Revenue Recognition - Long-term Contracts
Long-term contracts are multi-year contracts such as construction project. For these contracts, the earnings process extends over several accounting periods. Delivery of the final product may occur years after the initiation of the project.
For these contracts the revenue is recognized before delivery, and there are two methods to do so.
1. Percentage of Completion method
- The percentage-of-completion method recognizes revenue on a long-term project as work progresses.
- Revenues, expenses, and gross profit are recognized each accounting period based on an estimate of the percentage of completion of the project.
- The percentage of completion is generally measured by dividing the total cost incurred till date divided by the most recent estimate of the total cost of the project.
- Project costs and gross profit to date are accumulated in the inventory account (construction in progress.)
- Progress billings are accumulated in a contra inventory account (billings on construction in progress)
2. Completed Contract method
- Revenues, expenses, and resulting gross profit are recognized only when the contract is completed.
- As construction costs are incurred, they are accumulated in an inventory account (construction in progress).
- Progress billings are not recorded as revenues, but are accumulated in billings on construction in progress account that is deducted from the inventory account (i.e., a contra account to inventory).
- At the completion of the contract, all the accounts are closed, and the entire gross profit from the construction project is recognized.
US GAAP vs. IFRS
Long-term construction contracts when outcomes can be reasonably estimated:
- The percentage-of-completion method is used under both IFRS and GAAP.
Long-term construction contracts when outcomes cannot be reasonably estimated:
US GAAP: Must use Completed Contract Method (No revenue or expense is recognized until the end of the contract)
IFRS: Must use the zero-profit method (revenues are recognized only to the extent of costs)
US GAAP: Follow specific industry guidance for revenue recognition
IFRS: Typically use the % Completion method (or straight-line if services are specified over a period of time)
- Loss (if expected) must be recognized immediately under both IFRS and GAAP
Let’s say we have a 3-year contract to construct a bridge. The contract value is $1,000,000 and the estimated total cost is $700,000. During the next 3 years, the costs are incurred as follows and the project is completed by the end of the third year.
Let’s determine the recognition of revenue, expenses and profits under different methods.
US GAAP: Percentage-of-completion Method
This assumes that the project outcomes can be reliable estimated. Revenues, expenses, and gross profit are recognized each accounting period based on an estimate of the percentage of completion of the project.
|Percentage Completion||=350,000/700,000 = 50%||=175/700,000 = 25%||=175/700,000 = 25%|
|Revenue||=50% of 1,000,000=5,00,000||=25% of 1,000,000=2,50,000||=25% of 1,000,000=2,50,000|
IFRS: Percentage-of-completion Method
This assumes that the project outcomes can be reliable estimated. The results are same as above
GAAP: Completed Contract Method
This assumes that the project outcomes cannot be reliable estimated. Revenues, expenses, and resulting gross profit are recognized only when the contract is completed.
This means that no revenue, expense or profit will be recognized in 2011 and 2012. In 2013, the revenue of 1,000,000, cost of 700,000 and profits of 300,000 will be recognized.
IFRS: Zero-profit Method
Revenues, expenses, and resulting gross profit are recognized only when the contract is completed. Revenues are recognized only to the extent of costs as shown below:
- Income Statement
- Formats of Income Statements
- Principles of Revenue Recognition
- Revenue Recognition - Long-term Contracts
- Revenue Recognition - Instalment Sales
- Revenue Recognition - Barter Transactions
- Expense Recognition
- Inventory Expense Recognition
- Depreciation Expense Recognition
- Amortization Expense Recognition
- Bad Debt Expense and Warranty Expense Recognition
- Financial Reporting of Non-recurring Items
- Operating and Non-operating Components of Income Statement
- How to Calculate Basic Earnings Per Share (EPS)
- Impact of Stock Dividends and Stock Splits on Earnings Per Share (EPS)
- Diluted EPS
- Calculation of Diluted EPS (Convertible Preferred Stock)
- Calculation of Diluted EPS (Convertible Debt)
- Common Size Income Statement
- Performance Measures of a Company
- Comprehensive Income