3.2.1. Long-Term Contracts

#cfa-level-1 #reading-25-understanding-income-statement #revenue-recognition

A long-term contract is one that spans a number of accounting periods. Such contracts raise issues in determining when the earnings process has been completed and revenue recognition should occur. How should a company apportion the revenue earned under a long-term contract to each accounting period? If, for example, the contract is a service contract or a licensing arrangement, the company may recognize the revenue on a prorated basis over the period of time of the contract rather than at the end of the contract term. Under IFRS, this may be done using the percentage-of-completion method.16 Under the percentage-of-completion method, revenue is recognized based on the stage of completion of a transaction or contract and is, thus, recognized when the services are rendered. Construction contracts are examples of contracts that may span a number of accounting periods and that may use the percentage-of-completion method.17 IFRS provide that when the outcome of a construction contract can be measured reliably, revenue and expenses should be recognized in reference to the stage of completion. US GAAP have similar requirements for long-term contracts including construction contracts.

Under the percentage-of-completion method, in each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. Contract costs for the period are expensed against the revenue. Therefore, net income or profit is reported each year as work is performed.

Under IFRS, if the outcome of the contract cannot be measured reliably, then revenue may be recognized to the extent of contract costs incurred (but only if it is probable the costs will be recovered). Costs are expensed in the period incurred. Under this method, no profit is recognized until all the costs had been recovered. Under US GAAP, but not under IFRS, a revenue recognition method used when the outcome cannot be measured reliably is the completed contract method. Under the completed contract method, the company does not report any income until the contract is substantially finished (the remaining costs and potential risks are insignificant in amount), although provision should be made for expected losses. Billings and costs are accumulated on the balance sheet rather than flowing through the income statement. Under US GAAP, the completed contract method is also acceptable when the entity has primarily short-term contracts. Note that if a contract is started and completed in the same period, there is no difference between the percentage-of-completion and completed contract methods.

Examples 1, 2, and 3 provide illustrations of these revenue recognition methods. As shown, the percentage-of-completion method results in revenue recognition sooner than the completed contract method and thus may be considered a less conservative approach. In addition, the percentage-of-completion method relies on management estimates and is thus not as objective as the completed contract method. However, an advantage of the percentage-of-completion method is that it results in better matching of revenue recognition with the accounting period in which it was earned. Because of better matching with the periods in which work is performed, the percentage-of-completion method is the preferred method of revenue recognition for long-term contracts and is required when the outcome can be measured reliably under both IFRS and US GAAP. Under both IFRS and US GAAP, if a loss is expected on the contract, the loss is reported immediately, not upon completion of the contract, regardless of the method used (e.g., percentage-of-completion or completed contract).


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