Principles of long-term contract accounting
October 27, 2014
Revenue recognition is one of the key issues accountants have to deal with on a regular basis. It’s usually straightforward for a merchandiser, but when should revenue be recognized when the company accepts a contract that will take several months to several years to complete? In this article, we’ll discuss two methods for recognizing revenue from contracts.
Revenue should be recognized when realized and earned. Recognition rules include a determinable price, collection that is reasonably assured, and the fact that something has been delivered or services have been rendered.
Long-term projects pose serious recognition questions companies (e.g., construction companies, government contractors). At what point do you recognize revenue on a two-year, multimillion-dollar contract? At the beginning? Sometime in the middle? The very end of the project? When all the bills have been paid by the customer?
Two well-known methods of revenue recognition for long-term contracts are the completed contract method and the percentage of completion method. Which one should be used depends on the specifics of the project.
The completed contract method is a simple way of recognizing revenue for a contract – all revenue is recognized at the end of the project, when the contract has been substantially completed. Expected losses, however, should be recognized immediately in order to comply with the rule of conservatism. This method is used if it’s not possible to reliably estimate future costs, the project is short, or there are so many projects ongoing that a roughly equal number of contracts are finished every year.
The main problem with the completed contract method is that it may result in volatile earnings from one period to the next. Another problem is that work is performed throughout the length of the contract, but revenue is only recognized in one of the periods. On the other hand, it’s more precise than the second method because revenue recognition is not based on estimates.
When utilizing the percentage-of-completion method, revenue is recognized throughout the project based on the estimated completion percentage to date. Under ASC 605-35, there is a rebuttable presumption that management is capable of making these estimates and that, therefore, the percentage-of-completion method is the preferable method of accounting. There are different ways of estimating the completion percentage: using inputs (e.g., the cost-to-cost) and outputs (e.g., units delivered). If, at the end of the year, $100,000 has been spent on the project and management estimates that the company will have to spend $900,000 more to complete the contract, then 10% of the estimated gross profit should be recorded. As with the completed contract method, a loss should be fully recognized as soon as estimated total costs become greater than the contract price.
Although this method satisfies the matching principle, revenue recognition can be manipulated because the cost to complete the project must be estimated.
Note that there are several different types of journal entries that are made throughout the life of a project, no matter which method is chosen. In addition, the balance sheet shows several assets and liabilities related to contracts that are in progress. Explanations for these entries and balance sheet accounts are beyond the scope of this article. It is also interesting to note that international accounting standards (IFRS) do not permit the completed contract method.
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