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:
- 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
- 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:
- For a specified number of similar acts, an equal amount of Revenue is recognized for each act.
- 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.
- 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:
- Initial direct costs, directly associated with negotiating and signing the contract (for example, legal fees)
- Direct costs, directly related to services performed (for example, labor costs)
- 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.