overruns, regulatory delays, weather impacts in construction)

Testing Contract Estimates and Assumptions

Auditors don't just accept management's numbers. They take several steps:

1. Review the estimation methodology for reasonableness and consistency with prior periods
2. Compare past estimates to actual results to evaluate management's track record of accuracy
3. Test underlying data (subcontractor bids, material invoices, labor records) for accuracy and completeness
4. Engage specialists when needed, such as engineers or appraisers, to evaluate complex technical estimates
5. Perform substantive procedures on contract balances, billings, and cost accumulations

The goal is to verify that the financial statements faithfully represent the economic substance of these contracts, not just management's optimistic projections.