Accounting: The Language of Business - Vol. 2 (Intermediate: Part 127)

Importance of Ethics

It’s not all been plain-sailing for the accountancy profession. The 21st century has seen some dubious actions by accountants causing large-scale scandals. The Enron scandals in 2001 shook the accounting industry, for example. Arthur Andersen, one of the world’s largest accounting firms at the time, went out of business. Subsequently, under the newly introduced Sarbanes-Oxley Act, accountants now face harsher restrictions on their consulting engagements. Yet ironically, since Enron and the financial crisis in 2008, accountants have been greatly in demand, as corporate regulations have increased and more expertise is required to fulfil reporting requirements (https://yourfuture.accaglobal.com/).

Revenue Recognition (Part N)

by

Charles Lamson

Accounting for Long-Term Contracts

Long-term contracts are a type of transaction for which firms report revenue, costs, and gross profit over time as opposed to at a point in time. They are prevalent in industries such as communications, home building, software development, aircraft, shipbuilding, and construction. Consider a company that enters into a contract to manufacture or build a product for the consumer when the manufacturing process will take a period of time substantially longer than a year. If the firm recognized revenue at a point in time, it would not recognize the revenue (and associated gross profit) attributable to the long-term contract until it completed the product and delivered it to the customer. However, as we discuss next, this approach may not provide the most accurate presentation of the company's financial position and economic performance.

There are two accounting methods for revenue recognition for long-term contracts: the percentage-of-completion method and the completed-contract method. Total revenue and costs for a long-term contract are the same under both methods. The difference between the two approaches is the timing of revenue and gross profit recognition on the contract. The percentage-of-completion method recognizes gross profit over the production period whereas the completed-contract method recognizes gross profit only at the end of the contract.

Recall from Part 125 that goods or services are transferred over time if the seller meets any one of the following three criteria:

1. The customer receives and consumes the benefits of the goods or services simultaneously (for example, health club memberships and magazine subscriptions).

2. The customer controls the asset as the seller creates it or enhances it over time (for example, software updates).

3. The asset the seller is creating does not have an alternative use to the seller, and the seller has an enforceable right to payment for the performance completed to date.

An entity should use the percentage-of-completion method when it meets one of the three criteria for goods and services transferred over time, and it can reasonably measure its progress toward completion. If these conditions are met, the financial statements are more accurately presented under the percentage-of-completion method because the entity's economic activities are reported on the income statement. If the contract does not meet any of the three criteria or if the entity cannot reasonably measure progress toward completion, then it uses the completed-contract method. For example, General Electric Company will use the completed contract method to account for the revenue from the production of commercial airplane engines because contracts do not transfer control during the manufacturing process. We discuss each of these methods next. 

Percentage-of-Completion Method

In this section, we discuss accounting for contracts under the percentage-of-completion method. We begin with a discussion of estimating the percentage of completion of a long-term contract. Then, we explain the accounting procedures and introduce accounts specific to accounting for long-term contracts.

Determining the Estimated Percentage of Completion. Firms can estimate the degree of completion by using input measures (for example, miles of highway and the number of cell towers installed), or engineering estimates.

Input Measures. A common method used in practice, the cost-to-cost approach estimates the cumulative percentage of completion by dividing the total cost incurred to date by total estimated costs as follows: 

Cumulative Percentage Complete = Total Costs Incurred to Date / Estimated Total Cost of the Project     (8.1)

The estimated total cost of the project equals the total actual costs incurred to date plus the estimated costs to complete the project. The estimated total cost of the project is likely to change throughout the contract. This does not create a problem because the ratio is computed each period using the current costs to date and estimated total cost.

Determination of Revenue, Costs, and Gross Profit under the Percentage-of-Completion Method. Under the percentage-of-completion method, firms recognize revenues based on the project's stage of completion. Specifically, firms recognize revenue, cost, and gross profit in each year by:

1. Computing cumulative revenue by multiplying the total estimated contract revenue times the percentage complete. Revenue for the current period is cumulative revenue less revenue recognized in all prior periods.

2. Recording actual costs for the current period as incurred (This is simplified somewhat. Some costs will actually be capitalized and amortized in a systematic basis consistent with the transfer of the good or service to the customer.)

3. Computing gross profit for the year as the revenue recognized in the current period in (1) less the costs recognized in the period in (2). 

If the reported costs exceed the reported revenues in a given year for an otherwise profitable contract, then the gross profit is negative. In this case, the firm credits construction and progress in the journal entry made to record revenues, cost, and gross profit.

Example 8.21 illustrates the computation of revenue and gross profit under the cost-to-date approach. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 401-403*

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