Revenue Recognition Prior to the Period of Sale

Long-term construction contracts arise when a company agrees to construct an asset (e.g., buildings, ships,
bridges) for another entity over an extended period. The buyer may provide advance
payments to help finance construction, but the legal sale does not take place until
the asset is complete. Two alternative revenue recognition methods are possible:
(1) the percentage-of-completion method in which a company recognizes profit each
period during the life of the contract in proportion to the amount of the contract
completed during the period, and values its inventory at the costs incurred plus
the profit recognized to date, less any partial billings; and (2) the completed-contract
method in which a company recognizes profit only when the contract is complete and
records inventory at cost, less any partial billings.


A company can
determine the percentage completed by either “input” or “output” measures. The cost-to-cost
method or efforts expended method are two input measures. With the cost-to-cost
method, the company measures the percentage of completion by comparing the cost
incurred to date with the expected total costs for the contract. With the efforts-expended
method, the company measures the percentage of completion by comparing the work
(labor hours, labor dollars, machine hours, material quantities, etc.) performed
to date with the total estimated work for the contract. Under either method, once
the percentage of completion is determined, this percentage is multiplied by the
total revenue on the contract to compute the revenue to be recognized to date. The
revenue to date minus the revenue recognized in previous years is the revenue to
recognize in the current year. The expense to be recognized is determined in the
same way. Alternatively, a company can use output measures such as units produced,
units delivered, value added, or other measures of production to measure the percentage
of completion. The results achieved to date compared to the total expected results
of the contract are used to measure percentage of completion. The revenue and expense
are computed in the same way as discussed above for the input measures.



Under the percentage-of-completion
method, a company uses an account titled Construction in Progress to record all
the costs incurred on the project as well as the gross profit recognized to date.
A Partial Billings account is used to record receipts paid by the buyer during construction.
This account is a contra account to Construction in Progress. When there is a net
debit balance in the Construction in Progress account, it is reported on the company’s
balance sheet as an asset, and when there is a net credit balance, it is reported
as a liability.



Consistent with
the conservatism convention, a company must record estimated losses on long-term
contracts in full under both the percentage-of-completion and completed-contract
methods at the time it estimates the losses. If there is a loss in the current period,
but a profit on the total contract is anticipated, the loss recognized is equal
to the difference between the revenue recognized for the year and the construction
costs incurred for the year. However, if a loss on the total contract is anticipated,
the gross profit on the contract to date must be removed, in addition to recognizing
the loss. This is done by debiting Construction Expense for the amount of the loss
plus the amount needed to reduce the cumulative profit in the Construction in Progress
account to zero. The provision for the loss is a contra-account to Construction
in Progress.



When more than
one act is required under a long-term service contract, a company recognizes revenue
by the proportional performance method. That is, the company recognizes revenue
in proportion to performance of each act, as discussed below.



Recognition under
the proportional performance method depends on the type and number of service acts:



(a) For a specified
number of similar acts, an equal amount of Revenue is recognized for each act.



(b) For a specified
number of defined but not similar acts,



Revenue recognized
for each act is based on the ratio of the direct costs (see below) of the act to
the total estimated direct costs under the contract.



(c) For an unspecified
number of similar acts, revenue is recognized on a straight-line basis over the
performance period.



Costs under a
long-term service contract include (a) initial direct costs, directly associated
with negotiating and signing the contract (for example, legal fees), (b) direct
costs, directly related to services performed (for example, labor costs), and (c)
indirect costs, not included in either of the preceding categories.



Initial direct
costs are deferred and allocated over the performance period, in proportion to service
revenues recognized. Direct costs and indirect costs are expensed as incurred.